(Bloomberg) — As a crash in commercial property prices continues to roil markets, distressed investors are finding one of the best opportunities in a generation to buy troubled U.S. real estate assets.
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Private equity firms are already gearing up to seize the opportunity: About 64% of the $400 billion the industry has set aside for real estate investments is headed to North America, the highest share in the past two decades, according to data compiled by Preqin.
Elsewhere, there are fears that a stronger U.S. bias could mean the rest of the world won't generate the same demand as the U.S., slowing the liquidation of troubled loans and properties.
PE firms are hoping to take advantage of steep discounts in the U.S. after office prices fell nearly 25% last year compared to Europe as the pandemic shifted people to work from home.More U.S. commercial real estate-related debt is set to mature this year, and rising defaults as borrowers can't repay will give buyers of distressed assets more options, according to the Mortgage Bankers Association.
“Compared to the savings and loan crisis or 2008, we're still in the first or second innings in terms of troubled assets,” said Rebel Cole, a finance professor at Florida Atlantic University who advises Oaktree Capital Management. “The tsunami is coming, and the waters are receding from the shore.”
John Brady, global head of real estate at Oaktree, is equally blunt about what's to come: “We may be on the brink of the most significant real estate investment cycle in the last 40 years,” he wrote in a recent report on the U.S. “We believe there are few asset classes more unpopular than commercial real estate, and therefore few better places to find great bargains.”
That focus means that in other regions, so-called “bottom feeders” — who typically submit low bids — could become the main bidders, threatening to push prices further down in Europe and Asia and send some markets into a tailspin as sellers and lenders refuse to budge from ultra-low bids.
Omar El-Trai, research director at data provider Altus Group, said a strong North American economy, market depth and a strong currency could contribute to a “delayed market recovery” outside the region.
The story continues
The opportunity in the U.S. comes as lenders pull back from commercial real estate as borrowing costs rise and prices plummet. Asset manager PGIM estimates there is a roughly $150 billion gap between the amount of loans coming due this year and the amount of new credit available.
“As you start to get into the cycle, you find opportunities in big markets,” John Graham, chief executive officer of the Canada Pension Plan Investment Board, said in an interview. From private equity to private credit to commercial real estate, “the U.S. is the largest and deepest market.”
Smaller institutions appear especially vulnerable because of their higher real estate-related risks, and the sector has already seen turmoil: New York Community Bancorp Inc. had to inject more than $1 billion in capital earlier this year as its financial troubles deepened. Pimco says regional bank failures will likely be driven by real estate-related liabilities.
Oaktree's analysis found that if CRE prices fell just 20% from their peak, the number of U.S. banks at risk would exceed those seen during the 2008 financial crisis. U.S. office building prices fell 23% last year, according to the IMF.
Barry Sternright, chairman of real estate investment firm Starwood Capital Group, also sees more problems ahead for lenders.
“It makes you wonder what's going on, why aren't they suffering bigger losses, especially in their office portfolios,” he said of regional banks on an earnings conference call in May.
Starwood has not been immune to the problems. Its real estate income trusts have tightened restrictions on investors' ability to withdraw money from the trusts in an effort to preserve liquidity and discourage asset sales.
A shrinking pool
While the US looks attractive to private equity buyers, the overall pool of PE capital for CRE is shrinking, which will create some problems for credit investors, for example.
The amount of capital secured by firms globally for real estate debt strategies fell 26% from the end of 2021 to May to $56.1 billion, according to Preqin data. This could limit buyer interest in distressed CRE loans from South Korea to China, for example, if the loans go bad.
“Dry powder is declining,” said Charles McGrath, a vice president at Preqin, as rising borrowing costs mean private equity investors are “seeing a sharp decline in fundraising and deals.”
One of the main deterrents for European investors is doubts about the robustness of property and loan valuations. “Property and loan valuations do not always accurately reflect the true value of assets, especially given changing market conditions,” the European Insurance and Pensions Agency wrote in a June report.
German banks, for example, update the valuations of the buildings they finance less regularly than their U.S. counterparts, which is why problems take longer to surface: The region's banking regulator says write-downs are lagging even as CRE debt with loan-to-value ratios above 100% approaches 160 billion euros ($173 billion).
This suggests that defaults and failed asset sales will have a massive impact on balance sheets, but the structure of the debt means the full extent of the problem may take years to become apparent.
European Banking Authority President Jose Manuel Campa told Bloomberg Television that the situation could worsen further as bad loans rise. “This is not a short-term trend.”
–With assistance from Anna Edwards.
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