If you are a distressed real estate investor with capital to deploy right now, you do not have a great deal of time to place your bets if you are to make the most of the current opportunity. That is how John Grayken sees it.
With Western economies visibly starting to get a grip on rising inflation and interest rate hikes moderating in tandem, the veteran boss of private equity real estate giant Lone Star Funds thinks the best opportunistic plays will happen before there is widespread agreement about settled market conditions.
This journalist asks: is it important to place capital before interest rates settle? “Probably,” responds Grayken. “Once there is a general consensus, usually it’s too late for investors like us.”
He will not today be drawn on the firm’s investing activities, nor will he talk about performance or fundraising. But, in this rare interview, he is willing to share his views on the current market.
Given his vast experience, his perspective provides a lens through which to view current dislocations in the sector and gauge where opportunistic performance can be achieved. And while he will not talk specifically about any Lone Star business, he is clear that investors like him “need to be a step ahead of the market to get returns like that.”
To take such a step, a top-down perspective should be combined with more granular, asset-level analysis, Grayken says.
He recaps the state of the current US economy, which contains the world’s biggest commercial real estate market and, as such, frequently provides indicators of what is in store elsewhere in the world.
“This industry has enjoyed low interest rates, and, for the most part, accommodative monetary policy for 15 years,” he says. “During that period, the Fed funds rate maxed out for 10 years, between 2008 and 2018, at 2.5 percent. Now we’re at 5 percent – doubled. And we got to 5 percent very quickly when you consider we were at 25 basis points in March of last year. “But a lot of things happened in the 15 years in terms of valuations and capital structures. The industry became very reliant on the availability of debt capital that was inexpensive. That’s changed – dramatically and quickly.”
Grayken highlights how real estate’s heavy dependence on leverage is also a key component of the sector’s cyclicality. He notes secular differences between property markets today and before. But he reckons this perpetual relationship with debt means the next cycle should carry similar ramifications. Subsequently, he contends that sensible leverage assumed before today’s crisis will be a key determinant for the predicaments of many landlords today. “If you are a holder of this asset class and you are not properly capitalized for the environment we’re in now, you’re going to be under some pressure,” he says.
Offering further insight on the big picture, Grayken believes the “easier part” of governments’ efforts to curb inflation has now been accomplished. He lists tapering energy and food costs, a rationalization of supply chain issues following covid and the start of the war in Ukraine as contributing factors. “The global economy has adjusted to some of that,” he says.
Nevertheless, he adds, in the US, “the last numbers indicate we’re still inflating at 5 percent, which is 300 basis points above their target.” For Grayken, important questions remain unanswered: “What is the terminal rate going to be? How long will it stay there? When does it start to decrease? What is going to be the rate of decrease and over what period of time?”
“If you are a holder of this asset class and you are not properly capitalized for the environment we’re in now, you’re going to be under some pressure”
Grayken is also wondering whether there will indeed be a recession. “We’ve seen the beginnings of a slowdown, but not an outright recession. As monetary policy acts with a lag, there’s a lot of uncertainty as to what the effects of these rapid increases in interest rates will be on the macroeconomy.”
This uncertainty has paralyzed many real estate investors. According to broker JLL, global investment volumes in the fourth quarter of 2022 – the period when interest rates doubled to 5 percent – plummeted 58 percent on a year-on-year basis to $203 billion, dragging the year’s total to $1.03 trillion, 19 percent down on 2021.
While the market grapples with the macroeconomics, distressed investors must figure out what moves to make. In one key difference between now and the global financial crisis of 2008, property markets are, generally, not overleveraged. There has been little recent speculative development either.
Today’s markets are, instead, challenged by uncertainty stemming from accelerated secular changes. This has distressed investors worried about catching falling knives, as Grayken puts it. He adds his voice to a chorus which says retail and offices are facing structural issues. “There’s still some uncertainty about the ultimate level of online penetration. People still don’t know that. And I think there’s still a lot of uncertainty with respect to working from home. Certainly, that’s a trend. But we haven’t had time to measure its long-term effect on productivity. It may be the effect is not as dramatic as a lot of people think.”
For Grayken, grappling with these issues requires “a framework” around considerations of demand. Within that, it will be important to consider individual properties on their own merits. “Then price them based on your cost of capital and how you see the future from an occupier’s standpoint and from the standpoint of financial markets, cap rates and interest rates.”
