Originally published January 2021.

Real estate distress cycles generally offer rich pickings to investors, but that’s unlikely to happen this time – and here’s why.

This article discusses the potential path for a distress cycle in US commercial real estate given today’s combination of central bank policies, investment product innovation and investor demand for commercial real estate. From a fundamental standpoint the imbalance of supply and demand in certain key coastal cities (most importantly New York) means that the odds of a significant wave of distress taking place seem quite high.

The risks were building even prior to the covid shock to demand, created by aggressive overbuilding and overpricing of real estate over the last decade. The covid shock has brought simultaneous pressures to bear on retail, office and residential property which significantly outpace anything seen even in deep recessions, greatly increasing the pressure on an already tricky environment. However, the odds of a traditional distress cycle creating outsized returns for intrepid investors seem quite low. Instead we have probably entered a long period of substandard returns, even losses, that frustrate those looking to take advantage of distress in the months ahead.

I am no stranger to distress investing in real estate myself, having amassed a portfolio of multi-family properties in the aftermath of the savings and loans crisis in the early 1990s and raised a commercial mortgage-backed securities fund in the aftermath of the global financial crisis. The opportunity set this time around looks much less appealing, for reasons I will discuss. But first it is worth revisiting the previous two distress cycles in order to reveal what made them so destructive to the original investors and so rewarding to those that followed.

During the 1980s the boom in regional commercial real estate markets was funded almost entirely by conventional bank mortgages. Investor capital was generally raised in GP/LP (general partner/limited partners) structures, and typically the general partner was required to provide a personal guarantee for the mortgage. Lenders grew rapidly, and typically issued multiple loans to the same investor groups.

As the boom progressed the Federal Reserve started to tighten monetary policy in 1986, taking the policy rate up to 9.75% in 1989, 300 basis points above its earlier level. This raising of interest rates proved fatal to commercial real estate in many key markets (NYC was pre-eminent), leading to a rapid spike in delinquency. Although banks retained personal guarantees, these became worthless in the face of losses that outstripped borrowers’ finances, and the wave of foreclosures was quickly followed by a widespread failure of second-tier lenders that became known as the savings and loan crisis.

This created a toxic combination of expensive money, low liquidity, transfer of ownership to banks that were administratively incompetent and increasingly insolvent, and a pool of industry veterans crippled by personal guarantees and broken promises to end investors. The US government entered the fray by creating the Resolution Trust Company, which sold assets stripped from defaulting banks to the small pool of investors willing and able to purchase them. By 1992 it was not unheard of for NYC multi-family properties to trade at 20% of prior peak valuations, and a multiple of five times gross rental income was considered a high price to pay. Despite the difficult operating environment and unavailability of loans for financing, it was hard for distress investors not to make excellent long-term investments at these prices. Unfortunately, the complete absence of demand for CRE investment made raising the funds required extremely onerous, but the deals that were done were generally extremely profitable.

The distress cycle of 2007-08 looked very different. Lending had migrated away from traditional bank lending towards commercial mortgage-backed securities, which it was anticipated would spread risk efficiently over a wide variety of investors, each of which could balance the risk it wished to take against the reward on offer. This is recent enough history for me to assume that readers have a high degree of familiarity with the debacle that followed, but it is worth pointing out that relatively little true distress took place in commercial real estate. The collapse of CMBS prices was driven mostly by the absence of liquidity in financial markets. The forced liquidation of massive leveraged books built by credit hedge funds and investment banks trying to benefit from the small carry between AAA CMBS tranches and Treasury yields created an excellent opportunity for those able to deploy new capital in the aftermath of the crisis. The absence of personal guarantees also left the original sponsors free to rescue their own underwater projects.

Once again, lessons were learned and new mistakes made. On the plus side CMBS underwriting became much more stringent, with far lower LTVs allowed and more conservative appraisals. Less helpful was the emergence of the belief that commercial real estate was a defensive asset, and that global cities such as New York are immune to the norms of investment cycles. Crucially, the gap between CMBS and bank loan funding levels available in the current cycle and prior LTV levels was filled by mezzanine lending, and the splitting of debt capital among bank and non-bank lenders. What had been a bi-party (borrower and lender) relationship in 1990 and a tri-party (borrower, lender, CMBS investor) relationship in 2008 has expanded into a multi-tiered structure. Similarly, the equity invested is now likely to come from a dedicated real estate fund or REIT rather than from the relatively small pools of capital that previously made up equity.

All of the above has created an environment that is arguably less risky for the traditional bank lenders, but the risk has been effectively transferred to the various pools of professional real estate investors that now dominate equity and non-bank financing, and their client base of institutional and high-net-worth investors. An additional wrinkle is that many fund families have raised multiple products that play at different levels of the capital stack, be it equity, mezzanine or junior debt. This has created a very incestuous environment whereby the same sponsors now commonly appear in each other’s deals taking different roles. During the recently completed boom this hardly seemed to matter, with the process being essentially collaborative and constructive. However, with the tide now going out and foreclosure activity rising, the strains between what are after all competing fund complexes can be expected to show.

Unlike the prior two distress cycles, this one is taking place against a backdrop of super-abundant liquidity and record low interest rates. The popularity of commercial real estate has if anything been enhanced, leading to a wave of outsized fund raising by dedicated distressed funds, many of which are controlled by those who already dominated real estate funding and lending. For a sense of what happens next one should look at the energy sector, which has been suffering a long and brutal bear market that started over five years ago and is yet to obviously reach its conclusion.

Back in 2015, the energy sector was the largest issuer of high-yield credit and was enjoying a boom that many predicted would last for a decade or longer. The collapse of prices that followed caught most by surprise, and since this peak hundreds of billions of dollars have been written off both equity and debt values. Despite these enormous losses, the US banking system has suffered no obvious distress (it is hard to identify a single large regional bank brought to its knees by energy loans). Instead the pain has been transferred to public and private equity markets and a large pool of dedicated energy investors. These include some very prominent distress investors that aggressively entered the sector following its collapse in 2015-16.

Only after five years have we reached the point at which dedicated money for energy investing is very hard to raise, with most distressed funds shuttered and double-digit yields in blue-chip equities such as Exxon and a host of master limited partnerships shunned. Investors are now more worried about the return of capital than the return on it, which may indicate we are finally close to a bottom for this beleaguered sector.

The energy sector’s situation seems a much more useful template for commercial real estate in the coming quarters than the prior two real estate cycles. Relatively conservative bank and CMBS lending makes these venues unlikely sources of stress. Instead we envision a hot-potato cycle, whereby a deteriorating set of cash flows sees an asset transferred from equity holder to mezzanine and then to loan capital. We are much less likely to see a cascade of distressed assets hit the market under this scenario; instead the process is likely to be greatly elongated and remain largely trapped within the existing pool of investors.

The abundance of dedicated distress capital raised means those assets that are disgorged are likely to be the subject of bidding wars, making bargains extremely unlikely to be available. The paradox of liquidity is that a distress cycle at a time of ultra-loose monetary policy means it is now far easier to raise capital for distress investing than in the periods following the savings and loan crisis or the global financial crisis, but the odds of generating an acceptable return seem far lower this time around.