Private equity firms have more flexibility than other financial institutions. They have access to more cash in the form of new investments, loans, and the leveraging of their securities and real estate investments. This flexibility provides a great investment environment for capitalizing on commercial real estate in distress. Over the years, investors big and small have taken advantage of the low interest environment to buy real estate investments. Many of those investors leveraged their properties into more and more commercial real estate.
Higher Interest Rates
Low interest rates cannot last forever, and high inflation in December 2021, dwarfed by even higher inflation in January 2022, left the Federal Reserve with no choice but to raise interest rates and raise them fast. Suddenly, those interest-only loans required higher payments, payments that couldn’t be covered by existing cash flow.
Worse, tenants were subject to some of the same problems. Too little staff, increasing supply costs, and pushing that line of credit to the max spelled trouble, especially for small businesses. These companies once propped up commercial properties, leased warehouses, and subleased office buildings. As they fold, or cut back, properties are hit with decreasing revenue.
Commercial real estate property owners aren’t fools. They could see the same problem coming that everyone else could. They needed to unwind some of their properties to reduce capital outflows. Unfortunately, you can’t sell a 20-story office building overnight. It takes more than a couple of weeks to find a buyer for a warehouse complex.
With many distressed commercial properties sitting on the market, and many owners just months away from bankruptcy or worse, the only option is to price lower and act more aggressively. Unfortunately, that may not be enough. There simply aren’t enough buyers, and interest rates are continuing to increase. If only there were a buyer willing to take on such a building in exchange for a rock-bottom price.
Cue the private equity firms.
Private Equity Cashes In
Commercial real estate investments cycle just like stocks do. However, COVID has drastically affected the real estate market. The great migration from office buildings to home offices showed businesses that they can reduce their footprint. White collar employees now are working remotely or in a hybrid workspace, which has caused office space to have occupancy rates as low as 30%. This is where private equity plans have an opportunity to capitalize on a building. The difference is the amount of time they can hold an asset, waiting for occupancy rates and the price per square foot to increase.
Sometimes, all it takes is time. The warehouse park that was worth several million dollars will be worth that amount again. The current cash flow might not be enough for the current owner to make their payments and turn a bit of a profit, but there are plenty of other creative ownership structures and ways to finance and leverage ownership of properties.
Leveraged financing, property market expertise, and smart money will use the weaknesses in the commercial real estate market to focus on properties where the owner is extremely motivated to sell and there is a discount to match. Other opportunities come from properties in great locations that suffer from older buildings and offices. Get the property for a good, heavily discounted price, pay the least amount of up-front cash possible, and then use this time of emptying offices to upgrade the building and interior. When tenants come back, they’ll be willing to pay more for the building investors got for a great deal.
It is no wonder that private equity firms consider investing in a distressed commercial property market a phenomenal opportunity.