A&D 2018 Meeting Report: How to Identify Value in Times of Change?
– Paul Simon
(For a print version, click here) It seems that the worst mistakes are often made in the final stages of a recovery cycle – and yet they usually look like good deals at the time. Why is that? How could institutional investors – with information, experience, and judgment from prior rising and falling real estate markets – ever mistake value for price?
Every investment manager acknowledges that markets are tight. And when the downturn comes, some of the prices paid today will be tough to sustain. Yet, most know that sitting this out completely is difficult if not impossible as institutional capital waits to be put to work.
Acquisitions and dispositions leaders from across NAREIM got together in New York City this February to explore the question: how to approach acquisitions in these uncertain times?
Hope vs. Fear
Inside every investor, there is an on-going debate between hope and fear. With rising interest and cap rates, slowing sales and leasing, and global political and social instability there is plenty of reason to be afraid. At the same time, strong job growth, demographic forces, and continued expansion make a strong case for optimism. Which way do you lean – and how should that influence your approach to acquisitions? Ari Abramson, Vice President of Acquisitions at Continental Realty Corporation pointed out that, “When you’re in the chase, there’s always pressure to buy. It takes foresight to be hopeful, but has the game changed? In today’s environment, when do you stop playing poker and show your cards?”
Some might want to pass on a few rounds of betting in this market, as one attendee contributed “Time is one of your greatest resources. Being in tune with the process is pretty important in order to be successful.” However, with uncertainty in any given market, Mr. Abramson asked, “But don’t you have to play a round or two of poker to know where or not the market is efficient or not? How else would you get a bite at the apple?”
The best investors confront both hope and fear at the same time. as another acquisitions manager reflected that “Acquisitions, by its very nature, requires a great deal of courage of conviction, ego, and even a little bit of luck. But I think everyone in acquisitions has run the gamut of emotions. It grounds me in so far as how I look for opportunity – but almost to a fault. It’s hard to find opportunity without seeing the potential mistakes.”
Brendan Coleman, Managing Director at Walker & Dunlop seemed to be more on the side of hope when he said that, “In 2017, Investment sales were down overall, in New York especially; so a lot of our activity has been focused on financing, restructuring and a lot of value-add deals. A lot of people, and a lot of money, sat on the sidelines last year and I expect that to change this year.” Raphael Fishback, a Principal at Mesa West Capital, remains cautious when he considers the fundamental demand for leased space. “One of the things that will be interesting to follow is whether multi-family operators will remain aggressive on offering deals that give 2 months free just to get people into the building. Concessions like these suggest the demand doesn’t support the current listed rents.”
That softening of demand in multi-family due to the increase in supply over the last few years is on many people’s minds, and yet by historical standards, there is still reason to be optimistic. Mr. Coleman suggested that, “If there’s a correction in this market, I don’t think it’s going to be in commercial real estate this time like it was in 2008. We did more loans last year that we ever have before, but the credit fundamentals haven’t really deteriorated like they did before. The underwriting has remained pretty sound.”
Inside every investor sits a tension between hope and fear – and how one navigates that tension may determine the resiliency of the portfolio. Whichever way one looks at the current markets, it is clear that any optimism should be balanced by caution.
What is the impact of tax reform and a new regulatory regime?
The SEC has not gone away – it continues to pay close attention to real estate investment managers. Investors have to be mindful of the SEC’s concerns, even as they wrestle with the challenges of a competitive market. Eva Ciko Carman, a partner at Ropes & Gray, encouraged disclosure to investors. “The SEC asks two questions: did you have a conflict with your investor and was it disclosed? Which means that when dealing with your investors, the way that you charge fees and expenses – even before the sale of an asset – has become a primary focus. They want disclosure on your part before the conduct.”
In addition to fees and expenses, there are a couple of other areas that investors should pay special attention. “The SEC will often insist that you prove market rates third-party services such as leasing or property management. Do you have more than one quote to support your assessment of “market” rates?” Another area of growing concern to the SEC is exposure and vulnerability to cyber crime. “An asset’s exposure to cyber risk is something that the SEC will investigate. closely”
When it comes to tax reform, Kristen Winckler, a partner at Ropes & Gray noted that the new laws have particular benefits for the real estate industry. “In addition to lower tax rates for individuals and corporations, there is a new 20 percent deduction, roughly translating into an effective maximum tax rate of 29.6 percent, applicable to qualified business income earned through entities such as partnerships or LLCs. There are limitations on the availability of the effective rate that are based on the wages paid and capital invested in depreciable property by the business. The property element enables real estate intensive businesses to maximize the availability of the lower effective rate. In addition, REIT dividends are eligible for the lower tax rate without regard to the wage/property limit.”
However, it is difficult to anticipate precisely how some of the changed rules will impact real estate. Partner David Djaha of Ropes & Gray pointed out, “Caps on deductibility of home mortgages might effect single family housing values and reverberate through the condo and co-op markets especially in big cities. That may mean lower property values, less velocity in sales and loss of equity. It’s an interesting time because we don’t necessarily know what’s around the corner.”
How is real estate demand changing?
Clint Myers, the Chief Strategy Director at Hines recalled how his firm used to identify itself primarily as an office developer. However, as they re-evaluated demand over the past 15 years they are seeing the future much differently. According to Mr. Myers, “The demand for office is going to be lower by about 50%. The demand for retail, of course, is considerably lower than that. The two sectors that stand out are industrial which we expect to be 75% higher, as well as seniors housing which is showing at 200% more demand.” More than just an office developer, “Hines is glad to be in the game with industrial and senior housing, as they are shifting how we’re thinking about markets.” Sarah Hawkins, Hines Managing Director, pointed to healthcare as a real driver for new markets: “The healthcare systems only a few years ago represented only 1% of the leasing activity in New York; today that’s up to 9%.”
As the use of real estate evolves, Adam Berry, Senior Vice President for Investments at Essex Property Trust reflected on how the work of developing assets is changing. “With all of the potential changes coming in the near future, how we design and build properties is a major factor. For example, we are looking deeply into modular construction because it could diminish the time of construction dramatically. With labor shortages, being able to put up a nineteen-story high-rise in a third of the time is compelling.”
The evolving demographics are also forcing change. Mr. Myers noted that “Millennials are beginning to make moves away from urbanization into suburban based on three factors: affordability, school systems, and commute time. If you can optimize those few things, you can start to figure out the different neighborhoods that upwardly mobile millennials find interesting.” Mr. Berry added, “From a residential standpoint, the preconception that millennials are renters by choice is shifting. New suburbs are going to be different than the past; they’ll be denser and more transit oriented. We’re seeing millennials in their early 30’s move towards these suburban areas which is where we anticipate shifting our development towards larger units than just studios and one-bedrooms within those suburban markets.” Yet, Ms. Hawkins offered a different perspective: “What may resist the trend of millennials moving to the suburbs the same way their parents did is the prevalence of duel income families. In the 1960’s, 25% of households were dual income earners; today that number is over 60%. Having both parents over a hour and a half away is incredibly hard. In considering multifamily, proximity to the city is still important.”
Hope and Fear, Regulation and change. These are challenging and interesting times to be investing in commercial real estate. If ever there was a time for thoughtfulness, this year certainly qualifies. It may be impossible to look around the corner and know precisely what will happen, but it is difficult to believe it will be the same as today.← Letter from NAREIM Chair, Peter DiCorpo Spring EO 2018 Meeting Report: Culture Shift →