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Should Investors Looking for Distress Strike While the Iron is Warm?

The window of opportunity for distressed assets in this cycle will depend mainly on whether or not a recession materializes.

Distressed assets offer intriguing possibilities for investors, but the broader economic outlook remains muddled.

The most accurate way to describe the state of the real estate market today is complicated. That might feel like a cop-out, but these are uncertain—and perhaps even unprecedented—times. With economic challenges upon us, assets (and entire markets) still fresh from the impact of a global pandemic are enduring new headwinds—and perhaps offering new opportunities.

What does the distressed asset landscape look like today? How did we get here, what larger forces and smaller factors are shaping the contours of that landscape, and where might we be headed in the not-too-distant future?

Then and now

Whenever there is a disruption in the market, everyone's sights naturally turn to distressed assets. Even when the disruption is historic in size and scope, as with the pandemic, the distressed market takes time to materialize. The first movement is typically in the public markets. Private markets usually take more time to emerge and depend on various factors, market-specific dynamics, and owner, operator and lender leverage.

With COVID, certain asset types were likely to be impacted more than others, notably hospitality and office. Multifamily, on the other hand, was relatively resilient. What we are seeing now is something different. Office is still sluggish, despite more people returning to the office, but hotels are performing much better.

Systemic shock

With the macroeconomic environment becoming increasingly volatile, large-scale distress has returned. After years of being in a low interest rate environment, inflation has been an economic shock to the system. As such, borrowers now face a higher cost of borrowing.

Consequently, the math doesn't add up for some assets, especially those where investors were buying at low cap rates. It's not always clear how to get out of that asset or deliver returns to investors. We're also seeing some mortgage REITs and even equity REITs down, simply because of higher borrowing costs. Additionally, we're starting to see credit issues at some properties. Whether it's priced into the market or not, we already feel the impact of consumer spending reductions.

An inflation hedge

As a rule, inflation is the real estate industry's friend. It allows rent increases that are hopefully higher than increases in operating costs. Hence, real estate is an inflation hedge, particularly for properties with short-term leases. Real estate fundamentals are not the principal culprit; the higher cost of capital slows investment in real estate. There is no doubt that inflation and a recession could adversely affect demand for some types of properties. There may be fewer people who spend money on retail or hotels as discretionary spending decreases.

Opportunity: hard knocks

The window of opportunity for distressed assets will depend mainly on whether or not that recession materializes. In the event of an economic slowdown, reworking these businesses and addressing distressed assets could last a couple of years. It's likely that the level of distress will not be as severe without a recession, and it will probably take less time to work through it.

If a recession materializes, distressed opportunities could arise from problematic assets and capital stacks. The general expectation from real estate investors is that more challenging economic headwinds and expensive debt will result in more distressed asset sales. This will prompt capital to shift to safer havens with more predictable cash flows. If that happens, we'll likely see a reallocation of capital to commercial sectors such as multifamily, self-storage and industrial.

Change and resilience

There are also fundamental post-pandemic behavioral and operational changes emerging across industries that are expected to change work environments, impact consumer preferences, disrupt supply chains and upend the travel industry.

For now, a well-functioning debt market appears to have ensured that assets better positioned to survive economic changes may avoid distress. Real estate fundamentals remain strong, creating a disconnect between property markets and capital markets. It goes without saying, real estate is a leveraged business, and each must work together.

Sector-specific considerations

Multifamily and industrial properties continue to be in high demand. Rising home ownership costs further fuel multifamily demand. Several challenges have plagued the retail industry for years, as oversupply slowly winds down and retailers adapt to new consumer preferences. Investors and owners continue to face significant risks in the office market. Each month, more workers are returning to the office. However, most workers do not want to be in the office full-time, particularly since gas prices have risen. Many tenants are trying to renegotiate rent and reduce space before the expiration of their leases. Others will reduce space and move to higher quality properties as leases turn over.

Headwinds and hesitation

Distressed or not, every transaction requires a willing seller and a willing buyer. Currently, divergent views keep activity somewhat muted, with some sitting on the sidelines waiting for the dust to settle. Investors are hesitant to move too soon, leery of catching a falling knife and waiting to see where the market is headed. Something that looks like a discount today can be deceiving. Is it the correct basis, the right price? Do the rents make sense? As an investor, are you being compensated for the appropriate risk?

Savvy investors need to have a clear viewpoint on these issues, and clarity can be brutal in a chaotic environment. With rising capital costs, rent and cash flow growth are even more imperative for successful investing. Negative leverage is currently facing investors due to the unusual inversion of lending and capitalization rates.

As a result of rising cap rates, particularly in the absence of adequate rent growth, we can expect a decrease in property values. For investors, this is perhaps the most problematic development.

The current price discovery period is characterized by buyers looking for deals and sellers unwilling to lower asking prices. Moreover, the lending market has slowed down. Lenders have tightened underwriting with higher rates and recession concerns, often reducing loan proceeds and adding structure to bolster credit. Lenders mainly focus on debt service coverage, given the potential for weaker cash flows and the near certainty of higher rates.

The bottom line

In the following year, there may be an uptick in the distressed market. While the current geopolitical landscape has created probelms, including supply chain issues and energy sector volatility, it also provides undiscovered opportunities in new markets.

Mark Green serves as chief investment officer of Los Angeles-based Cottonwood Group, a private equity real estate investment firm focused on equity and debt opportunities across all property sectors and geographies. To reach him directly, email [email protected].

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