A once-in-a-lifetime opportunity or a potential minefield of uncertainty? Richard Lowe talks to both European investors and advisers on the ground about distressed opportunities in the US

One thing is certain, 2009 is going to be a tough year for the US real estate market, and total returns are expected to remain firmly in negative territory for the first time in nearly two decades. Investors and property companies that have taken on too much debt in recent years will find it most unforgiving, as they are unable to refinance loans approaching maturity and the economic recession (which started in December 2007, according to the National Bureau of Economic Research) weakens demand and increases vacancy levels.

Of course, one investor's loss is more often than not another investor's gain. Those with cash to deploy have much to capitalise on, in theory, since 2009 is generally expected to be the year in which widespread distressed selling in the US finally arrives. Some real estate experts are suggesting that 2009/10 could be one of the best opportunities to buy US real estate in living memory.

Certainly, there is no shortage of opportunistic players vying to benefit from bargain deals, including a number of private equity-style fund managers sitting on billions of dollars of capital.However, there is still a great deal of uncertainty in the US market, especially for non-US investors who may still regard it as the epicentre of the tremor that shook the world's financial system to its core.

There are concerns about the trajectory of the country's economy (although many are forecasting the US to lead the economic recovery ahead of the UK and continental Europe) and how this will affect real estate fundamentals over the months and years. And the US Treasury's sudden U-turn on its original plan to purchase toxic assets from the balance sheets of troubled financial institutions has only added to the confusion and unsettled investors.

In the past, the UK-based Scottish Widows Investment Partnership (SWIP), for example, has invested in the US. Today, however, SWIP has no exposure to US property and does not intend to alter this in the near future."My impression is that Americans haven't quite got to grips with all of their problems in the way that I think we have in the UK," says Malcolm Naish, head of property at SWIP. "I am reluctant at the moment to commit to the US."

He explains: "There is probably some very good value and there is a probably some very bad value, and it is quite hard to determine which is which… Buying distressed assets in the UK and also continental Europe is probably more attractive for a UK investor at the moment. I think it is easier to understand and I think it is easier to quantify and I think it is easier to begin to understand the risks as well."

Last year, IPE Real Estate reported on how Vital Eiendom, which manages the real estate investments for Norway's largest privately owned life and pension insurance company, Vital Forsikring, was planning to invest in US real estate to further diversify its Europe-only portfolio. In the summer of 2008, Stein Berge Monsen, senior portfolio manager at Vital Eiendom, told IPE Real Estate that the US market was the logical first choice when looking outside of Europe.

However, the heightened turmoil in the financial markets and economic uncertainty after the failure of Lehman Brothers, means Monsen is no longer looking at the US with any intention to invest - certainly not in 2009. "We will not invest in the US at the moment," he states. "It is prudent and it is right to stay away from that market for a period."
Vital Eiendom is in the same position as the vast majority of institutional investors in Europe, reluctant to make any new commitments to real estate funds until some stability and clarity has returned to the world's markets.

But if he had to invest to capital, Monsen suggests his first choice of destination would be the UK, partly because the market appears to have corrected the most and consequently is likely to be the first to recover. "That is the only good opportunity we see at the moment," he says.However, if it is to be believed that some of the best buying opportunities to arise in the US in recent times will arrive in 2009, such a stance could be considered detrimentally cautious.

Michael Pralle, chief investment officer and chief operating officer at US-based fund manager JER Partners, concluded his white paper on ‘US Distressed Opportunities', published in November 2008, with the lines: "Falling prices will wipe out equity holders that leveraged at 75% to 80%, leading to foreclosures and highly-motivated sellers. This dramatic asset repricing will result in some of the best bargains in real estate investing during our lifetimes emerging over the next six to 12 months."

Speaking to IPE Real Estate in December, Pralle is reluctant to say it will be a "once in a lifetime" opportunity. But he is adamant that it is clearly "going to be an extraordinary opportunity for investors that have cash to invest in real estate" over the given period.
"I wouldn't wait too long," he warns investors looking to invest in the US. In his experience of investing in dislocated markets, it is invariably "the people who got in early" who "did much better".

Scott Sweeney, executive vice-president at Falcon Real Estate Investment Company, agrees there is a danger of missing the boat if investors wait too long to enter the US market. However, he also recognises the conundrum facing pension funds and other institutional investors in their need to be careful and cautious.

"They're not the people who'd be the first to jump into the market once it starts to turn," he says. "But hopefully, by the end of 2009 or the beginning of 2010, a buyer profile like that could be active and comfortable that they're getting into the market at a proper time and not missing the appreciation that happens very quickly in the beginning of the turn."

One large European institution hoping to capitalise on distressed assets in the US over the next two or three years is Denmark's €40bn ATP pension fund. Although the decision to invest in the US for the first time was made predominantly from a long-term diversification standpoint (until 2008, ATP had invested only in European real estate), the pension fund is determined to benefit as much as possible from the US market's current point in the cycle.

"I am happy we didn't start in the US two or three years ago, because then we would have been sitting here with a much larger portfolio," says Michael Nielsen, head of real estate ATP. "But right now we are in a position where we really can take advantage of the outlook for the coming two or three years."