“The industry became very reliant on the availability of debt capital that was inexpensive. That’s changed – dramatically and quickly”
He admits the process is going to be “complex.” But he says it is precisely because of this complexity there is such a notable bid-ask spread across markets at the moment, and that should be interesting to distressed investors. “It will persist for a period of time until there’s more clarity.”
When pressed for a timeframe, Grayken says the next two years will be important for investing while most wait for this clarity. “There clearly will be opportunities in the next 12-24 months. There’s no doubt about that. Would that be the window? I’m not sure.”
He explains there could be more than one window of opportunity, depending on whether a recession does in fact occur. “We could get into a recession. If we do, there’s going to be political pressure on the Fed to stop [raising interest rates] because of concerns about employment.” Referring to a period in the 1970s, he says: “We’ve seen it before when they stopped, but too early. And then we inflated again and there was another tightening cycle.”
Ignoring the chorus
For the current window, a significant degree of conviction about asset types is important, Grayken believes. For many, this especially applies when considering growth strategies. But he believes this also matters when running the rule over distressed assets as both can deliver profitable outcomes for opportunistic capital.
We speak shortly after Blackstone, the world’s biggest private real estate manager, announced a final closing on the sector’s biggest opportunity fund, Blackstone Real Estate Partners X, for which the firm collected $30.4 billion. Blackstone expects to make large bets in logistics, rental housing, hospitality, laboratory offices and data centers – sectors with commonly accepted growth trajectories. Conversely, the firm is publicly distancing itself from offices. Shortly after its fundraising announcement, Ken Caplan, the firm’s co-global head of real estate, posted on LinkedIn how US traditional office made up less than 2 percent of the firm’s real estate assets. In his post, he said the sector “faces unprecedented challenges, with high vacancy and rent pressures.”
Caplan is among a growing chorus blaming the office sector for much of the increasingly negative commentary about the commercial real estate sector. Indeed, offices have been widely connected to the banking crisis, which started in March with the collapse of Silicon Valley Bank and has since included trouble at other US regional banks. In another example of office ostracization, CenterSquare Investment Management, a Plymouth Meeting, Pennsylvania-based manager, released a research note extolling the resilience of the country’s REIT sector by demonstrating its exposure to office was just 3 percent of total assets.
Within this great office aversion, West Coast cities have become pariah locations. According to CBRE research, San Francisco’s office vacancy rate by Q2 this year was 29.4 percent, compared with less than 20 percent pre-pandemic. Future vacancy predictions are as high as 50 percent for the city. Other US gateway cities are suffering comparable prognoses, including Chicago, Los Angeles and New York.
But such widespread repulsion has the opposite effect for Grayken. “When I hear certain cities are being written off, that sounds interesting to me. These types of broad conclusions, they can be challenged. It may be the problems there are serious enough where pricing levels are going to be very low and unattractive to sellers. But it’s unlikely that, for a lot of these assets, the answer is zero – they’re not worth anything. I’ve heard that sort of thing before – a lot – and that usually turns out to be wrong.”
He discusses San Francisco. “Look at that market. The assets are very much technology-based. There are a lot of work-from-home effects there. But it sits adjacent to Silicon Valley, which has been the most prolific creator of wealth in this country for the last 50 years. Would I write off San Francisco? I think that would be a mistake.”
Similarly, Grayken takes a nuanced view on the retail sector. “There are certain types of retail formats which I still think have a lot of value and are not going away. If you look at the underlying business model for most retailers, the most expensive part of the distribution network is the last mile. This is where margins really get devastated.”
As a consequence, Grayken thinks there could be value in real estate that accommodates “click and collect” services. “You do need a store front for that,” he says.
He also thinks hospitality faces no structural issues now that covid is in the rear-view mirror. “It’s more cyclical. But, of course, how a cycle plays out can be the difference between a good investment and a bad one.”
Speaking of cyclicality, while today’s market circumstances might seem unprecedented to the uninitiated, Grayken speaks like a man whose many years in distressed investing have made him hard to surprise: “We’ve been through a number of these over the years going back to the early 1990s during the Savings and Loan Crisis.”
Harking back again, he recounts a chronology of crises including the Asian financial crisis, the dot.com crash, the GFC and covid. “It’s a scenario I’m familiar with,” he says.
