Investment strategies for 2020 range from selling overpriced industrial assets to taking a full accounting of the top Commercial Real Estate risks.
With the holiday weekend behind us, it is not too soon to look at what will be the top investment strategies for next year. They include:
- Sell Overpriced Industrial Assets
The industrial market has been booming for the last few years and is the favored asset class among institutional investors. The market is “hot” because of the strong economy, increased demand for warehouse and distribution space due to rising Internet sales and last-mile same- day delivery of online goods. Cap rates for industrial properties have compressed 1.5% to 2.0% during the last 18 months and we would be net sellers of industrial assets in this market.
- Acquire Beaten up Retail Assets
Many shopping center and mall real estate assets are selling at 7.0% to 10.0%+ cap rates and some of these assets should be bought. Retail assets have been out of favor for the last few years and although there are tenant risks, with bankruptcies and store closures, they can still provide a higher risk-adjusted return than other CRE assets. A number of the public retail malls are also selling at deep 50%+ discounts to net asset value and are also ripe for a buyout or being taken private. These distressed retail deals are opportunistic investments and need significant renovation and releasing.
- Invest in Data Analytics Companies
One of the key growth areas of CRE is in data analytics. Data analytics encompasses all aspects of big data for CRE including; demographics, ownership data, property data, historical value information, sales/lease data and financial analysis. The data analytics space is very fragmented with a few large companies like CoStar, RealPage, REIS (a unit of Moody’s) and many local and start-up companies. These larger firms have been acquiring smaller competitors to expand their service offerings and customer base. Recently, CoStar acquired Smith Travel Research, the leading hotel/lodging consulting firm, for $450 million and RealPage acquired Buildium, a property management software firm, for $580 million. As the industry grows, there will be more consolidation and an opportunity to acquire these smaller private firms and even establish a platform to consolidate these entities.
- Sell Overpriced Core Assets and Reinvest in Opportunistic Assets
The risk and return for various CRE investment strategies range from the lowest risk, core investments, which are typically fully leased, institutional quality, Class A properties with little or no leverage, to value-added strategies which are higher risk strategies that involve some property redevelopment, tenant adjustment or leasing or with operational problems to opportunistic strategies, which are the highest risk category that involve a high degree of redevelopment, leasing, tenant relocation or change or may be in financial distress. Many core properties are still trading at 3.0% to 4.5% cap rates and should be sold. The proceeds should be reinvested in higher return opportunistic strategies, as discussed in #2 above, buying beaten up retail assets.
- Provide Participating Mezzanine Loans
Even though there is a lot of capital sloshing around chasing deals, there is a dearth of debt/equity capital for the portion of the capital stack above the first mortgage at about 65%-70% and below the minimum owners’ equity investment of 10.0%. This slice of 20% of the capital stack is ideal for a participating mezzanine loan. The participating mezzanine loan may have terms as follow; interest rate at LIBOR plus 4.0%+, loan fees of 1.0%-3.0%+ and 20.0% to 30.0%+ ownership of the deal. The mezzanine lender will typically not be secured by a second lien on the property but by an ownership guarantee and assignment of the owner’s interest in the property. The lender is entitled to the equity kicker because it is taking some of the equity risk of the project. Internal rates of return of 12.0%-15.0%+ can be delivered with this strategy, which is very attractive for a fixed income investment.
- Perform a Systematic Review and Analysis of the 15 CRE Risks
As we have discussed before, there are 15 risks inherent in CRE investment as follows:
- Cash Flow Risk-volatility in the property’s net operating income or cash flow.
- Property Value Risk-a reduction in a property’s value.
- Tenant Risk-loss or bankruptcy of a major tenant.
- Market Risk-negative changes in the local real estate market or metropolitan statistical area.
- Economic Risk-negative changes in the macroeconomy.
- Interest Rate Risk-an increase in interest rates.
- Inflation Risk-an increase in inflation.
- Leasing Risk-inability to lease vacant space or a drop in lease rates.
- Management Risk-poor management policy and operations.
- Ownership Risk-loss of critical personnel of owner or sponsor.
- Legal, Title, Tax and Political Risk-averse legal, tax and political issues and claims on title.
- Construction Risk-development delays, cessation of construction, financial distress of general contractor or sub-contractors and payment defaults.
- Entitlement Risk-inability or delay in obtaining project entitlements.
- Liquidity Risk-inability to sell the property or convert equity value into cash.
- Refinancing Risk-inability to refinance the property.
All investors that own CRE should perform a detailed and systematic review of the above risks and their potential effect on an asset or portfolio.
By Joseph J. Ori
Joseph J. Ori is executive managing director of Paramount Capital Corp.