For those waiting for a 1990s-style fire sale of distressed assets, do not hold your breath. This time things are different, says Lee Menifee

Many prospective property buyers are waiting for an investment environment like the mid-1990s - an abundance of high-quality properties available in major cities at prices that will generate 20% IRRs. We suspect most will be left waiting.

Encouraged by recent stabilisation, many property owners are hoping to ride out the current downturn without further damage. They too are waiting. But unlike in the mid-1990s, many of them will be able to wait for a long time. Distressed sales may well remain the exception, not the rule.

You can thank - or blame - governments for the muted distress this time around. There is much more support now for government involvement in the private sector and banking. Many countries' banking systems are de facto nationalised, and in exchange for this support banks are increasingly being told how to run their operations. When it comes to commercial real estate, the message to banks in most countries is: reduce your exposure to property loans, but do it gradually to prevent a free fall in property prices that would further stress bank balance sheets.

There are exceptions. Governments in Iceland and Ireland are too stretched to fully support their banking systems, and as a result banks are reducing their real estate exposure via forced sales - so far, primarily of properties located outside the banks' home countries. Some CEE countries may soon follow; plus, in the event of currency devaluations and/or the unilateral imposition of loan modifications, the Swedish and Austrian banks with large exposures to the region would also be put under pressure.
In contrast, some Asian countries are actually experiencing an expansion in real estate lending, most notably China. As a result, the investment environment in Asia is looking more like a real estate bull market than a bear market, supported by well-capitalised banks.

For most of Europe and North America, however, the most likely outlook is for a relatively orderly asset liquidation process. Banks' capital reserves have been boosted by government infusions and, more recently, equity offerings. Most governments' stated long-term goal is to further increase banks' capital reserves, but their short-term goal is to relax reserve requirements, in part so banks do not have to reduce their commercial real estate exposure too quickly.

For example, in the US, a recent policy statement permits lenders to restructure a single troubled loan into two parts, with a first note ‘that is reasonably assured of repayment and performance according to prudently modified terms' and a second note ‘not reasonably assured of repayment… and charged-off as appropriate'. Instead of counting 100% of a loan balance as troubled, banks can restructure the loan so that most of the original balance is considered a performing loan, and the rest written off. Presto: no more distressed loan!

Government support for the banking sector means there will be a relative trickle of buying opportunities rather than a flood. For buyers, pricing should be good for years… but only good, not great. For owners, they may find it advantageous to hold rather than sell if they have a long-term investment horizon, are sufficiently well capitalised and if they believe their asset values have already hit close to bottom.

For those expecting that an increase in distressed sales is imminent, consider that the recent yield compression in some markets is causing property valuations to increase. If maintained, this will result in fewer loans breaching loan-to-value covenants and consequently even less pressure on banks to force sales.

So, is there nothing to be done? It may seem that way for buyers who are looking for high-return opportunities, but there are less obvious strategies that make sense:

Do not be overly cautious. Today's income yields are historically attractive. In the UK the spread of property yields over inflation-indexed gilts is 666bps - a huge improvement from the anaemic 240bps spread in June 2007 and 260bps higher than their 15-year average. Yield spreads are similarly attractive in the US and some other European countries. Yes, interest rates are likely to rise over the next few years. But today's spreads are so wide that it is not necessarily true that property yields will rise along with them; Recogning risk will be important to achieve high returns. In this cycle, there will be very few opportunities to buy stabilised assets at distressed prices. It may be too early to execute a lease-up strategy, but given the near-complete shutdown in speculative construction in most of the world, occupier markets will recover. Look for markets where tenant demand is likely to rebound but investor demand for non-stabilised assets is lacking; Consider alternatives to direct property investing. The competition to buy top-quality, stabilised properties is rapidly rising, so the price correction for these types of ‘bondable' assets may already be over. For investors with lower current income requirements, indirect investments may offer better value than buying properties in some countries. Some limited partners looking for early exits from closed-ended funds are willing to sell their interests at sharp discounts. Many quality companies and funds still need to be recapitalised, often on very attractive terms. And then there is debt. Banks will continue to extend existing loans and at the same time need to reduce their commercial real estate exposure, which means they will be unable to originate many new loans. This reduced competition will be lucrative for lenders with capacity, as they will be able to target high-quality buyers that will be willing to pay relatively high interest rates.

For investors looking for better-than-core returns, passive strategies will not work this time around. Do not expect sellers to come hat in hand.