For roughly 18 months, the real estate market has been close to a standstill. As a result of rapid inflation, the Federal Reserve has hiked interest rates 11 times, pushing the fed funds rate to its highest level in more than 20 years. As a result of the unpredictability in interest rates, inflation and other factors, buyers and sellers have reached an impasse in valuing properties. While this reality has created challenges for a large portion of the real estate industry, it is likely to provide compelling opportunities for investors over the next year.
In assessing the near-term investment climate, it is instructive to look back 15 years to the global financial crisis (GFC). In the mid-2000s, real estate pricing was divorced from property fundamentals and properties were overleveraged as a result. Following the fall of Lehman Bros. and the market crash, prices for many buildings quickly dropped by 30 percent to 40 percent. Once the market tanked, deal activity stopped immediately — buyers had no desire for properties whose value was in a nosedive. At the same time, while countless mortgages defaulted, lenders were generally uninterested in taking back buildings at a time when no one was leasing or buying, so they predominantly negotiated workouts with the borrowers; many will remember the phrase “extend and pretend” being a predominant theme at the time.
After the dust began settling in 2009 and 2010, investors with cash and vision began buying. In some cases, they bought properties in structured sales with the foreclosing lender and defaulted borrower; in others, they acquired the notes themselves with “loan to own” intentions. In both instances, aggressive investors who smelled the market comeback were able to access valuable real estate for dimes on the dollar. Of course, those brave enough to begin investing in the early stages of the recovery stood to benefit the most.
Despite the many parallels between today’s market and the GFC, there are a few significant differences. For one, during the GFC, borrowers and lenders alike were generally interested in negotiating workouts. Lenders had little interest in owning these properties, and realized their borrowers simply ran into unlucky timing. Borrowers still believed in their assets and were confident the values would recover in the not-too-distant future. Today, however, that latter point isn’t necessarily the case. For borrowers, it only makes sense to renegotiate a loan if there is a reasonable chance the deal will succeed with its new terms. Class B office buildings in particular have seen valuations decline precipitously. For some of these properties, owners have no equity left in the assets, and there is little expectation that the values of these buildings will ultimately bounce back to levels where they will have equity in the asset.
To be clear, many of these properties will have a future. But — as we have already told a handful of our clients in recent months — if a borrower’s equity has been wiped out with no reasonable expectation of that changing, a loan modification may not make sense. In that instance, the borrower should strongly consider giving the property back to the bank, requesting consent to a short sale or some other consensual exit from the investment. For the existing investors who have been upended by a rapidly shifting office market, this is obviously unfortunate. However, for investors with capital who are seeking opportunities, there is real potential for profit in office properties purchased at a significantly reduced basis that can either be converted to another use or maintained as office properties with lower rent-roll requirements.
Of course, buying real estate typically involves the use of financing, and that is also increasingly challenging in today’s climate. With asset values unclear and interest rates at such high levels, the loans being made today are typically at much lower leverage, leaving a gaping hole between the debt financing and the equity. This phenomenon is affecting both new buyers and borrowers who bought when lending standards were looser and are now unable to receive the same proceeds when refinancing their properties.
All these capital stacks searching for additional financing present another investment area for opportunistic capital. Whether structured as preferred equity or mezzanine financing, capital that goes between the debt and equity — sometimes called “gap capital” or “fulcrum capital” — will be critical for investors trying to piece together deals for the foreseeable future. Investors willing to provide this financing can expect to see opportunities come their way.
If the biggest takeaway from the GFC was the economic repercussions of overvaluing properties, the second biggest lesson was the buying opportunity that market disruption offers to investors — particularly, the first investors putting out new money after a disruption.
In the months leading up to the GFC, there were a number of market participants who anticipated the downturn and sold their properties (or were lucky in terms of timing of their sales). These investors held their cash for a few years, and then made outsized returns by buying when the market was flooded with real estate at bargain prices. That lesson should hold true now. Real estate professionals who are holding dry powder at this juncture have a number of avenues in which to invest it. Of course, the risks of investing in distress are real, but if the GFC is any indicator, investors with discerning approaches will be able to deploy capital strategically and create successful deals even in this difficult market.
Christopher Gorman is real estate practice group co-chair at Adler & Stachenfeld.
