Private Equity Will Have To Work Harder To Win This Downturn

Private equity firms were the big winners and made huge profits in the wake of the last major real estate downturn. This time around, they will need to find a new playbook. 

“Low economic growth and high interest rates is not a great recipe for real estate investment,” for buyers that use debt especially, MSCI Head of EMEA Real Estate Research Tom Leahy said. 

In Europe, private equity firms were net sellers for only the second time in the past four years, MSCI data showed. In the U.S., where rates rose sooner, these buyers turned net seller in the second quarter of the year, before becoming net buyers again in the third quarter. 

“You have to wonder whether some of these firms are sitting on the sidelines as they have issues financing deals,” Leahy added.

After the 2008 collapse of Lehman Brothers, several factors fell into place for real estate private equity firms looking to make high returns. Banks pulled back on financing and had to sell properties at rock bottom prices, driving down values almost indiscriminately across the board. But tenants were still able to pay the rent, meaning buyers could acquire good assets at distressed prices. 

Pension funds and sovereign wealth were not as big a part of the real estate investing world in the noughties, and investment managers and REITs were among the players that had borrowed big and needed to sort out their own balance sheets. For those private equity firms new to the game or that had not overindulged during the boom, there was little competition. 

If you could source debt, central banks had cut interest rates to near zero, meaning that good, income-producing property could be bought using almost free debt. Even when financial normality returned and distressed deals dried up, interest rates stayed at zero, meaning opportunistic buyers could build up portfolios in sectors like industrial or multifamily and sell them at a higher price to pension funds hungry for real estate because it yielded more than bonds. 

Cut to today and the picture is far different.

Inflation is rampant in the U.S. and UK, and interest rates have spiked as central banks try to curb it. In most sectors, the cost of debt is above real estate yields and cap rates, per MSCI data, meaning buyers are paying more in interest than they receive in rent and making it unprofitable to buy assets at current prices for buyers that use debt. 

Sovereign wealth funds and pension funds are now prolific and sophisticated investors. And they don’t have to rely on debt to buy. As Leahy points out, growth is expected to be moribund, with the same high rates that are a challenge to real estate investors capping economic expansion. 

Distress is set come, but not in a way that is as easily accessed as previously.

Among real estate asset classes, the picture is far more mixed than in the post-2008 world. Retail remains severely challenged, the future of the office is up for grabs, and that stalwart of the last decade, industrial, is being repriced the fastest. 

It’s going to take a new strategy for private equity firms to profit from the dislocation set to affect the market, experts told Bisnow.

The drive toward more sustainable real estate might just be the big opportunity for opportunity funds this time around. Learning to love inflation, leaning on banking relationships and returning to good old fashioned asset management rather than relying on low interest rates to keep pushing up prices could be the order of the day. 

“It comes down to the levers you can pull, the nuts and bolts of picking the right location, managing the asset to increase the rent,” Crosstree Real Estate principal Safinaz Zakaria said. “As a market everybody has just been riding a wave.”

Zakaria pointed out that although rates have risen sharply this year, looked at in even a medium-term context, they are not that high. Crosstree is financing projects at the same sort of levels as 10 years ago, and is still finding finance that is accretive to acquisitions in the current market.

“It’s about sweating your banking relationships,” she said. “If you speak to lenders, there are still four or five bids to lend against good quality assets, so for some deals they will take some of the pain from rising base rates.”

The reason rates have risen this year is, of course, inflation, and while on a broader macro level high inflation is bad for economies, it is something real estate investors can tap into and profit from. 

“The correlation between inflation and property values is not as strong as some people think, the correlation between GDP and values is stronger,” Clearbell Senior Partner Manish Chande said. “But if inflation is going to remain high, there are assets that can provide protection against this.”

Chande pointed to hotels as an asset class that can be repriced daily. As costs such as staffing and food increase, prices can be increased in line. Student accommodation rents can be increased at least annually, sometimes even once every academic semester, and rented residential typically sees rents rise on an annual basis as well.

In the traditional big three asset classes of office, retail and industrial, assets with inflation-linked rents will be sought after, or investors will start looking for properties in good locations with strong demand but short leases. Even though industrial assets have repriced from historically low cap rates, rents are still predicted to grow by 10% or more in many U.S. and UK markets. 

Even in sectors like office, where levels of demand are currently uncertain, the fact that new supply will dramatically drop because of rising construction costs will support rents, and help increase them for better quality assets, Zakaria said. 

In terms of distressed deals, the kind that opportunistic and value-add investors live for, they will come through, but the pattern will be different than in the wake of the Lehman collapse.

Whereas in the post-2008 market it was loan-to-value covenant breaches that caused banks to sell, this time around it will be interest coverage ratio breaches. When a loan comes to be refinanced, if the income on a property has remained static, the fact that interest rates have risen means the income may not now exceed the interest payable. 

“There is only so much extra cost a borrower can take on the debt side,” ARA Venn partner Beatrice Dupont said. “There will be opportunities for investors to pick up assets that need to be refinanced by coming in as fresh equity.”

This might not happen to the same degree as during the financial crisis: Regulated investors like banks are a lot less heavily exposed to property than in 2008, even as the sector hit record investment volumes in 2018 and 2019. 

But where sales are forced, they will be forced a lot more quickly.

“One big difference between the [Great Financial Crisis] and today is this is not an LTV issue and you can’t brush it under the rug,” Zakaria said. “If the interest payments are not being covered, then it is a lot harder to kick the can down the road.”

One strategy Crosstree is pursuing is buying into development schemes that need to be refinanced and where there is a gap between existing debt and what a new lender will provide, providing equity to plug the hole, she said.

ARA Venn’s Dupont, who runs the company’s debt fund business, said that stepping into the breach left by retreating lenders is a good way to make money at the moment, and one which private equity firms would pursue. In 2008, such firms were mainly equity investors, but now many of them have set up debt businesses as well. If it’s harder to make money in the equity world because of the cost of debt, the reasoning goes, then provide that debt instead. 

“We’re seeing deals that we would not previously have been able to finance, it would have been a bank or another core lender,” she said. “But those groups are retrenching.”

Meanwhile, the drive to decarbonise the built environment would be a major opportunity for investors willing to take on more risk, MSCI’s Leahy said. The firm’s data showed that green buildings are now selling at significant premiums to less green counterparts. There is opportunity for private equity buyers to acquire older buildings that are likely to be facing loan maturities, bring them up to regulatory code and lease them out at higher rents, he said. 

Ironically, it could be the world’s addiction to cheap finance that means the era of more expensive finance being faced by private equity firms doesn’t last long.

“It’s not just a real estate thing, governments got the whole nation hooked on cheap debt,” Zakaria said. “About 40% of people’s mortgages renew next year. I think it’s unlikely that rates stay as high as markets are predicting, the swap curve always overshoots. The entire economy can’t handle rates rising at that pace.”