If you are a distressed real estate investor with capital to deploy right now, you do not have a great deal of time to place your bets if you are to make the most of the current opportunity. That is how John Grayken sees it.
With Western economies visibly starting to get a grip on rising inflation and interest rate hikes moderating in tandem, the veteran boss of private equity real estate giant Lone Star Funds thinks the best opportunistic plays will happen before there is widespread agreement about settled market conditions.
This journalist asks: is it important to place capital before interest rates settle? “Probably,” responds Grayken. “Once there is a general consensus, usually it’s too late for investors like us.”
He will not today be drawn on the firm’s investing activities, nor will he talk about performance or fundraising. But, in this rare interview, he is willing to share his views on the current market.
Given his vast experience, his perspective provides a lens through which to view current dislocations in the sector and gauge where opportunistic performance can be achieved. And while he will not talk specifically about any Lone Star business, he is clear that investors like him “need to be a step ahead of the market to get returns like that”.
To take such a step, a top-down perspective should be combined with more granular, asset-level analysis, Grayken says.
He recaps the state of the current US economy, which contains the world’s biggest commercial real estate market and, as such, frequently provides indicators of what is in store elsewhere in the world.
“This industry has enjoyed low interest rates, and, for the most part, accommodative monetary policy for 15 years,” he says. “During that period, the Fed funds rate maxed out for 10 years, between 2008 and 2018, at 2.5 percent. Now we’re at 5 percent – doubled. And we got to 5 percent very quickly when you consider we were at 25 basis points in March of last year.
“But a lot of things happened in the 15 years in terms of valuations and capital structures. The industry became very reliant on the availability of debt capital that was inexpensive. That’s changed – dramatically and quickly.”
“If you are a holder of this asset class and you are not properly capitalised for the environment we’re in now, you’re going to be under some pressure”
Grayken highlights how real estate’s heavy dependence on leverage is also a key component of the sector’s cyclicality. He notes secular differences between property markets today and before. But he reckons this perpetual relationship with debt means the next cycle should carry similar ramifications. Subsequently, he contends that sensible leverage assumed before today’s crisis will be a key determinant for the predicaments of many landlords today. “If you are a holder of this asset class and you are not properly capitalised for the environment we’re in now, you’re going to be under some pressure,” he says.
Offering further insight on the big picture, Grayken believes the “easier part” of governments’ efforts to curb inflation has now been accomplished. He lists tapering energy and food costs, a rationalisation of supply chain issues following covid, and the start of the war in Ukraine as contributing factors. “The global economy has adjusted to some of that,” he says.
Nevertheless, he adds, in the US, “the last numbers indicate we’re still inflating at 5 percent, which is 300 basis points above their target.” For Grayken, important questions remain unanswered: “What is the terminal rate going to be? How long will it stay there? When does it start to decrease? What is going to be the rate of decrease and over what period of time?”
Grayken is also wondering whether there will indeed be a recession. “We’ve seen the beginnings of a slowdown, but not an outright recession. As monetary policy acts with a lag, there’s a lot of uncertainty as to what the effects of these rapid increases in interest rates will be on the macroeconomy.”
This uncertainty has paralysed many real estate investors. According to broker JLL, global investment volumes in the fourth quarter of 2022 – the period when interest rates doubled to 5 percent – plummeted 58 percent on a year-on-year basis to $203 billion, dragging the year’s total to $1.03 trillion, 19 percent down on 2021.
While the market grapples with the macroeconomics, distressed investors must figure out what moves to make. In one key difference between now and the global financial crisis of 2008, property markets are, generally, not overleveraged. There has been little recent speculative development either.
Today’s markets are, instead, challenged by uncertainty stemming from accelerated secular changes. This has distressed investors worried about catching falling knives, as Grayken puts it. He adds his voice to a chorus which says that retail and offices are facing structural issues. “There’s still some uncertainty about the ultimate level of online penetration. People still don’t know that. And I think there’s still a lot of uncertainty with respect to working from home. Certainly, that’s a trend. But we haven’t had time to measure its long-term effect on productivity. It may be the effect is not as dramatic as a lot of people think.”
For Grayken, grappling with these issues requires “a framework” around considerations of demand. Within that, it will be important to consider individual properties on their own merits. “Then price them based on your cost of capital and how you see the future from an occupier’s standpoint and from the standpoint of financial markets, cap rates and interest rates.”
“When I hear certain cities are being written off, that sounds interesting to me. These types of broad conclusions, they can be challenged”
He admits the process is going to be “complex.” But he says it is precisely because of this complexity that there is such a notable bid-ask spread across markets at the moment, and that should be interesting to distressed investors. “It will persist for a period of time until there’s more clarity.”
When pressed for a timeframe, Grayken says the next two years will be important for investing while most wait for this clarity. “There clearly will be opportunities in the next 12-24 months. There’s no doubt about that. Would that be the window? I’m not sure.”
He explains there could be more than one window of opportunity, depending on whether a recession does in fact occur. “We could get into a recession. If we do, there’s going to be political pressure on the Fed to stop [raising interest rates] because of concerns about employment.” Referring to a period in the 1970s, he says: “We’ve seen it before when they stopped, but too early. And then we inflated again and there was another tightening cycle.”
Ignoring the chorus
For the current window, a significant degree of conviction about asset types is important, Grayken believes. For many, this especially applies when considering growth strategies. But he thinks this also matters when running the rule over distressed assets, as both can deliver profitable outcomes for opportunistic capital.
“When I hear certain cities are being written off, that sounds interesting to me. These types of broad conclusions, they can be challenged. It may be the problems there are serious enough where pricing levels are going to be very low and unattractive to sellers. But it’s unlikely that, for a lot of these assets, the answer is zero – they’re not worth anything. I’ve heard that sort of thing before – a lot – and that usually turns out to be wrong.”
He discusses San Francisco. “Look at that market. The assets are very much technology-based. There are a lot of work-from-home effects there. But it sits adjacent to Silicon Valley, which has been the most prolific creator of wealth in this country for the last 50 years. Would I write off San Francisco? I think that would be a mistake.”
Similarly, Grayken takes a nuanced view on the retail sector. “There are certain types of retail formats which I still think have a lot of value and are not going away. If you look at the underlying business model for most retailers, the most expensive part of the distribution network is the last mile. This is where margins really get devastated.”
As a consequence, Grayken thinks there could be value in real estate that accommodates “click and collect” services. “You do need a store front for that,” he says.
He also thinks hospitality faces no structural issues now that covid is in the rear-view mirror. “It’s more cyclical. But, of course, how a cycle plays out can be the difference between a good investment and a bad one.”
Speaking of cyclicality, while today’s market circumstances might seem unprecedented to the uninitiated, Grayken speaks like a man whose many years in distressed investing have made him hard to surprise: “We’ve been through a number of these over the years going back to the early 1990s during the savings and loan crisis.”
Harking back again, he recounts a chronology of crises including the Asian financial crisis, the dotcom crash, the GFC and covid. “It’s a scenario I’m familiar with,” he says.
Grayken’s is a nuanced position when compared with much of the commentary in the market right now. Like many others, he too wonders about all the secular changes informing the use of real estate at the moment.
But, unlike them, he is most convinced that basic rules around the use of leverage will be ultimately responsible for much of the winning and losing in private real estate in the coming years. Given his record of right calls after past crises, it would be a bold call to contradict him.