Starwood’s pivot on distress should not concern investors

Starwood now expects less troubled deal flow to emerge in the non-performing-loan space from the current pandemic crisis than it did before. But that should not worry investors which committed to its latest ‘distressed’ fund.

The last time Starwood Capital Group was in the market with a distressed real estate fund was nearly 10 years ago. The fund in question was Starwood Distressed Opportunity Fund IX Global, which was launched in 2011 in the aftermath of the global financial crisis and ultimately went on to attract $4.2 billion at its final close in 2013.

Almost a decade later, Starwood is nearing the final close for its latest opportunistic real estate fund, Starwood Distressed Opportunity Fund XII Global, for which the firm has already smashed its $7.5 billion target. The Miami Beach-based manager is on track to hit its $10 billion hard-cap later this year.

Fund XII, in contrast to its two predecessor vehicles, is the first fund since Fund IX to have ‘Distressed’ in its name. Starwood declined to comment, but PERE understands that when the firm launched the fund during Q2 2020, the firm expected the opportunity set post-covid to be similar to what emerged coming out of the GFC.

To be sure, Starwood has deployed or committed about 20 percent of Fund XII’s capital and already allocated more capital to distressed investments than it did with Fund XI. That vehicle only had exposure to distress through some of its tail-end deals, including providing rescue capital to TPG’s mortgage REIT in May 2020. Fund XII’s investments, meanwhile, included examples of classic distress – namely buying non-performing loans – as well as acquiring properties from distressed sellers, such as the purchase of a hotel in Copenhagen from a high-net-worth investor who needed liquidity after some of his businesses were severely impacted by the pandemic. Other investments have been opportunistic plays rather than traditional distress, such as buying non-strategic assets from publicly traded companies keen to generate liquidity.

However, a year after the vehicle’s launch, the distressed opportunity set for Fund XII has been less robust than anticipated. This is not surprising, considering some of the most compelling distressed opportunities after the last crisis emerged one year to two-and-a-half years after Lehman Brothers’ collapse. It is conceivable that some banks may begin selling off troubled loans within a similar timeframe post-covid. However, that sell-off has not happened at scale yet. And it is looking increasingly unlikely to reach the scale seen post-GFC, given the unprecedented amount of government stimulus that has allowed banks to forebear and not offload their NPLs.

Fund XII, notably, has sizable target allocations – 20-30 percent each – to hospitality and offices, two property sectors where distress has been widely expected to emerge. But those allocation targets are not significantly different from those of Fund XI. Instead, the new fund will be more heavily weighted to industrial, a sector in which Starwood did not invest with Fund XI. Industrial, along with data centers and single-family rentals, is a sector where Starwood anticipates not only outsized growth, but also steady cash yields. Other high-octane opportunistic plays include investing in specific geographic markets with outlooks for strong job, population and rental growth and cap rate compression.

Starwood is not the only private real estate manager to not have seen as much distress as originally predicted. But investors in the firm’s opportunistic fund series will care more about their capital being allocated to high-returning investments overall, not whether those investments are classic distress plays. After all, a large percentage of Starwood’s opportunity fund LPs are return investors that have committed to the fund series regardless of whether a particular vintage has a distress focus.

Moreover, Starwood’s performance track record has earned it strategic flexibility. It shows it has consistently met its 14-16 percent net return targets. Ultimately, that is what matters most to investors, even if its latest fund may not live up to its name.