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Opportunistic and Distressed Investing Trends in Commercial Real Estate: 2020 and Beyond

By Nat Kunes September 3 2020 15 min read

As the commercial real estate market begins its downward cycle, a growing number of real estate investment managers have been holding capital in reserve, ready to add distressed assets to their portfolios when the time is right.

In this article, we’ll examine how the recession of 2008 might act as a guide for opportunistic investing today, explain what the “new normal” of commercial investing may look like going forward, and identify the most distressed commercial real estate asset classes.

Lessons Learned From The Global Financial Crisis of 2008

The nearly overnight insolvency of Lehman Brothers and Bear Stearns was the spark that ignited the economic catastrophe of 2008 that was felt around the world. 

Over the following few years, the tightening of bank lending standards caused development to halt and investment activity to freeze. Tenant incomes, occupancy levels, and property values all declined while the Federal Reserve lowered the federal funds rate by more than 500 basis points between January 2007 and January 2009.

The Fed’s efforts to re-start the economy quickly began to pay off. 

In an article published a few years after the Global Financial Crisis, commercial real estate development association NAIOP noted that while investment sales among all asset classes declined by 88% between 2007 and 2009, sales volumes dramatically grew over the following four years:

  • 2010 sales volumes increased 120% year-over-year (YOY)
  • 2011 sales volumes increased 59% YOY
  • 2012 sales  volumes increased 30% YOY
  • 2013 sales volumes increased 19% YOY

As of June 2020, the effective federal funds rate is at 0.08%. So, short of implementing a negative interest rate policy, there is very little left for the Fed to work with on the interest rate side to turn the economy around. 

However, one investment bank believes that the recession may be shorter than originally expected. Barron’s reports that analysts at Morgan Stanley are pleasantly surprised at consumer spending data and policy actions, increasing the chances of a V-shaped recovery.

How the “New Normal” May Forever Change Commercial Real Estate Investing

As McKinsey & Company notes, crises tend to accelerate broader pre-existing market trends. For example, regardless of what shape the recovery takes, retailers will still have to learn how to manage changing consumer behavior and office owners need to keep preparing for the acceleration of workplace digitization and online work.

While nobody knows for certain what the “new normal” will look like in the years ahead, there are trends emerging that can help investors to make an educated guess. 

Urban areas such as New York City and Las Vegas that are heavily dependent on the global business, convention, and tourism trades will likely lose their lustre in favor of cities that can be reached by car in one day or less. Restaurants that are successful in shifting their business models from mainly dine-in to primarily take-out and delivery should capture more market share and legitimize the concept of “cloud kitchens”, as the Harvard Business School recently explained.

These two trends alone will likely have a significant impact on market values, and tenant and investor demand across all commercial real estate asset classes. Recently, Northern Trust listed six trends that commercial real estate investors should understand not only for the rest of this year, but also for the years ahead:

  • Retail and office rental rates may decline as businesses realize that physical space is not the necessity it once was, due to rotating in-office schedules and increased work-at-home schedules for employees.
  • Lease terms may shift in the favor of tenants as landlords struggle to maintain current cash flows, including provisions for future pandemic response and office users requesting the same go-dark clauses that are common in retail leases.
  • Extended bankruptcy proceedings could affect revenues while non-paying tenants continue to occupy space, effectively taking leasable square footage off of the market while the courts review each case.
  • Industrial may benefit if the demand for storefronts continues to decline as a wider variety of businesses incorporate e-commerce into their overall business plans.
  • Location will still matter – although perhaps not in the same way – while investors and governments question whether density in urban areas and mass transit-oriented developments still hold their pre-pandemic appeal.
  • Risk and reward profiles of asset classes and individual property types may change if trophy properties in metropolitan areas are seen as being more risky than “plain vanilla” industrial and suburban-area multifamily projects and office parks.

Which Asset Types Are The Most Distressed?

Monitoring the issuance and performance of existing commercial mortgage-backed securities (CMBS) is one of the best ways for investors to identify distressed asset types on a macro level. Opportunistic investors can watch delinquencies, default rates, and special servicing activity to locate assets under the most financial stress.

Trepp is a firm often cited as having the largest commercially available database of securitized mortgages. The asset classes below are listed in order from the most to least distressed, according to Trepp, and may act as a guide for opportunistic distressed investing:

Lodging

Lodging special servicing currently stands at 20.47%, an increase from 16.21% in May. In March, the lodging rate was slightly over 2%. Hotels dependent on business and foreign travelers will suffer more than property located in areas that can be driven to from large parts of the U.S.

Retail

The special servicing rate in the retail sector rose to 14.24% from 9.31% in May. Many of the retail CMBS loans originated over the last several years were on property that was generating just enough cash flow to service the debt. As tenant vacancies increase, term defaults will grow as well. 

Office

The special servicing rate in the office sector has held relatively steady over the past 12 months. In June, the office rate was 2.68% compared to 2.42% in May and 3.61% in June 2019. While office owners will likely see a fundamental shift in occupancy use as companies adopt flexible scheduling between working from home and the going into the office, some tenants may require more office space to meet social distancing requirements.

Multifamily

Multifamily special servicing clocked in at only 1.86% in June, below the 2.56% rate from June 2019. However, if the recovery takes longer than expected and unemployment continues to rise, occupancy rates may decline along with rental rates, especially in Class A luxury properties and 24-hour major metropolitan areas.

Industrial

The special servicing rate in the industrial sector has consistently declined since June 2019, except for an incremental uptick in October of last year, and currently stands at just 1.4%. Industrial assets face the fewest concerns and possibly the healthiest demand, in part due to business models transitioning from store fronts to delivery and e-commerce.

How Digitization Can Streamline Distressed Investing

There is a growing disconnect between buyer and owner price expectations, according to Real Capital Analytics. The true price discovery phase of the downturn won’t begin until on-site property visits can be conducted safely.

However, when that time arrives, it’s likely that property prices will decline as reduced cash flows motivate sellers to take losses. When that occurs, purpose-built software can help investors act on potential distressed investing opportunities.

In “Achieving digital alpha in asset management,” McKinsey & Company explains how digitization offers the ability to generate value in asset management.

Asset and portfolio managers can improve the retention of assets under management and make faster and better-informed with improved position and performance reporting. 

Streamlining the investment process also allows stakeholders to qualify distressed investing opportunities more quickly, while purpose-built software can help portfolio managers to avoid potential behavioral bias when making investment decisions.