#writing As private equity has grown to seemingly own the world it has drawn many industries into it's gravitational field and in doing so has concentrated risk reducing the value of diversification. The fates of private equity and commercial real estate are increasingly tied together. Maybe family offices will ride in to the rescue? Both industries are negatively impacted by higher interest rates and PE having drawn CRE into it's orbit serves to exacerbate the issue for both. Private equity is funding more CRE than you may have realized and recently they have turned off that spigot leaving many developers and traditional CRE investors in the lurch. Exploring the current market structure of CRE to understand the motivations and constraints of the different players in the market. --- **June 24, 2024** As we are well aware at this time, when the Fed raised rates at the fastest pace ever in 2022 it caught a few regional banks offsides. Whenever you get something historic like that things break, and this time it was Silicon Valley Bank that broke. If one had taken a look at SVB prior to the collapse they would have been more concerned about the credit risk in Silicon Valley's loan portfolio which was primarily to tech startups, but it turns out they had a ton of duration risk which is what took them down. When one bank fails everyone checks their bank to see if the thing that took down the one might take down theirs and that is how bank runs start. We saw a bank run in 2023 which cut off a major source of credit for the commercial real estate market. Regional banks like Signature Bank, New York Community Bank, Bank OZK, and others had made a large push into commercial real estate after the GFC providing  roughly [80% of all loans to CRE firms according to Goldman Sachs](https://edition.cnn.com/2024/02/29/business/regional-banks-cre-exposure-explainer/index.html). When that source of capital turned off the CRE industry came under attack on two fronts: 1) higher interest rates which increases the cost of capital AND puts downward pressure on valuations, and 2) a credit crunch which lowered the overall supply of capital for the industry. When the CRE industry started to retrench it put further pressure on the regional banks, which had loaded up on short-term but risky development and bridge loans, creating a self-reinforcing credit cycle. Higher rates led to lower valuations and lower valuations led to less lending from the banks which put further pressure on valuations and increased defaults, and more defaults put further pressure on banks and their ability to make new loans. The Federal Reserve created the Bank Term Funding Program in March 2023 to arrest this cycle and provided nearly $108 billion of one-year advances to banks during the life of the program which ended in March 2024. Today, interest rates have stopped going up and the debt markets are starting to open back up for CRE as expectations for interest rate cuts permeate through the capital markets. The CMBS market has rallied significantly this year (chart below) and issuance has picked up which is a good leading indicator for future lending volumes. Banks and other lenders are back in the market making big loans (below) and transaction activity is starting to pick up with ["owner-users" overtaking private buyers as the primary buyers of office properties](https://wfgtitle.com/commercial-market-review-q1-2024/) and continued demand for datacenters, logistics, and multifamily properties. However, the improvement we are seeing is very limited with transaction volumes still down 56% year-over-year in the first quarter according to CoStar and the supply of equity capital is greatly diminished. ![[Pasted image 20240622122442.png]] ![[Pasted image 20240624110751.png]] Valuations continue to be a headwind for equity investors. Today, it is common to see the cost of debt higher than cap rates which is unattractive for equity investors. In this situation equity returns are reduced and reliant on aggressive exit assumptions since the cost of debt capital is not accretive to the equity. The ideal situation for an equity investor is the going in cap rate should be higher than the cost of debt so that the borrowed money is accretive to equity returns and builds in a cushion for future valuations. However, for this to happen today cap rates on existing properties would need to increase which would lower the equity value for current equity investors. Current investors are reluctant to take a loss or realize an impairment on performing, high-quality properties especially with the hope of lower interest rates present and a thawing debt market. However, there is a larger issue at hand: Private Equity has probably become (I don't have the data) the largest provider of equity capital for CRE and is pulling back significantly. While those PE funds have dry powder and are raising "distressed" and "opportunistic" funds, that money is earmarked to invest at wider cap rates than existing investors are willing to sell and new development projects are shied away from because they are expecting cap rates to increase which challenges the economics of new development projects. Also, [since PE is estimated to be the largest ownership group of US CRE](https://fnrpusa.com/blog/commercial-real-estate-numbers/) often times they are also the current investors in properties who do not want to sell or realize an impairment which creates a complicated situation