Grayken’s is a nuanced position when compared with much of the commentary in the market right now. Like many others, he too wonders about all the secular changes informing the use of real estate at the moment.
But, unlike them, he is most convinced that basic rules around the use of leverage will be ultimately responsible for much of the winning and losing in private real estate in the coming years. Given his record of right calls after past crises, it would take a bold person to contradict him.
Fund fit for a crisis
The Lone Star Real Estate Fund series was launched during the global financial crisis. With the world now in another crisis, LSREF VII is again expected to capitalize on the distress it brings.
Gayken would not be drawn on specific fundraising or investing activities. However, it is widely understood that Lone Star is currently gathering capital for its seventh opportunistic private real estate fund, Lone Star Real Estate Fund VII.
The firm is seeking $6 billion of equity from institutions for the vehicle, according to a document approving a commitment by the Arkansas Teacher Retirement System. A successful raise would see the firm haul approximately $1.5 billion more than it raised for LSREF VI in 2019.
The fund’s size is a notable indicator of the scale of distressed opportunity Grayken’s firm expects to arise from current macroeconomic conditions. It has usually been proven right. Since Grayken founded it in 1995, Lone Star Funds has generated positive performances from all but one of its 21 funds to date, according to a prior report by PERE about Grayken’s career. Specifically, this performance looks like a 25 percent internal rate of return or higher and almost 2x in equity multiples, as per US pension documents mentioned in that report.
The Arkansas Teachers’ document, in which consultant Townsend Group recommends a $50 million commitment into LSREF VII, demonstrates a likelihood at least some of the $6 billion Lone Star hopes to corral will end up in at least some of the sectors Grayken discussed with PERE.
“For this vintage, the manager expects over-weights to more distressed property types, retail and hotels, and to operationally intensive sectors, hotels and senior hotels and senior housing, where the manager sees long-term
structural demands interrupted by short-term factors,” the documents state.
They note Lone Star’s track record, which reflects a variety of different access points to assets affected by some form of distress: non-performing loans, bank-held commercial real estate properties, distressed real estate
companies, incomplete developments, REITs with liquidity issues, to name a few. On occasion, the firm has even bought banks heavily exposed to property markets.
Common to each is a short timeframe in which the firm has bought assets, plied its trade on them and then exited them. As the Arkansas document states, the firm’s funds are often eight years in length – shorter than many opportunistic rivals – and hold periods can be as short as two years.
The pension is among several convinced that Lone Star’s short-term approach is suitable to capture a contemporary opportunity brought about by a damaging combination of secular trends compounded by the pandemic and then accelerated macroeconomic movement in its aftermath. Another investor committing capital is Teachers’ Retirement System of Louisiana, which approved a $75 million commitment in March, according to its documents.
As if they were flies on the wall of PERE’s interview with John Grayken, a panel of executives in New York addressed much of what we discussed.
Grayken says much of the better dealmaking will happen before the private real estate sector finds a firm footing on supply and demand, valuation and liquidity assessments. Judging by comments made at a real estate capital markets panel discussion in New York at the end of April, such a footing is still some way off.
At the session, hosted by Fordham University, Lou Mirando, founder of Streamline CRE Funding Group, a New York-based real estate lender, said: “Every time there’s a train wreck, the question becomes severity. Is it a minor derailment, or a gamechanger? Today, with rising interest rates and effects on valuations, there’s a lot of speculation as to what this means.”
Blair Welch, co-founding partner at Toronto-based manager Slate Asset Management, agreed with Grayken about leverage being a factor from one crisis to the next. But he said: “What wasn’t normal was zero interest rates… and we are now just dealing with that. It’s going to take longer to unwind the low interest rates.”
Like Grayken, Bob Knakal, senior managing director and head of the New York Private Capital Group at broker JLL, also referred to the Savings and Loan Crisis, great recession and GFC. However, he pointed out a fundamental difference this time: “With those three corrections, all asset classes and all product types were moving in unison. They were going down by different percentages, but all going down… this time around, different asset classes are moving in different ways.”
Pinpointing offices like Grayken did, Paul Massey, chief executive of New York-based capital advisory firm B6 Real Estate Advisors, also cast doubt on whether working from home would last long as a trend. Calling it “a fad,” he said: “There will always be a place for certain alternative working styles. But if you had a bucket of cash and went out and bought an office building right now, you’d look like a genius in two years.”