CPP Investments' CEO Ready to Seize Opportunities in Real Estate?

Neil Callanan of Bloomberg reports distressed commercial property buyers see ‘exceptional bargains’:

Distressed investors see one of the best opportunities in a generation to buy troubled US real estate assets as the commercial property crash continues to roil the market.

Private equity firms are already positioning to take advantage. About 64% of the $400 billion of dry powder that the industry has set aside for property investment is targeted at North America, the highest share in two decades, according to data compiled by Preqin.

The fear elsewhere is that a strong US bias will mean other parts of the world won’t draw the same demand, delaying the work out of troubled loans and properties there.

PE firms want to take advantage of deep American discounts after office values fell by almost a quarter last year, more than in Europe, following the pandemic work from home shift. Almost $1 trillion of debt linked to commercial real estate will mature this year in the US, according to the Mortgage Bankers Association, and rising defaults as borrowers fail to repay will create more options for buyers of distressed assets.

“Compared with the Savings & Loans crisis and 2008, we’re still in the first or second innings” when it comes to troubled assets, said Rebel Cole, a finance professor at Florida Atlantic University who also advises Oaktree Capital Management. “There’s a tsunami coming and the waters are pulling out from the beach.”

John Brady, global head of real estate at Oaktree, is similarly blunt about what’s ahead: “We could be on the precipice of one of the most significant real estate distressed investment cycles of the last 40 years,” he wrote in a recent note on the US. “Few asset classes are as unloved as commercial real estate and thus we believe there are few better places to find exceptional bargains.”

That focus means other regions could be left with bottom feeders — so called because of the low offers they typically make — as the main bidders. That risks dragging values in Europe and Asia down further, or leaving some markets stuck in stasis as sellers and lenders refuse to cave to super-lowball bids.

The strong North American economy, deeper markets and currency strength may contribute to “a delayed market recovery” outside the region, said Omar Eltorai, research director at data provider Altus Group.

The opportunity in the US is being driven by lenders pulling away from commercial real estate after borrowing costs rose and values plunged. Asset manager PGIM estimates a gap of almost $150 billion between the volume of loans coming due and new credit availability this year.

“When you start to get into the cycle, the big market is where people find the opportunities,” John Graham, chief executive officer at Canada Pension Plan Investment Board, said in an interview. For everything from private equity to private credit and commercial real estate “the US is the biggest and the deepest market.”

Smaller lenders look particularly vulnerable because of their real estate exposure, and there’s already been turmoil in the sector. New York Community Bancorp had to take a capital injection of more than $1 billion earlier this year after its financial challenges mounted. More regional bank failures are likely because of their property debt, according to Pimco.

Based on Oaktree analysis, the number of US banks at risk would exceed levels seen in the 2008 financial crisis levels if CRE values fell by only 20% from their peak. Office values there fell 23% last year, according to the IMF.

Barry Sternlicht, chairman of real estate investor Starwood Capital Group, has also indicated that he sees more problems ahead for lenders.

With regional banks, “you wonder what’s going on, like how could they not be experiencing larger losses, certainly in their office portfolios,” he said on an earnings call in May.

Starwood also hasn’t been immune to the troubles. Its real estate income trust tightened limits on investors’ ability to pull money from the vehicle to preserve liquidity and stave off asset sales.

Shrinking Pool

While the US looks attractive to private equity buyers, the overall pool of PE capital for CRE has shrunk. That will throw up some problems for credit investors, for example.

The amount of money set aside for real estate debt strategies globally by the firms shrank by 26% to $56.1 billion through May from the end of 2021, Preqin data show. That could, for example, limit buyer interest in non-performing CRE loans from Korea to China as loans sour.

“Dry powder is declining,” said Charles McGrath, an associate vice president at Preqin. Higher borrowing costs mean private equity players are “seeing a sharp decline in fund raising and transactions.”

One of the key deterrents for investors in Europe are doubts about the robustness of valuations of real estate and loans. They “may not always provide an accurate reflection of the true worth of the assets, especially in the light of changing market conditions,” the European Insurance and Occupational Pensions Authority wrote in a June report.