Nielsen reveals that the two funds in which ATP is invested are specifically looking at distressed assets at the moment.There are no plans to make any further commitments to other US focused funds, but rather ATP will scrutinise closely the activity of its two funds and see how the US market develops.

"What we really hope - and it is the intention of these funds - is they will be very patient and use the whole investment period to make sure they time all their acquisitions as best as possible," Nielsen says.
Pension funds with healthy cash reserves find themselves in a strong position potentially to benefit from the current market downturn. The opportunity "to capitalise on distress" is being sold far and wide by real estate fund managers.

The US is an obvious market to attempt to do this, but the ‘US opportunity' is in some sense in direct competition with another market attracting a lot of investor attention and which appears ripe for distressed opportunities: the UK. The views of both Naish and Monsen reveal that, at least, some European institutional investors see the UK as a safer market to commit capital to distressed opportunities.

This might be down to the geographical proximity and investor familiarity, but the UK also looks attractive because the market has already visibly corrected, as evidenced by data from International Property Databank (IPD), which suggests capital values have fallen by 24.5% since their peak in June 2007. NCRIEF total returns, meanwhile, did not drop into negative territory until the third quarter of 2008, suggesting a perceptible lag.

However, Jason Spicer, managing director at DTZ Rockwood, suggests that investors should not be misled by the fact the NCRIEF index is not showing the write-downs in values to the scale seen in some of IPD's indices. There is a certain level of disconnect between market values in the US and the NCRIEF index, which only reflects 5-7% of the US investment universe as a whole, compared with IPD, which represents much closer to half of the UK investment market.

"Those values are not indicative of some of the yields we think are going to be able to be achieved in the very near term from distressed sellers," Spicer says.
There is also the prospect that the US will lead the UK in its economic recovery, having entered a recession first, as fellow DTZ Rockwood managing director Colin Thomasson points out.

"There is no question that the UK repriced its real estate quicker than the US did, but that doesn't mean the UK will be recovering quicker economically than the US will," he says. "It may be that UK real estate stays depressed for longer and has to wait for the US recovery to help the UK [economic] recovery and from there to help UK real estate."

Opportunistic investors in the US have identified real estate debt and recapitalising over-leveraged borrowers as the best approaches to capitalise on distress, rather than purchasing the hard assets directly.

"The big opportunity today is probably to buy discounted loans," says Sweeney. "The other big area [opportunity] funds are probably looking at is to recapitalise distressed borrowers."Sweeney explains the latter approach allows investors to generate a return comparable to putting equity into a deal, without the equity risk. "All that they are doing is having the debt risk, where they are out of the deal first, but they are still getting equity returns," he says.

Pralle agrees: "Why do you buy the office? You buy the debt in my view. There is a mispricing between hard assets and real estate debt today, because of the lack of liquidity," he says. "People who hold these securities in general want to sell them. There is very little demand on the buying side for real estate loans, for real estate commercial mortgage-backed securities. That is in itself a kind of arbitrage opportunity between real estate debt and hard assets."

"Most people these days are interested in debt, in one form or another," says John Wilcox, at Savills, which set up a special distressed asset advisory group in New York in 2008. "There will be opportunities in the equity side. This will be a little different flavour of distress, if you will."

While the opportunity to invest in real estate debt is certainly there, whether this approach will appeal to pension funds that invariably require ‘pure' real estate investments for their clearly defined multi-asset investment strategies is another matter.Certainly, ATP is not looking to invest in real estate debt in the US. "Our focus is definitely pure real estate investments," says Nielsen.

"We have some other colleagues in ATP dealing with general debt products, but we are not doing any focused debt investments… the debt instruments are a little bit different even though the underlying asset is real estate."

Reaction to the U-turn
The US government's $700bn (€510bn) Troubled Asset Relief Program (TARP) was originally expected to buy up toxic assets on the balance sheets of financial institutions. Treasury secretary Henry Paulson has made a U-turn on this proposal, preferring instead to inject cash directly into the banks. What does this mean for distressed opportunities in the US?

"The concern was the opportunity funds would be competing with the US government for the bidding on these items. No one was clear, frankly, how it was going to work with the government buying the assets. There was a real sense… that if the government is buying these assets there will be no market price being set, because how do you set a market price if you are the only buyer? [Banks] will have a longer period over which to liquidate these assets, because of what changed in the policy. That is definitely a change, but: is it stabilising and letting them do it in an orderly manner, as opposed to a problematic liquidation and a crash?"
John Wilcox, managing director, Savills

 "It means you are not going to be able to - assuming they stick with this plan - either manage large pools of assets on behalf of the government for fees or purchase assets at distressed prices from the government as we did in the early 1990s from the Resolution Trust Corporation. However, there are going to be a large number of regional banks in the US that will be very motivated sellers, and there will be regional bank failures as well, so I think there will be opportunities to acquire portfolios of real estate assets from regional banks."
Michael Pralle, CIO, COO, JER Partners
"This has concerned a lot of people… I think now the banks that have that type of debt on their books have realistically to look at selling it directly to third parties and I think that is going to start in 1990… and I think that is an area where these vulture funds are going to find opportunities… It would have been easier to buy it through TARP for a lot of these funds… Now these funds are going to have to go to a lot of different individual financial institutions and negotiate each transaction separately."
Scott Sweeney, executive vice-president, Falcon Real Estate