Distress, Opportunistic Fundraising Dries Up With Deals Failing To Materialize

Historically, times of distress are when empires are made. 

So when Covid-19 spread across the globe, shuttering businesses and causing economic turmoil, real estate firms laid the groundwork to take advantage of others’ suffering. 

Since the second half of 2021, 594 real estate opportunity funds have been established, raising over $210B in aggregate capital, according to data provided to Bisnow by Preqin. Over the same time period, 33 distress funds were created, with over $6B raised.

However, four years since the onset of the pandemic, many of those funds have yet to be deployed. During that same time, investors have shifted their money away from acquisitions, eyeing a potential tsunami of debt maturities that could cause more pain to prey on.

“One of the challenges is that there has been a backlog of transactional activity,” said Eric Requenez, a partner in Ropes & Gray’s asset management group. “There are a lot of funds out there that are nearing the end of or have reached the end of their investment period that are going to investors to extend given the market.”

Since opportunity funds raised a total of $70B in 2022, contributions have dwindled, falling to under $56B last year and $31B in the first three quarters of 2024. Opportunity funds are defined by Preqin as those that invest in “high-risk real estate that provides high returns,” specifically in lower-quality buildings that need significant upgrades.

Investment in distressed assets have plummeted even more. In 2022, 13 funds were established, with $4B raised across new and existing funds. This year, just two funds were created with $240M raised. 

The number of U.S. properties in financial distress has continued to rise, reaching $102.6B in the third quarter, according to MSCI. But the pace of that increase has slowed. What's more, there was $261B of potential U.S. CRE distress at the end of September, but that number dipped from the second quarter. 

One reason for the lower-than-expected level of distress is banks have been more willing to modify or extend their loans, allowing owners to hang onto their properties for longer. A report by the Federal Reserve Bank of New York estimates that the banking sector has $400B in near-term commercial real estate loan maturities on their books. As of Q4 2023, the maturity wall represents 27% of bank capital, up 11 percentage points from 2020, according to the report.

In previous financial crises, distressed properties would have already worked their ways through the system, allowing opportunistic buyers to scoop them up on the other end.

In 2020, several CEOs who have benefited from that cycle in the past proclaimed that the latest economic downturn would once again be favorable for those who could stomach the risk. 

That includes Barry Sternlicht, who launched Starwood Capital Group in 1991 to buy assets being liquidated by the government as a result of the savings and loan crisis. Since then, his firm has grown to manage approximately $115B in assets and Sternlicht has become a billionaire.

“When it’s really ugly, it’s a good time to invest,” he said in May 2020.

Many other firms had the same thought. KKR & Co., Apollo Global Management, Ares, Blackstone and Lone Star Funds are among the equity giants that have raised billions of dollars in dry powder.

But now, deals have been stalled and investor money has simply been tied up. 

“There's a number of legacy, closed-end funds that have not had as many dispositions of their assets and thereby distributions of capital to their investors,” Requenez said. “As a result, the investors don't have as much capital to reinvest in the next product.”

Conversely, direct lending has steadily held interest, despite the number of funds established decreasing, according to Preqin data. These funds might be more in favor because of the dramatic pullback of traditional commercial real estate lenders like banks and CMBS.

KKR's head of real estate credit wrote in September that the space provides "equity-like returns" because of the vacuum left by banks in the sector.

Since the second half of 2021, firms have established 407 funds specializing in direct lending, raising $128B of capital. 

Goldman Sachs raised a $7B real estate credit fund this year, and Madison Realty Capital closed a $2B CRE debt fund in September. SL Green Realty, which is the largest owner of office buildings in New York City, launched a $1B opportunity debt fund earlier this year with an expected initial closing in Q4, according to earnings reports.

But experts say that in creating these funds, firms must be strategic.

Earlier this year KDM Financial launched its first-ever fund, seeking $350M to provide bridge and opportunistic lending primarily in the multifamily sector. 

KDM Financial CEO and President Holly MacDonald-Korth said that she believes now is the right time for the fund due to its ability to provide fresh capital for borrowers, including those who worked with funds launched in 2021 and 2022, looking for workouts as rates fall and assets are reassessed.

“It is a difficult fundraising environment right now,” MacDonald-Korth said. 

However, she added that KDM Financial’s fund has been well-received.

“Me versus a household name, what do I really offer to an investor, besides my excellent hands-on management and ability to be nimble?” MacDonald-Korth said. “The biggest institutions are, by feature of their size, not as creative, and our ability to problem solve is what lets us earn excess returns.”

Many funds launched earlier on failed to be as defined in their goals. Those are the ones that investors may be less likely to throw money at now, according to Ropes & Gray partner Matt Posthuma, who leads the firm’s real estate funds team.

“The funds that I'm seeing that are most successful are the ones that have specific, distinctive, niche strategies where the manager can really say, ‘I'm an expert in this asset class, geography or type of investment,’” Posthuma said. “It's really a tale of two cities.”