Banks in Germany, for example, update valuations of buildings they have financed less regularly than peers in the US, meaning it takes longer for problems to come to the surface. The lag in writedowns comes even as the amount of CRE debt with a loan to value ratio of more than 100% nears €160 billion ($173 billion), according to the region’s banking supervisor.

That suggests there’s a huge wave of defaults and soured asset sales to come through on balance sheets, though the structure of the debt means it could take years for the full scale of the trouble to appear.

The situation is likely to get worse, with a further increase in non-performing loans, European Banking Authority Chair Jose Manuel Campa told Bloomberg Television. “This is a trend that’s not going to be short term.”

There's no doubt about it, the commercial real estate market is undergoing a slow and painful transition and many regional banks which underwrote these loans are in big trouble.

They've managed to escape the coming crash so far but it's only a matter of time before this snowballs into something much bigger.

And it might be regulators that push the industry over the edge. The Wall Street Journal reports US prosecutors are cracking down on commercial mortgage fraud, a growing push that is sending shudders through the $4.7 trillion industry by raising questions about the numbers underpinning major property loans.

In many cases, the numbers are fictitious, marked to fantasy because if they had to sell these commercial real estate loans in the open market, they'd get pennies on the dollar. 

This is already impacting the industry as the plight of investors looking to pull money out of commercial real-estate funds has gone mainstream:

Big-name property funds like Barry Sternlicht’s $10 billion Starwood Real Estate Income Trust have been scrutinized for limiting investor withdrawals from niche funds that exploded in popularity among the well-heeled over the past decade.

And this isn't just a US problem. The Financial Times reports that large London buildings are proving impossible to sell as higher rates and investors' nerves over hybrid work have hit the market hard.

Bloomberg reports Hong Kong's commercial property deals have fallen to the lowest since 2008.

Where am I going with this? The commercial real estate market is vast and diversified but problems with offices aren't going away and they have hit large Canadian pension funds that needed to take writedowns in this sector.

But the flip side of this is as market dislocations just get underway, there will be forced selling and those Canadian pension funds with big credit operations will be able to swoop in and buy loans at a deep discount and hopefully rework these assets and sell them for higher down the road.

This is what John Graham, CEO of CPP Investments, was alluding to when he stated:

“When you start to get into the cycle, the big market is where people find the opportunities,” John Graham, chief executive officer at Canada Pension Plan Investment Board, said in an interview. For everything from private equity to private credit and commercial real estate “the US is the biggest and the deepest market.”

The dislocations in the US are finally happening, slowly but surely as the economy is weakening and unemployment starts rising.

The extend and pretend game banks are playing with commercial real estate loans can't go on forever. At one point, forced sales will occur and there will be a massive realignment of commercial real estate values downward.

That's when interesting opportunities arise for long-term investors.

And it's not just real estate, there will be opportunities in all private markets as dislocations take place and CPP Investments and other large Canadian pension funds will be ready to work with their strategic partners to capitalize on these opportunities.

It's in this environment that these long-term funds thrive, something Andrew Coyne who is mesmerized by the S&P 500 making record gains doesn't seem to get

Below, Howard Marks, co-founder and co-chair of Oaktree Capital Management, discusses what he sees as the risks facing the current investment environment and the outlook for the credit market on "Bloomberg Open Interest." 

And the commercial real estate market continues to experience volatility as US office values are 25% below their 2022 peak. However, SteelWave Co-Founder, Chairman and CEO Barry DiRaimondo believes this bear market could be a great investment opportunity.

"You've got two sides of the equation. You've got the capital market side, which drives values. And then you've got supply and demand, which drives leasing. And they're both a mess, candidly, at the moment," DiRaimondo explains. 

He notes that as the institutional capital world stays away from the office sector, "you can convince yourself that it's going to take ten years or longer to absorb all the vacant space. Now, historically, that never is what happens." He adds that the office market tends to recover in a "hockey stick" shape and believes the market is currently at the bottom.

As some companies allow employees to work from home, he notes that hybrid work situations won't affect the need for office spaces: "While there are some tech companies that have embraced the work-from-home environment, there's other ones that are clearly moving back to the more traditional with a little bit of a hybrid piece of the equation. But you know, if you're required to work three days a week or four days a week, you still need the same amount of office space because people are still coming into the space."