With the near-term outlook for commercial real estate performance becoming clouded because of rising interest rates and lingering fears of a recession, more investment managers are talking about putting together funds targeting opportunistic real estate investments. But what are opportunistic real estate funds and how do they differ from the funds targeting distressed real estate that proliferated in the wake of the COVID pandemic in 2020?
How the strategies differ
London-based research firm Preqin classifies opportunistic real estate investments as involving lower-quality buildings that often require significant enhancements to upgrade them to a higher class of property. The buildings can be located across all market tiers and involve any commercial property sector. Opportunistic real estate funds employ a broad range of strategies to achieve high returns, from ground-up development to redevelopment and adaptive reuse.
Preqin estimated that through the third quarter of 2022, there were 65 private equity real estate funds planning to pursue opportunistic strategies and they raised $29.6 billion in aggregate capital. Those figures still lagged the 126 such funds formed in 2021, which raised $59.4 billion. The high mark for this strategy was in 2019, when opportunistic real estate funds raised $78.5 billion.
However, according to Kunal Shah, managing director and head of private markets research for iCapital, interest in opportunistic funds is higher today than it has been in the last five to 10 years. From a portfolio allocation perspective, if you’re planning for a recession or an economic slowdown, opportunistic real estate strategies are a good bet, and that’s why people are taking a closer look at this category.
Meanwhile, distressed real estate funds typically invest in properties that are experiencing financial distress and might have fallen into loan default, foreclosure or bankruptcy. Funds specializing in distressed real estate opportunities rely on capitalizing on the seller’s financial distress by pursuing strategies including buying discounted loan notes from a lender or acquiring assets at steep discounts from liquidity-constrained sellers.
While distressed real estate funds, like opportunistic funds, tend to be market- and sector-agnostic, they require much greater focus on situational and niche opportunities because of their reliance on the owners’ financial distress.
According to Preqin figures, there was a total of $1.9 billion in distressed real estate funds raised through the first three quarters of 2022. That compares to $7.5 billion in such funds raised in 2021 and $4 billion in 2020.
What types of returns to expect
Institutional investors’ returns expectations for opportunistic real estate funds range from 8% to 10% when unlevered, and low teens when moderate leverage is employed, according to Raymond Davis, chief strategy officer with Red Oak Capital Holdings, a commercial real estate investment platform.
Returns on distressed real estate funds, on the other hand, typically reach low 20% when unlevered, and mid- to high-20% when leverage is employed.
“When you’re talking about distressed, you’re talking about something that’s going to be above a 20% return on an IRR basis,” says BJ Feller, a managing director and partner at Northmarq, a capital markets services provider for the commercial real estate industry. “If you’re jumping into the water and saving a drowning person, you have to be compensated for it.”
How long do investors have to wait for a payout?
Today’s opportunistic funds typically last three to four years before allowing for a liquidity event, while distressed funds have a horizon from four to eight years, with a carried interest kicker that is included with the longer terms, according to Davis.
“The shorter duration, the more confidence I can have with projections, and that aligns with opportunistic [strategies],” notes Feller.
However, Zach Vaughan, managing partner of real estate with Brookfield Asset Management, has a different perspective on the timelines. He views distressed funds as something that should feature an exit within three to five years. Opportunistic funds, on the other hand, can have a 10-year horizon as long as most of the money is invested within the first several years.
Hopes for these types of funds don’t always pan out
After the start of the COVID pandemic there were large distressed funds raised by experienced real estate players, including Brookfield, KKR and Blackstone. But the distress these funds were waiting for never quite materialized because the Fed’s monetary policy was successful at keeping liquidity in the marketplace. At the same time, government help for struggling businesses also helped many commercial tenants survive the COVID-related downturn, limiting the damage from unpaid rents.
Most funds have sunset provisions, so if the capital is not drawn on during a certain period, like it happened with COVID distress funds, the money just flows back to the investors.
Some real estate industry insiders say it’s possible the opportunistic funds being put together now might experience something similar.
“In order for there to be real opportunistic returns, there have to be opportunistic deals and the volume of deals is so low because the bid/ask spread between buyers and sellers isn’t seen the same way,” says Nancy Lashine, founder and managing partner with Park Madison Partners, a boutique real estate capital solutions and advisory firm.
Still, it makes sense to take advantage of market conditions if there’s a possibility for reaching such attractive returns, notes Brookfield Asset Management’s Vaughan.
“If you look at the financial crisis in particular, a lot of large investors sat on the sidelines, given allocation concerns, and didn’t participate in some of the earlier transactions and deeply regretted it,” he says. “So, we are seeing people quite keen on these strategies right now so they don’t get left out of what could be some excellent buying opportunities.”