The credit collapse and the ensuing de- leveraging from financial institutions are expected to have a colossal impact on the real estate investment market.
If industry executives are right, fortunes could be made, but also the number of real estate investment managers will shrink because of the lack of available capital, and portfolio returns might suffer.
"I don't think anybody has lived through what we are living through right now unless they are 100 years old. The magnitude is so massive," said Tim Ballard, chief investment officer of Buchanan Street Partners, a Newport Beach, Calif.-based real estate subsidiary of The TCW Group Inc. of Los Angeles.
"This will affect ... job growth, consumption and other things. The [savings and loan] collapse did not have nearly the same effect," he said.
Commercial real estate is in the second or third inning of a game that might go into extra innings, industry insiders said.
Right now, though, enterprising real estate investment managers are calling on the financial institutions trying to get a slice of the institutions' combined $500 billion real estate holdings.
For example, American International Group Inc. of New York — which was buoyed by a two-year $85 billion loan from the Federal Reserve — is thought to be more likely now to spin off its real estate investment management business.
Although many are salivating over AIG's $16.1 billion in real estate holdings, including a number of trophy properties such as its Manhattan headquarters, managers don't expect properties to be in distress, because of the relatively low level of leverage used by the insurer.
Lehman Brothers Holdings Inc. of New York is expected to sell real estate securities and residential properties, including land, as part of its bankruptcy filing.
The Goldman Sachs Group Inc. and Morgan Stanley, both of New York, might have to sell off properties to raise cash and reduce the leverage on their balance sheets as they become bank holding companies.
TRILLIONS IN LEVERAGE
Financial institutions nationwide might have to reduce leverage by trillions of dollars, insiders said.
According to Buchanan Street estimates, that reduction could amount to $5 trillion.
"There will be some fabulous opportunities in this," Mr. Ballard said.
"There will be folks who are forced to sell because they can't refinance," he said. "There will be more sellers than buyers, and purchase prices will decline."
But observers say that while bargains will abound, buyers shouldn't expect fire sale prices.
For one thing, managers are sitting on billions of dollars, waiting to scoop up distressed assets.
For another, under the administration's $700 billion bailout plan, the government would be paying higher-than-market prices for securities financial institutions haven't been able to unravel and sell, thus keeping their securities from hitting rock-bottom pricing.
Richard C. Gallitto, executive director of Tremont Realty Capital LLC, a Boston-based real estate investment management firm and lender, said Resolution Trust Corp., a government-owned asset manager charged with liquidating the assets of failed savings and loans in the 1980s and 1990s, "was a different animal. The bank failed, and assets went to the RTC to be liquidated."
"Now the government is writing a check to buy it," Mr. Gallitto said. "I hope like heck that it will work."
Real estate investors anticipate that other, relatively healthy financial institutions will have to come to grips with investments clogging their books, Mr. Gallitto said.
MEETING OF MINDS
In the medium term, real estate professionals expect that the credit collapse will lead to a meeting of the minds between real estate buyers and sellers on price.
Over the past year, transaction volume has been way down, mostly because sellers have been asking more than buyers — fearing the continuing descent of prices — have been willing to pay.
Those days are coming to an end.
"Some real estate investors expect distressed sales to come within the next few months when short-term debt comes due and owners can't refinance and have to sell assets," said Susan M. Smith, director in the real estate advisory group of PricewaterhouseCoopers LLP of New York.
Deals will be different, though. There will be a "flight to quality," with well-located fully leased properties' fetching the best prices, Ms. Smith said.
Real estate with empty space will be tough to sell, because the banks that are still lending will lend only to the top-quality properties, she said.
Still, real estate investors won't see appreciation in their return equations, and they will have to shift their growth assumptions downward, said Sarah Snyder, vice president of Callan Associates Inc., a San Francisco-based consulting firm.
"I think you will have some good opportunities. We are starting to see some distressed debt filter back into opportunistic strategies that are more diversified," Ms. Snyder said.
"I think investors will look closer at how managers leverage and structure their debt," she said.
Market observers said that cash will again be king because investors will need a lot more equity.
Mezzanine funds will become extremely important to lenders because they will be among the few with money.
While a number of managers raised mezzanine funds during the past year, the amount raised isn't even close to the projected lending need.
The hardest loans to get will be first mortgages.
Sellers and the government may have to take back mortgages to make deals work.
"The amount of equity needed will be twofold what it was in 2006 and early 2007, impacting valuations and impacting the speed of transactions, which will be much, much slower," Mr. Ballard said.
He said that the transactions now might take months, compared with two weeks for multibillion-dollar transactions when the real estate market was hot.
Commercial real estate across the board will face significant challenges because capital issues are creating lower valuations, Mr. Ballard said.
The number of real estate investment managers will shrink because "capital will not be available for everybody," he said.
Philip J. McAndrews, managing director and head of global real estate at TIAA-CREF of New York agrees: "As we move further into the cycle, there will be fewer players."
The field will be left to investment managers with ready cash who can move quickly and who can make returns with a minimum of debt, he said.
"You need the acumen to find the best relative value among the opportunities. A distressed transaction is not always an excellent transaction because it's under distress," Mr. McAndrews said.
Arleen Jacobius is a reporter for sister publication Pensions & Investments.