So, About That Distressed-Asset Feeding Frenzy ...

The back half of this year promises chances for private equity to make opportunistic real estate plays, but it won’t be as straightforward as the recovery from the global financial crisis.

Two running themes in the real estate market in the early portion of this year are likely being monitored by private equity investors looking for a post-pandemic windfall: the anticipated wave of distressed-asset sales and the persistent discounts at which some public real estate investment trusts are trading relative to their net asset values.

Private equity managers like Blackstone were able to take advantage of post-recession conditions over a decade ago to buy billions of dollars’ worth of commercial property. In late 2010, 20% of all commercial property sales were distressed-asset deals, according to Real Capital Analytics.

Without being beholden to risk-averse shareholders, the thinking goes, private equity can go against the grain to place bets when others are playing defense. Billions of dollars are being raised for that purpose at this very moment, The Wall Street Journal reports. There might be as much as $200B in capital ready to invest in distressed assets, according to CoStar Risk Analytics. But conditions are quite different this time around.

“The debt market is extraordinarily liquid, whereas it was frozen during the GFC,” JLL Senior Managing Director Steve Hentschel told Bisnow. “Hands won’t be forced the way they were before.”

Because capital markets weren’t the root cause of this recession, its impact varies wildly depending on the sector. And because the recession changed the way society lives and operates, distress for an asset might be more of a permanent condition, which makes the job of actually turning around the property a much more arduous task.

“One of the differences about this cycle is that you used to be able to buy a distressed asset and turn it back into what it once was,” CenterSquare Investment Management Chief Investment Strategist Scott Crowe said. “This time, you’ll need to convert it into something new, because the pandemic has accelerated previously existing trends.”

Shopping malls had been falling out of favor for years before they all but emptied out in 2020, and office-using companies were already rethinking their space needs before remote work became absolutely necessary. Hospitality and urban multifamily may recover in short order once the coronavirus vaccine is widely distributed, but when or if that will happen is impossible to project.

“If we do observe that some of the behaviors that have emerged during the pandemic exhibit significant persistence, that will present some challenges for institutional participants in the real estate market that have specific sector expertise,” said Sam Chandan, New York University's Larry & Klara Silverstein Chair of Real Estate Development & Investment and the dean of its Schack Institute of Real Estate.

Since hotels suffered the most immediate economic effects of the pandemic and have yet to start truly recovering, smaller owners are the most likely to have their hand forced and lose properties to foreclosure.

Hotel owners aren't as likely to voluntarily turn over the keys as are mall owners, since it remains possible that business can come roaring back once an as-yet-unknown threshold of community vaccination has been reached. Malls are the properties Trepp considers most likely to see deed-in-lieu activity in its 2021 forecast.

“If you’re the owner, you’re probably fighting to not give the asset back and kick the can down the road as much as you can, because by the end of this year things might be very different,” Crowe said.

Lenders have similarly not been eager to take possession of struggling assets before a sure path to recovery is visible, which is why the foreclosure rate for CMBS loans has remained below 1.5% through December, according to Trepp. When the CMBS market was in its most dire state after the great financial crisis, the foreclosure rate was over 2.6%. Still, there might come a breaking point if too many loan payments are missed or an asset starts lagging behind the overall market.

“Servicers, lenders — everybody was willing to work with borrowers because of the pandemic issue, and everyone was working together to maximize value,” said Mark Silverman, who co-leads national law firm Dykema’s CMBS special servicer group. “So if forbearance was necessary to get through a period of time, great, but the question as that forbearance period ends is, “Now what?’”

Even if the distressed asset market never materializes as some hope, REITs with exposure to the struggling sectors have been trading at discounts relative to their estimated net asset value for months now. REITs are often among the savviest players in terms of reacting quickly to market trends — by the end of 2009, REITs had already largely recovered from the 2008 crash — those trading discounts may correspond to a lack of available equity or debt capital to act on their knowledge, Hentschel said.

The longer a REIT trades at far below its NAV, the more likely it is to either be snapped up in a merger or taken private, like Brookfield Asset Management is attempting to do for its main property vehicle. One stumbling block for acquisitive private equity investors is that NAV is so difficult to determine. The lack of sales for analysts to form comparisons could translate to NAV being the element that’s due to be corrected.

“If these valuations stick around, you are going to see privatizations, and you’ll see it toward the end of this year,” Crowe said. “You haven’t seen quite enough price discovery in the private markets for those buyers to transact.” 

Other factors could also be at play, such as the subtype of property that REITs tend to own. Within multifamily, public companies are more likely to hold core urban assets, which are the worst-performing in the sector. Combined with low sales activity, that could explain why residential REITs ended 2020 trading at a 2.4% median discount relative to NAV, according to Seeking Alpha, while the private multifamily market has been strong, Hentschel said.

As the economic picture becomes clearer in the latter part of the year, some distressed-asset sales are likely to occur, and private equity will likely be well-positioned to take advantage, Hentschel and Crowe agreed. But those who have kept powder dry in anticipation of a bonanza might be left disappointed.

“Private equity will come into play here, but I don’t think it will be at the pricing everyone expects,” Silverman said.