Distress will be felt beyond ‘the epicenter of the earthquake’

When it comes to distress in private real estate, the office sector is just the tip of the iceberg.

Although the first significant defaults of the current cycle have been concentrated in the out-of-favor sector, they are just the early signs of what Ralph Rosenberg calls “pattern recognition that’s going to be applicable to all property types in all markets, based on the capital constraints and the cost of capital.”

Speaking with PERE over Zoom, the global head of real estate at New York-based mega-manager KKR explains “there are a few high-level issues going on that people cannot ignore.”

The first is the lower amount of available liquidity in the financing markets for all property sectors, as lenders take higher reserves and potential losses from write-downs in the office sector.

Even in favored property types and markets, lenders will be more defensive, conservative and discriminating about originating an incremental loan going forward due to the negative effects of their exposure to the office sector, which accounts for about 40 percent of real estate exposure across both regional and money-center banks, Rosenberg points out.

“The epicenter of the earthquake might be traditional commodity office space, but the tremor will be felt in all other sectors based on availability of capital and the pricing of that capital.”

Office was the largest source of distress among property types during the second quarter, representing nearly 35 percent of total outstanding distress and 27 percent of total potential distress, according to data provider MSCI’s Q2 2023 US Distress Tracker. However, while apartments made up less than 10 percent of outstanding distress, they accounted for more than 23 percent of potential distress – the second-largest source after office.

“The potential distress in the apartment sector is unexpected when you look at it relative to, say, office,” says Alexis Maltin, head of Americas real assets research at MSCI. That is primarily because of the considerably larger size of the apartment sector relative to office; Maltin estimates the investable universe for US apartments is more than 180,000 assets, compared with fewer than 100,000 for US offices.

‘Massive deleveraging cycle’

For Rosenberg, the second high-level issue is interest rate caps needing to be extended as $1.4 trillion of mortgages – the majority of which are floating rate – are due to mature over the next two years. “You’re effectively prepaying a lot of interest and the cost of those caps is going to put, in our opinion, an unsustainable overhang on the real estate industry that we’re just starting to see. And a lot of borrowers are just not going to have the financial wherewithal to fund the cost of these caps as SOFR has gone from zero up close to 6 percent.”

As a result, borrowers in even the healthiest of property types are putting more equity into refinancings because the cost of borrowing has quadrupled on an absolute basis over the past two years, while the availability of loan proceeds is much lower, he says.

The third issue is the multiple types of property owners that have limited access to capital and will need to create liquidity by selling properties. This includes managers of open-ended funds and non-traded real estate investment trusts that are facing redemptions and are unable to raise new money; sponsors of value-add and opportunistic funds that lack sufficient reserves to be able to draw capital to de-lever; developers that financed projects with short-term construction loans and now need to put permanent capital in place; and listed REITs with maturing mortgage debt.

The confluence of these issues will result in distressed investment opportunities in many on-trend real estate sectors. “Self-storage, senior housing, student housing, multifamily, single family for rent, life sciences, manufactured housing, data centers are all examples of themes that we believe have durability and sustainable demand drivers going forward,” Rosenberg says. “And within those themes, there’s a whole world of real estate opportunities available that could be very healthy properties, but that are going to be subject to this massive deleveraging cycle.”

A different distress opportunity

But compared with the aftermath of the global financial crisis, when distressed properties were cash-flowing but overleveraged assets, “it’s a different distress opportunity cycle,” Jim Costello, chief economist at MSCI Real Assets, remarks. “It’s largely a fundamental problem.”

One exception is the apartment sector, where distress is primarily coming from multifamily syndicators that took on too much debt and got into trouble when interest rates went up. “Apartment is still cash flowing,” he says. “It’s not like it’s suffered a fundamental shock, where people are wondering if it ever works again.”

Distressed buyers are also more likely to pursue opportunities in apartments and other highly favored sectors because those assets generally do not require repositioning, unlike office or retail. “Some of the struggling asset classes, those assets may not be usable in their current form,” explains Maltin. “To the extent that you’re buying an asset, and you’re not interested in redeveloping or really spending more money to repurpose that asset, that might not be a viable opportunity for you.”

Although private equity firms and other institutions are ready to deploy dry powder in distress, buyers to date have been primarily local developers or owner-operators. “The institutional players largely target those larger deals,” Maltin notes. “They need to put more capital to work in a single deal for a deal to make sense for them. And we just haven’t seen that happen thus far.”