Where is the distress?
Investment firms have been circling the commercial real estate market for several years now, waiting for the right time to acquire distressed assets. This strategy gained traction following the upheaval in the capital markets as the Federal Reserved began tightening monetary policy. Firms saw an opportunity to acquire commercial real estate assets at an attractive basis due to the wave of debt that was coming due in an higher interest rate environment than it was originally financed in. Despite the Fed keeping interest rates higher for longer, there have been few distressed sales thus far. Why has this proven to be the case?
Source: Preqin
From 2022 to 2023, loan modifications increased by 150% across all commercial real estate property types. Lenders and property owners agreed to these loan modifications to extend the maturity date on the loans. This was done to provide more time for rates to come down, to improve operations, to wait for a more favorable exit environment, or all of the above. With the exception of office and particular types of retail, commercial real estate as a whole has a positive long-term outlook. Lenders are not currently under pressure to unload assets at a loss or to recover their debt basis. As such, for assets where it makes sense, investors and lenders will continue to work together to create workouts and loan modifications. As such, they will continue to hold assets until a more favorable exit environment and as a result will minimize the amount of distressed sales.
Source: CRED IQ
The darlings of real estate investors for the past decade, multifamily and industrial real estate, both currently have ample supply pipelines set to deliver in 2024 and through the end of 2025. These deliveries, which were in response to the strong performance previously experienced, are challenging occupancy and rent growth in the near-term. However, once the new supply comes online through the end of 2025, the supply pipeline for both asset classes will return much closer to their historical norms. Once the near-term headwinds pass by, operators will be in a much more favorable environment given the existing supply and demand fundamentals that made both multifamily and industrial real estate attractive investment opportunities. Investors and lenders alike are reluctant to let go of assets since there are strong long-term fundamentals and will hold onto them for as long as possible to ensure they can realize the upside they believe is possible.
Although record amounts of capital has been allocated to this strategy of acquiring distressed commercial real estate assets, few sales have occurred. This has happened despite a record amount of commercial real estate debt facing a much higher interest rate environment than it was financed in. Owners and lenders are unwilling to let go of any assets right now as they still believe in the long-term upside due to favorable supply and demand dynamics across commercial real estate. To date, they have been able to come to the table and create workouts to extend the maturity date until they can exit in a more favorable market. Until enough pain comes to bear that would force the hand of an owner or lender to give up long-term gain, distressed sales will continue to few and far between.