By Meghan Hall
Investors have been watching the commercial real estate industry with bated breath, hoping that a wave of distressed assets will come to market, providing opportunities to snag a good deal. Many of these expectations have been colored by the Great Recession of 2008 and 2009, where commercial real estate took a hit across all product types and asset classes. However, a recently issued report from Marcus and Millichap indicates that distressed properties will be concentrated in select sectors, and competition for them will likely be fierce.
“Every time there is a recession of greater or lesser magnitude, investors are always looking for opportunities,” explained Marcus & Millichap’s Senior Vice President and National Director of Research Services, John Chang. “Part of the issue is that right now, liquidity levels and availability of capital are so high. There have been literally hundreds of billions of dollars put into funds to target assets that go into distress. The money is there; it’s on the side lines; it’s ready to go. [Investors] are just kind of waiting for the shoe to fall.”
Currently, the pool of capital waiting to be deployed is at a record level, with close to $5 trillion sitting in money-market funds. This, states Marcus and Millichap, is a 32 percent increase over the course of 2020. However, there are a number of differences between the Great Recession of 2008 and 2009 and today’s market correction that could temper the number of distressed assets coming to market—and push out when the metaphorical shoe “drops.”
“This cycle is completely different than the global financial crisis of 2008 and 2009, in that we had a financial market lock-up,” said Chang. “[Then,] the financial markets were frozen and so liquidity was constrained. It was very difficult to get a loan, and the banks and institutions weren’t lending…That really slowed down the commercial real estate market dramatically.”
Thus far, borrowers, lenders and tenants have largely remained committed to delaying foreclosure as much as possible, working with different parties on forbearance foregrounds to delay payments.
“What that is doing is giving the investors more latitude and more maneuvering room,” stated Chang. “They, in turn, can work with their tenants because they are not under pressure from their lender.”
Also giving investors additional wiggle room has been fairly rapid action on behalf of both Congress and the Fed. Since the beginning of the health crisis, the Fed worked to increase the money supply by 10 percent, reaching $18.5 million. By comparison, M2 only increased by four percent over the course of the previous recession.
And, added Chang, Congress acted far quicker than in previous recessions in an effort to mitigate the effects of the current recession. During the 2008-2009 financial crisis, it took the government about 13 months to deploy stimulus and support for the market, which came in at about six percent gross domestic product (GDP). During the pandemic, the government took about seven weeks to deploy capital of about 30 percent GDP.
“They dropped rates and drove in an enormous capital infusion into the markets to make sure they didn’t go back into the freeze like they did in ’08-’09,” said Chang. “…The package was five times bigger, and it came ten times as fast.”
The infusion of liquidity should prevent banks from over tightening on lending standards. More borrowers are also in good standing with financial institutions in large part due to more conservative underwriting and better structured property prices—lessons learned from the previous cycle. Marcus and Millichap predicts that the ultimate result is that fewer assets will be returned to lenders in the future.
When distressed assets begin to hit the market, however, remains largely unclear. Failure by the federal government to introduce and pass a new stimulus package could bring about foreclosures sooner. Even with the stimulus package, economic growth during the second quarter was negative 32 percent, what Chang deemed as a “severe impact.” And, while some states reopened, boosting local economies in the short-term, widespread illness and increasing infection rates remain a large threat to the economy and commercial real estate.
“Now we are in a situation where that short-term stimulus that was built is running out; it is expiring… We have more cases and significant stress on the economy because of the acceleration of the pandemic,” said Chang. “And congress is going to have to find a way to support economic growth once again…If they do nothing, the economic consequences could be significant.”
If current conditions continue, it will still be some time before distress begins appearing in the market. At the earliest, Marcus and Millichap believes that foreclosure processes will not begin until the end of this year or beginning of 2021 for assets to come to market. The properties most at risk are those unable to open due to coronavirus: mainly, hospitality and retail assets. Often, noted Chang, these are assets that were facing trouble even prior to the start of the pandemic.
“You’re seeing retailers going out of business that were already facing an uphill battle because of e-commerce and because of their business models,” said Chang. “They have not had the staying power to last through a downturn. And so retail is really about an acceleration of a preexisting cycle that was already taking place.”
When assets do come to market, competition will likely be strong, and pricing discounts might not be as steep as many expect. While there will be high demand for limited supply, there has also been more liquidity in the market and a higher access to capital thus far. Combined with low interest rates, investors will be willing to pay higher prices for distressed properties.
“For those investors sitting on the sidelines and waiting, they have a lot of competition sitting on the sidelines with them,” noted Chang. “Investors were much better positioned coming into this cycle…the amount of distress is going to be less than what we’ve seen in the past.”
Investors looking at distressed assets will also be competing with those playing a longer-game.
“On the other side of the equation, there are investors thinking long term,” Chang added.
They’re not looking for the opportunistic buy. If they find one they’ll take it, but that’s not their key driver.”
Appreciation—even at what appears to be the height of the market—could continue in places driven by strong demographic changes. Chang emphasized that between the fourth quarter of 2017, just prior to the Great Recession when peak pricing occurred, and the fourth quarter of 2019, all asset classes saw appreciation. Apartment appreciation increased by 61 percent, while self-storage appreciation increased by 56 percent. Industrial followed behind with appreciation increases of about 40 percent. Retail, office and hotel saw less appreciation, at 20 percent, 18 percent and 17 percent, respectively. The lesson, ultimately, is that commercial real estate is a long-game, even when investors are looking to make a deal.
“We really need to drive home that there is a short-term perspective that is very challenging. Investors are looking at [the market] on a day-to-day basis; they’re closely monitoring their rent collections, what happens in Congress, etc.,” said Chang. “And then there is the long-term perspective…If you ha d purchased a property at the peak of the last cycle in 2008, just before the market locked up, and you “overpaid” for that property, and then you didn’t over leverage and you held onto it until today, in many cases the value of that property has more much more than what was paid at the peak of the last cycle.
Chang concluded, “It’s the long term that people have to keep their eyes on.”