Some pension funds are betting that distressed real estate debt will continue to offer attractive investment opportunities, even though the amount of distress investments in the market has dwindled. With a high volume of commercial real estate loans due over the next few years, a number of plan sponsors and consultants believe that there are still ample investment opportunities in the space and that even more opportunities are going to emerge.
“The excessive use of leverage during the real estate peak has resulted in a historical volume of distress during the global financial crisis,” said consulting firm Hewitt EnnisKnupp in a presentation to one of its pension fund clients. “Although significant progress has been made to resolve distressed situations, a significant amount of distress remains.” Since 2008, the ratio of distressed real estate debt to resolved or restructured debt has shrunk considerably, according to Hewitt. Still, the firm estimated that $400 billion of commercial mortgages became distressed during the past cycle, but that only half of those have been resolved or restructured, leaving roughly $200 billion of “outstanding distress.”
Based on Hewitt’s recommendation, the San Diego City Employees’ Retirement System (SDCERS) carved out a 2-3% bucket for opportunistic real estate at its June 28 meeting; the fund plans to target distressed real estate debt and equity (MMI, 07/01). SDCERS is only the latest pension fund to eye the asset class: the $11.4 billion Los Angeles City Employees’ Retirement System and the $6 billion Contra Costa County Employees’ Retirement Association (CCCERA) have both approved allocations to distressed real estate debt since the start of the year, while four other funds have committed a collective $620 million to the asset class, according to iiSEARCHES data.
Growing interest in distressed real estate debt can be partially attributed to overcrowding in the core space. Pension funds jumped into core real estate shortly after the financial crisis, but many are now looking elsewhere to avoid the high prices and long queues for core funds (MMI, 2/01). “Much of the capital raised post-2008 has gone into the core assets,” wrote Timothy Price, chief investment officer of CCCERA, in a May 8 memo to the pension fund’s board of retirement. “Depending upon the valuation method used, core real estate appears to be fully to slightly over-valued relative to its own history.” At the meeting, CCCERA earmarked up to $241 million for non-core real estate, with $100-175 million set aside for distressed opportunities (MMI, 07/01).
Value-added strategies have also proven popular as pension funds have moved away from core real estate investments. But value-added real estate usually requires investors to purchase assets that are in transition and convert them to core, either by finding tenants or renovating the properties. By contrast, investors in distressed real estate debt may have less work to do. “In some cases, they could just be a passive buyer of the debt,” said Christian Busken, senior v.p. and director of real assets at Fund Evaluation Group. “They may or may not be in the business of owning property and doing workouts with the borrower—it depends on their capabilities.”
Investment returns on distressed real estate debt have also drawn investors. In its recommendation to SDCERS, Hewitt said it expects distressed real estate debt investments to provide “attractive risk-adjusted returns,” and that it would seek investments with a 17-20% target return. Similarly, CCCERA found that its distressed real estate investments had the highest capitalization rates with the least amount of leverage when compared to its other real estate investments, according to pension fund documents.
Even if the market for distressed real estate debt isn’t booming right now, some plan sponsors and consultants say that more opportunities are coming down the pipeline. Upon approving the $100-175 million allocation for distressed real estate debt investments, CCCERA declared its belief that the market will soon make a comeback. According to Price, trillions of dollars in commercial real estate loans are coming due over the next several years, paving the way for more distress.
But others say the asset class is past its prime. “If you’re barely starting to do distressed real estate debt, you’re behind,” said Busken. “There’s still some distress out there, but it’s certainly not the magnitude that we saw in 2009 and 2010.”
Busken said looming commercial real estate debt maturities will not necessarily translate into more opportunities. Factors such as the continued availability of credit, the willingness of lenders to restructure loans and property values must also be considered. “You can’t look at [debt maturities] in isolation in making a case for distress,” he said.
Article originally appeared in Money Management Intelligence. Link here (paywall).