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Special Report: How to Make Money from Distressed Real Estate in 2021

Pension funds and other institutions are considering investing in problem properties via KKR, Apollo, Blackstone, and other Wall Street players. The goal: turnarounds.

By Larry Light

Art by John Rego


The most hazardous territory in the commercial real estate market—where the properties can’t meet their debts amid lagging rents, or are headed that way—is an aching problem for their owners. And a tantalizing opportunity for intrepid investors willing to venture into this blighted landscape. 

Distressed investing isn’t a starkly visible presence in the commercial real estate (CRE) world. Not quite yet, anyway. But large investing firms such as KKR, Apollo Global Management, and Blackstone Group are amassing sizable funds to buy these damaged assets and sometimes the debt that supports them, as well.

Pension plans and other institutions are slowly, quietly buying positions in these funds. By all accounts, this is a nice, if risky, opportunity for them. The affected properties’ prices have begun to slide, spelling bargains for the the bold, who hope to capitalize on turnarounds. 

More and more properties are entering the distressed category, although this has been a slow-motion process. “There is often a lag when economic distress manifests in rent and occupancy declines,” wrote Victor Calanog, head of CRE economics for Moody’s Analytics Real Estate Information Services (REIS). 

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Helping the lag: Washington since last year has offered aid to wounded businesses, in the form of grants and low-interest loans. And residential real estate has been granted a freeze on foreclosures, called “forbearance.” While CRE isn’t covered per se, this spirit often extends to commercial buildings, according to real estate experts.

The result is a postponement of crackdowns on borrowers. A lot of lenders regard CRE loan delinquencies as a temporary phenomenon. “They think, ‘These guys were good to us before the pandemic, and now the vaccines are coming,’” observed Paul Norris, Conning’s head of structured products. If lenders foreclose now, “they’ll lose money.”

Amid the plummeting prices, a floor exists somewhere, because of all the distressed capital coming into the picture. Private real estate debt funds raised some $20 billion last year, the most of any strategy, by the count of data firm Preqin.

Nevertheless, some properties could take a long time to spring back. Those are the ones the distressed funds are eyeing the hardest. Retail, especially the much-endangered shopping mall, was on the downswing even before the pandemic.

Other real estate is imperiled owing to COVID-19. Offices are in extremis because of the uncertainty surrounding whether companies will need as much space in the future, now that people have a taste for working at home. And lodging has gotten hammered by the drop in travel, although an uptick has appeared lately thanks to growing inoculations. The question for hotels, especially in cities, is whether business travel will bounce back in the age of Zoom.

Large banks, still smarting from the shellacking they took in 2008 and under Federal Reserve capital constraints, aren’t eager to ride to the rescue of limping CRE. “We’ve seen a dislocation in capital markets as traditional lenders,” meaning money-center banks, “have stepped back,” said Joshua Pristaw, head of capital markets at GTIS Partners. That’s where the new cavalcade of distressed investing funds comes in.

For example, real estate investment firm GTIS just made a $146 million loan to help a new condo tower called The Kent, in New York, where the pandemic has keelhauled the property market. Only half of the 104 units have been sold, so GTIS’s money gives the project some breathing room until the health threat has ebbed. The firm emphasizes that it doesn’t consider The Kent “distressed.”

But the annals of financial winners are festooned with those who bought ailing assets cheap and profited mightily as the investments improved, often with the aid of some tough workouts. Such CRE distressed funds have scored annual returns in the low teens in the past.

Famously, after the 2008-09 financial crisis, Blackstone bought thousands of foreclosed residences and turned them into rentals for its subsidiary, Invitation Homes. The strategy was a marked success.

The private equity titan paid $4 billion for 24,000 homes. Invitation, now the US’s largest single-family-home landlord, is solidly profitable. In 2017, Blackstone took the company public as a real estate investment trust (REIT), and later sold off its position for a major gain.

Stocking the War Chests

Bent on replicating that coup, Wall Street has set about raising funds to gobble up hurting CRE property. In June, Rockpoint Group, a real estate investment company, launched an “opportunistic” fund—i.e., one dedicated to undervalued properties—raising $3.8 billion. That haul handily exceeding its $3 billion target. Among the investors is the Florida State Board of Administration (SBA), which as of last summer had $4.1 million in the entity.

While the larger pension programs have real estate staff, the appeal of farming out this strategy to CRE pros is strong, regardless of size. That’s why the New Mexico State Investment Council (NMSIC) recently plugged $75 million into the new KKR Real Estate Partners Americas III. “KKR has good experience and a track record,” said Robert “Vince” Smith, the sovereign wealth plan’s CIO. 

KKR, which has about $16 billion in real estate, is raising money for this partnership (with a $3.5 billion goal, it would be the firm’s largest CRE effort ever), focusing on what it calls “cyclical dislocation,” i.e., economic damage brought on due to the virus.

