Market Report: CRE Investors Anticipate Distress Opportunities

Executive Summary

As of late 2023, CRE investors hold over $300 billion but face a challenging market with minimal distressed sales, only $3.1 billion in Q1 2024. Borrowers experience significant pressure, notably in office properties, with distressed assets totaling $294.5 billion. High interest rates and foreclosure complexities prolong resolution processes, causing frustration among investors. Some turn to debt alternatives for better yields. Despite the market's difficulties, selective investment strategies can still uncover valuable opportunities. The overall environment remains tough, with distressed sales comprising just 3.9% of global CRE deal volume amidst evolving Federal Reserve rate expectations.

Introduction

Commercial real estate (CRE) investors seeking distressed and opportunistic deals find themselves in a challenging market environment. Similar to baseball teams in an offensive slump, they might occasionally achieve minor successes, but significant opportunities are scarce. As lenders and borrowers await a more favorable financing landscape, investors grow increasingly impatient.

As of late 2023, investors have amassed over $300 billion for investment in the United States. Despite this, the market remains difficult, with many waiting for prices to decline and a surge in distressed opportunities. Initially expected due to pandemic lockdowns and subsequently anticipated from the Federal Reserve's rapid federal funds rate hikes beginning in early 2022, widespread defaults, foreclosures, and distressed sales have not materialized as expected. Distressed sales accounted for only $3.1 billion in Q1 2024, representing a mere 3.9% of global CRE deal volume.

Industry Tension

Borrowers in the CRE sector are undeniably under significant pressure. The total existing and potential distress across major property categories reached $294.5 billion in Q1 2024, reflecting an 8% decrease from the previous quarter. Office properties lead this distress, with $38.2 billion recorded in the first quarter.?

An illustrative case is the unoccupied mid-rise office building at 995 Market St. in San Francisco. After the sponsor defaulted on more than $45 million in CMBS debt, special servicer LNR Partners acquired the property for approximately $6.6 million in April, a 90% decrease from its 2016 value. However, such resolutions are rare; most lenders prefer to extend loans, keeping borrowers in place to maintain occupancy and rental income.

Prolonged Processes

Even in robust markets, structuring agreements can be time-consuming. High interest rates resetting property values and the complexities of foreclosure processes are delaying the resolution of distressed assets. Additionally, companies like Google and Amazon reconsidering their office space needs add uncertainty to future demand.

These factors, coupled with a preference for loan extensions, may extend the distressed sales process over the next three years. This contrasts with the prior year's expectation that the auction of Signature Bank's property loans would catalyze transactions. Instead, foreclosure procedures have decelerated these resolutions.

A potential decline in interest rates could accelerate sales, as banks might offer more attractive property prices, either through borrower collaboration or foreclosures.

Redefining Investment Strategies

Frustrated by the slow deployment of capital, some equity investors are exploring debt alternatives as demand for rescue funding rises. They are considering high leverage-stretch senior loans, preferred stock, and mezzanine debt to achieve high yields in exchange for lending up to a specified percentage of the asset's perceived value.

Equity investors see opportunities in lending rather than outright purchasing, seeking returns higher than typical equity investments. While they lack full ownership control, lenders can secure specific rights depending on their position in the capital stack.?

Not all equity investors have faced setbacks. In December, value-add investor Harbor Associates and joint venture partner F&F Capital Group acquired a 165,000-square-foot creative office facility in Los Angeles for $44.7 million, roughly half of its previous purchase price in August 2018.

Conclusion

Despite the highest percentage of distressed sales since 2015, the volume remains minimal compared to post-Great Financial Crisis levels, where distressed sales constituted 10-15% of deals. In Q1 2024, distressed sales were just $3.1 billion, or 3.9% of global CRE deal volume.

Bond traders have postponed expectations for the Federal Reserve to lower interest rates from early 2023 to as late as September, influenced by persistent inflation and a robust labor market.

Investing in office buildings now requires precise strategy and identification of unique opportunities. While many investors approach the sector broadly, targeted investments based on a contrarian thesis can uncover valuable transactions.

Unlock CRE Investment Opportunities with Gallagher & Mohan

Navigating the challenging commercial real estate (CRE) market requires expertise and strategic insight. Gallagher & Mohan, a leading real estate KPO in the US, specializes in identifying and capitalizing on distressed and opportunistic deals. With over $300 billion waiting to be deployed, our team offers:

Market Analysis: Comprehensive evaluations to pinpoint high-yield investment opportunities.

Risk Management: Strategic guidance to mitigate risks associated with distressed properties.

Investment Strategies: Tailored approaches to maximize returns through debt alternatives and selective acquisitions.

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