Economic Landscape for Real Estate Private Equity: Facing the Triple Threat of a Shifting Market
November 29, 2022
By Joe Rubin
Real estate investors have had a difficult year, and private equity funds are no exception. While in 2021 the sector soared out of the disruption of the pandemic and demand continued to benefit from a strong job market, 2022 brought the Triple Threat: higher interest rates, high inflation, and the probability of a recession. Of the three, higher interest rates have had the largest impact, curtailing capital flows, derailing planned investments, and shrinking investor returns and private equity fund promotes. In short, a robust investment cycle through the first half of the year came to an abrupt halt, and it will likely take years to clean up the mess.
Interest rates have been artificially low since the Great Recession thanks to the Federal Reserve’s elongated accommodation. Instead of gradually reverting to market-based rates in the normal course over the last decade, the Fed responded to pandemic-driven inflation by raising rates in large increments. It was the abruptness of the change that has stunned the real estate market, making cash flows and returns more uncertain and, therefore, riskier. Historically, the real estate cycle changes when investors believe the existing risk premium is no longer adequate: then spreads rise and values fall. But it takes time for all market participants to accept the new reality, and bid-ask spreads have widened dramatically as buyers and sellers embark on what will be a long journey to price discovery.
The result has been felt in the extreme slowdown of transactions across property types and markets. Private equity funds’ hunts for new deals have been particularly challenging – it’s hard to price up front and it’s even harder to price the exit. And it’s also hard to find financing that makes the deal work, given the onset of negative leverage and lenders’ growing cautiousness. Concerned about falling collateral value, lenders have tightened underwriting standards. Proceeds are down and debt yield and coverage requirements are up, further diminishing investment leverage and cash flows. Some deals don’t pencil out for either the equity or the debt.
Investors in existing deals financed with floating rate debt that was not protected with interest rate caps or swapped to fixed rate, or whose caps are expiring, are seeing robust property cash flow now going to the lender instead of their own pockets. Borrowers are dealing with breaches in debt service coverage and debt yield covenants. For investors whose loans are maturing in this new environment, refinancing is far more difficult. The new underwriting and lower proceeds are often requiring an equity infusion. The same is true for negotiating extensions. Lenders want to get their loan-to-value ratios down. For private equity this means finding the cash to keep the debt in place, potentially by calling additional capital from investors. There is already evidence of forced property sales out of portfolios to deal with loan maturities, wiping out any future upside.
At the end of the day many private equity investments may not deliver the promised level of annual distributions to investors, including the prized partial return of capital from refinancing mid-way through the investment period. In turn, those thinner margins will have a direct impact on promotes, and some deals may ultimately be “out of the money;” that is, the property will no longer be able to return enough net cash flow to investors to clear the performance hurdles required for the sponsor to achieve the promote. This is a striking turn of events from even six months ago. And if a recession comes that impacts demand, causing leasing to slow, transitional and development investments could be particularly hard hit.
Of course, a volatile economy is not all bad for funds. Disruptions and less perfect transaction markets make for opportunities to provide equity capital to other distressed investors. Funds are poised to take advantage of the turmoil and achieve outsized returns on discounted transactions. When we emerge from the transition from artificially low to more historically average interest rates, it is likely the private equity funds will have provided capital to stabilize otherwise tenuous situations and make up any margin squeeze in their core and value-add portfolios.
In response to the changing investment climate, private equity fund managers must rethink their new opportunity investment strategies and enhance due diligence, modeling scenarios for various economic growth, employment, and interest rate outcomes. But most of their time will likely be spent on analyzing existing deals, monitoring property performance and modeling cash flows to anticipate issues stemming from higher operating costs, retaining talent, leasing, and debt coverage or debt maturities. It is more important than ever that private equity funds receive timely and accurate information from their joint venture partners, and work closely to have the latest accurate, actionable data on hand for decision-making. That data will also allow managers to update their waterfall models and assess the impact of narrowing margins on promotes.
First and foremost is for the managers is beefing up communication with investors, to provide more detailed reports and make them aware of the risks ahead. Frank conversations about potential outcomes is critical to maintaining good investor relations. Real estate private equity funds were born out of the distress of the savings and loan crisis in the late 1980s. Taking advantage of volatility is in their DNA. Like all other real estate investors, they will need to stop some bleeding in the short-term, but they will develop new strategies to boost returns through the cycle.