The firm is making the rounds to pension programs and other institutions. Earlier this month, for instance, it made a presentation to the San Diego City Retirement System (SDCERS), which agreed to pony up $30 million. KKR’s two previous distressed CRE funds—one starting in 2013, the other in 2017, have clocked annual gains of 11.6% and 15.7%, respectively—adding credence to its appeal for the new endeavor.

Apollo Global Management, which has $34 billion in real estate assets (7.5% of its total), is raising money for property deals in the US and Asia, a good number of them for distressed situations. In its recent earnings conference call, company co-founder Marc Jeffrey Rowan crowed about how “we have an immense real estate footprint” that only will become larger. “We have a lot of white space” to be filled, said Rowan. The company does not break out its profitability for the real estate sector.

Apollo has agreed to pay $2.25 billion for an ailing set of resort properties owned by the late billionaire Sheldon Adelson’s Las Vegas Sands, which includes the Venetian casino-hotel in Vegas, as well as ones in Macao, Singapore, and Bethlehem, Pa. The real estate operating company lost $300 million in its last quarter, as virus-spooked gamblers and other tourists stayed away.

Real Estate, Real Headaches

The Federal Reserve, in its semi-annual report to Congress, expressed concern that distressed commercial properties were about to run into significant trouble. For now, prices have dropped, but high vacancy rates thus far haven’t registered a significant impact. The fear, the Fed report said, would come true if “the pace of distressed transactions picks up or, in the longer term, the pandemic leads to permanent changes in demand.”

Hovering over everything is $430 billion in commercial property debt that is due to mature this year. US banks lost $110 billion on commercial real estate in the last financial crisis, at least one-quarter of their total losses, according to Oxford Economics.

Office space, the largest single portion of the CRE realm, is seeing rents fall as vacancies rise. Property values eventually could plummet 20% to 35%, according to a recent Barclays report. Hotels and retail properties have been hurt even more. Other than fortunate pockets like warehouses, CRE stinks all over.

Distressed CRE loans—defined as borrowers having difficulty paying interest and principal—hit 8.2% as of year-end, and they are expected to keep climbing, according to research firm Intex Solutions. That’s more than double the rate in 2019. In 2009, distressed loans hit 12.6%.

Imperiled Commercial Real Estate Loans: Heading Back to Financial Crisis Peak

Percent of troubled loans* in commercial mortgage-backed securities

15%

Global financial crisis

12%

Pandemic ravages economy

9%

6%

3%

0%

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

*Troubled Loans: Borrowings that are having trouble servicing interest and principal payments, also known as in ‘special servicing’

Source: Intex Solutions


Property values for offices, lodging, and retail real estate may not touch bottom until mid-2021, declared CBRE Group, the real estate services firm. And recovery? Not until next year at the earliest. Research outfit Green Street found that office leasing activity last year got cut in half.

Other signals of distress have cropped up in the $529 billion market for CRE-backed bonds. The delinquency rate at year-end 2020 for commercial mortgage-backed securities was 20% for hotels and 14% for retail, according to Trepp, the financial data provider.

Big names are feeling the heat. In September, Barry Sternlicht’s Starwood Capital lost control of seven shopping malls it bought for $1.6 billion in 2013. When Starwood defaulted on the mall debt, bondholders took over the holdings. Privately held Starwood couldn’t be reached for comment, but it has said in the past that these malls were only a fraction of its assets.

One of the Starwood shopping centers, the almost 1-million-square-foot Louis Joliet Mall outside Chicago, defaulted on its $85 million loan last March, after two of its anchor tenants, department stores Carson’s and Sears, shuttered their outlets. The two remaining anchors, JCPenney (now exiting Chapter 11) and Macy’s (which barely avoided a bankruptcy filing last year by securing some funding), are struggling. 

In New York, Jared Kushner, former White House aide and Donald Trump’s son-in-law, is on the hook for a $285 million loan on a half-occupied building that once housed the New York Times. Back when he inked the loan, the building was valued at $470 million. Last year, the property got re-appraised at $92.5 million, a daunting 80% haircut. Wells Fargo reported that foreclosure proceedings have started. Kushner couldn’t be reached for comment.

Certainly, the current travail is cyclical and eventually capitalism’s creative destruction will put things right. Until then, pain will mount, and fortunes will be made.

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Home > News > Alternatives > Special Report: How City Office Centers, Written Off as Relics, Will Return, Post-Pandemic
Alternatives

Special Report: How City Office Centers, Written Off as Relics, Will Return, Post-Pandemic

The urban workspaces of the future are going to see more personalization, more automation, and more focus on health and wellness.
By Sarah Min


You have a couple options for your early morning commute. There’s the train or the company rideshare. But you have to drop your kids off at school, so you take the car. Once you’re in the city, you park in the firm’s smart garage, which directs you to an empty space. 