for investors and the PE firms. Blackstone and Starwood have private REIT vehicles that have been in the news recently for limiting their investors' ability to redeem their investments. These funds raised money from retail investors who see the negative CRE headlines today and want to sell their investments at the NAV that the PE firms are providing them which are usually based on low cap rates. The NAV is probably down, but not substantially so the retail investors, seeing an opportunity to sell today at yesterday's prices want out. However, the funds cannot just turn around and sell the properties in short order because it takes time to sell large and complex commercial real estate properties but also there are not many willing buyers at the cap rates the PE firms are using to value their portfolios. This is what we would call a wide bid-ask spread in market parlance. There is also the problem that the PE firms have when they sell a property below their valuation it causes them to have to mark down the rest of their portfolio which would only panic their investors even more. Many have criticized the PE firms for inflating their valuations but the PE firms rightly respond that they own high-quality, "trophy" properties that shouldn't be sold at a fire sale for pennies on the dollar as that would only hurt their investors. Luckily, the PE firms have been down this road before as the economics of the traditional PE business model has been challenged for some time. The traditional approach was to identify an undervalued company in the public market, borrow heavily to take the company private, improve the business and then sell the company back to public investors in the future at a higher valuation. This is basically what we call "value-add" investing in CRE. However, as the number of PE firms and the size of the industry has grown competition has made it harder to find and acquire undervalued companies, and as aggregate equity valuations have increased the opportunity set has diminished which has made it necessary for PE firms to shift their strategies. The first shift was to expand into different markets like commercial real estate, infrastructure, and private credit. The other shift was the emergence of secondary PE funds. While secondaries can take many different shapes the general idea is either PE investors or the PE managers want or need to sell their investments but not back to the public market where valuations tend to be higher, and instead to other PE investors. From a macro perspective this doesn't make much sense because PE investors have a higher expected return than public market investors, but when the issue is getting liquidity on existing investments then the valuation moves to the back burner. Not wanting to sell at pennies on the dollar the PE firms can buy their own assets into new funds or secondary funds that they manage or strike a deal with another PE firm that might have a slightly more positive view on the asset and provide a decent return to the selling investors. This creates all sorts of conflicts and challenges for the PE firms but the growth of the secondaries market and GP-led secondary funds is a testament to their problem-solving capabilities. As the PE industry has grown it has also had to face the challenge of how to deploy the large pools of capital it manages. PE firms naturally chase larger transactions which creates a  size bias in the market. Recognizing this PE firms also deploy their money by partnering with "sponsors" who can bring them a large number of smaller deals. These sponsors are called "independent" or "fund-less" and they are typically experienced bankers, developers, and other investors who have access to deal flow and sourcing relationships. However, in CRE today the fundraising channel for these sponsors has mostly been shut off. I have seen many projects come across my desk with good economics and debt financing and then struggle to raise the equity capital for the project. In a few instances these sponsors had a prior PE relationship that has is no longer willing to fund their projects. As the CRE market moves through this cycle it is likely that PE will figure out a way to maintain control of their best assets, but many of these smaller assets and sponsor relationships may be left on the vine. This is an opportunity for the family office industry to step up and take market share from PE and while they have the asset base to facilitate this sort of large-scale wealth transfer the majority do not have the operational and transactional capabilities to pull it off. There are over $2 trillion of CRE loans maturing over the next three years and those maturities will require something to be done with the existing owners and capital providers. These maturities will act as a catalyst for transaction volume and we will see how the large PE owners restructure the assets they want to and can keep and which ones they choose to let go. The secular trend for interest rates has reversed and as the tide has gone out we continue to learn new information about the market structure in different asset classes and industries. Commercial real estate has always been linked at the hip with banks and banks have always been sensitive to interest rates. What is new to this equation is the role of private equity and the effect their actions will have on this cycle. What is certain is that a new hand in the cookie jar doesn't make things any less complex.