(Bloomberg) — Desperate investors see one of the best opportunities in a generation to buy U.S. real estate assets as the commercial property crash continues to roil the market.
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Private equity firms are already positioning themselves to take advantage. About 64% of the $400 billion in dry powder the industry has set aside for property investment is targeted in North America, the highest percentage in two decades, according to data compiled by Preqin.
The fear elsewhere is that a strong US bias will mean other parts of the world won’t attract the same demand, delaying the work on distressed loans and properties there.
PE firms want to take advantage of deep US discounts as office values fell by almost a quarter last year, more than in Europe, following the pandemic work from home. Nearly $1 trillion in commercial real estate debt will mature this year in the U.S., according to the Mortgage Bankers Association, and rising defaults as borrowers default will create more options for buyers of distressed assets.
“Compared to the S&L crisis and 2008, we’re still in stage one or two” when it comes to distressed assets, said Rebel Cole, a finance professor at Florida Atlantic University who also advises Oaktree Capital Management. . “A tsunami is coming and the waters are receding from the beach.”
John Brady, global head of real estate at Oaktree, is equally open about what lies ahead: “We may be on the precipice of one of the most significant distressed real estate investment cycles of 40 years. end,” he wrote in a recent note on the United States. “Few asset classes are as unloved as commercial real estate, and so we believe there are few better places to find exceptional bargains.”
This focus means that other regions may be left with downstream suppliers – so called because of the low bids they usually make – as the top bidders. That risks dragging down values further in Europe and Asia, or leaving some markets stuck in limbo as sellers and lenders refuse to budge on super-low offers.
North America’s strong economy, deeper markets and currency strength could contribute to “a delayed market recovery” outside the region, said Omar Eltorai, director of research at data provider Altus Group.
The U.S. opportunity is being driven by lenders pulling back from commercial real estate as borrowing costs rose and values fell. Asset manager PGIM estimates a nearly $150 billion gap between the volume of loans coming due and the availability of new loans this year.
“When you start to get into the cycle, the big market is where people find the opportunities,” John Graham, chief executive at the Canada Pension Plan Investment Board, said in an interview. For everything from private equity to private credit and commercial real estate “the US is the biggest and deepest market.”
Smaller lenders appear particularly vulnerable because of their exposure to real estate, and there has already been turmoil in the sector. New York Community Bancorp had to take a capital injection of more than $1 billion earlier this year as its financial challenges mounted. More regional bank failures are likely due to their property debt, according to Pimco.
Based on Oaktree’s analysis, the number of US banks at risk would exceed levels seen at the 2008 financial crisis levels if CRE values fell by just 20% from their peak. Office values there fell 23% last year, according to the IMF.
Barry Sternlicht, chairman of real estate investor Starwood Capital Group, has also indicated that he sees more trouble ahead for lenders.
With regional banks, “you wonder what’s going on, how can they not experience bigger losses, certainly in their back office portfolios,” he said on an earnings call in May.
Starwood hasn’t been immune to trouble either. Its real estate income trust tightened limits on investors’ ability to withdraw money from the vehicle to maintain liquidity and avoid asset sales.
Shrinkage pool
While the US looks attractive to private equity buyers, the overall pool of PE capital for CRE has shrunk. This will bring some problems for credit investors, for example.
The amount of money set aside for real estate debt strategies globally by firms shrank 26% to $56.1 billion through May from the end of 2021, Preqin data shows. This could, for example, limit buyer interest in non-performing CRE loans from Korea to China as the loans go sour.
“Dry powder is in decline,” said Charles McGrath, an associate vice president at Preqin. Higher borrowing costs mean private equity players “are seeing a sharp decline in fundraising and transactions.”
One of the main obstacles for investors in Europe are doubts about the stability of real estate and credit valuations. They “may not always provide an accurate reflection of the true value of assets, particularly in light of changing market conditions,” the European Insurance and Occupational Pensions Authority wrote in a June report.
Banks in Germany, for example, update appraisals on buildings they’ve financed less regularly than counterparts in the US, meaning it takes longer for problems to surface. The delay in writedowns comes even as the amount of CRE debt with a loan-to-value ratio of more than 100% approaches 160 billion euros ($173 billion), according to the region’s banking watchdog.
This suggests there is a large wave of defaults and distressed asset sales to hit the balance sheet, although the debt structure means it could take years for the full scale of the trouble to emerge.
The situation is likely to worsen, with a further rise in non-performing loans, European Banking Authority President Jose Manuel Campa told Bloomberg Television. “This is a trend that will not be short-term.”
— With help from Anna Edwards.
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