The air seems cleaner and healthier in the office. A quick glance at your phone tells you your desk assignment for the day, what section of the building you’ll be in, even the room temperature. The area is too cold so you turn the thermostat up. Another tap and you have a list of colleagues who are also scheduled to be in. It’s been weeks since you’ve seen some of them so you’re eager to catch up. 

At noontime, you consider going through your options on UberEats, but the company commissary is right downstairs. So you scroll absentmindedly from your desktop to see what it has. 

Welcome to the future of office work. In the social sense, the environment will resemble what workers left last March. But like many other aspects of life now, the pandemic has accelerated some trends that had already been in place: more personalization, more automation, and more focus on health and wellness.

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With vaccines rolling out, companies are hard at work figuring out when remote employees can come in again and what will happen when they do.

That means employers have to help build trust on the health aspects of public spaces. That said, they also have to compete with the comfort of home offices, since many workers no longer need to be onsite to accomplish their tasks. Real estate firm JLL says it’s been working with many of its Fortune 500 clients to ready their workplaces.  

“If you’re going to attract and retain the right kind of talent, you have to provide these capabilities and abilities to people so they can be effective,” said Sanjay Rishi, JLL Americas CEO for corporate solutions.

Excess Office Space

All of this will be a boon to our once-bustling city centers. While residential neighborhoods in urban centers have remained lively, commercial buildings in places like Times Square have stood empty and abandoned for the past year. 

Commercial real estate has suffered. Last year, the value of office real estate investment trusts (REITs) tumbled 18.4%, according to numbers from the National Association of Real Estate Investment Trusts (Nareit). Those numbers have since bounced back, up 1.35% for the calendar year, although they remain far from returning to pre-pandemic levels.

As for whether office buildings will ever make a full comeback, the jury’s still out. At this stage, however, there likely will be “a reduction in office demand moving forward,” said Peter Rogers, director of investments and head of real assets research, Americas, at Willis Towers Watson. 

For wary real estate investors, the consulting firm has been recommending other return-generating properties such as senior housing, medical offices, data centers, and, recently, life sciences facilities. Willis said it picked these properties because they are much less likely to be tied to tenants who can opt to work home. 

Other experts have been thinking similarly. PwC forecasts that the impact on office demand could be minimal, or as high as 10% to 15%, in the future. 

Still, there are some notable trends that mean good news for office real estate investors. Owing to social distancing, the shift to densify space has reversed, requiring “more space per square foot per employee than perhaps you had historically,” Willis’ Rogers said. That may offset lower demand for the asset class as a whole. 

Not to mention, plenty of workers want to return to the office, with JLL finding three in four workers hope to come back at least part time—either for collaborative work projects or to spend some time with their colleagues around the water cooler. 

“The purpose of the office is tilting much more toward collaboration, toward innovation, toward the sense of community, toward the sense of belonging,” JLL’s Rishi said. “Because talent is so portable.” 

The Rise of Healthy Buildings 

As for how analysts expect firms will use office space, they say the square footage will have more smart property technology, which has gotten cheaper. Offices will have purification systems pumping out filtered air—a health consideration that is likely now ingrained into commercial buildings. 

“We’ve seen the demand for healthy buildings grow steadily over the last decade as property owners have increasingly recognized the connection between the built environment and holistic health outcomes,” said Joanna Frank, president and chief executive officer at the Center for Active Design.

“The pandemic has been a catalyst for accelerating this demand as they seek to mitigate the spread of infectious disease within their buildings,” she added. 

This nonprofit is the sole licensed operator of Fitwel, the healthy building certification system that was originally created by two federal agencies, the US Centers for Disease Control and Prevention (CDC) and the General Services Administration. Last fall, Fitwel launched its Viral Response module, setting baseline requirements to reduce transmission of infectious diseases. Supporting the Fitwel effort are leading asset managers including Brookfield Properties, Hudson Pacific Properties, and Nuveen Real Estate. 

Fitwel and other certifications such as Well are showing that there is a connection between investors and the health and safety of the buildings in their portfolio, Frank said. 

Much has changed in our relationship with public spaces since the pandemic started one year ago. When the coronavirus calms down, there’s a strong case that office space, and city centers, will come back. The question is when. PwC estimates it will take about three to five years for large cities like New York, Los Angeles, and others to fully recover. 

To Meredith Jenkins, chief investment officer at Trinity Church Wall Street, it’s hard to recreate the same kind of infrastructure elsewhere. She says her portfolio, which is more than half made up of directly held NYC commercial real estate, has remained resilient. That’s partially because blue chip tenants like Hudson Square have thus far wanted to remain at their Manhattan perches, even as they have announced publicly that they will allow significantly more remote work.

Besides, like many others, she is waiting to return to the vibrancy of large metropolises, as they continue to enchant new and old inhabitants. 

Said Jenkins: “I am quite positive that all of that will return.” 

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Forget Offices, Invest in Life Sciences Real Estate, Report Says

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