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.
We have probably entered a long period of substandard returns, even losses, that frustrate those looking to take advantage of distress
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.
