Friday Letter: Liquid gold

Falling US oil prices are causing private equity real estate firms to rethink the exit strategy. That’s a smart thing.

If oil isn’t on your mind, then perhaps it should be.

All through this week in the US, 'liquid gold' has been a major source of business stories. The price of crude oil has now crashed to around $50 a barrel – a 40 percent fall since June 2014 and the lowest on record since May 2009. Also, the flow of bad corporate news accompanying these falling prices has been steady. On Sunday, for example, Texas-based WBH Energy Partners became the first casualty by filing for bankruptcy protection.

The global real estate community is already waking up to what a fall in oil prices might mean for business and is forming its own thesis. In December, for instance, Jones Lang LaSalle issued a paper called “What does the drop in oil prices mean for the North American economy and office markets?” The paper talks about how the North American office markets most vulnerable to oil prices are Denver, Fort Worth, Houston and Calgary though it summises that the impact on real estate longer term depends on how long prices stay low for.

But by far the most interesting angle we here at PERE have heard has come from a real estate professional in Manhattan – well away from oil fields and ten-gallon hats. Our source, who is in touch with both real estate fund sponsors and global investors, suggests the oil price collapse is leading to firms contemplating extending the holding periods for assets no-matter where the location. And further, in communicating this to investors, this has exacerbated tension between certain managers who naturally want to earn more carry and certain investors who want to sell now for their own reasons.

Obviously, there is no 1:1 correlation between oil prices and real estate values. But according to our source at least, what’s running through the mind of some fund sponsors is that the oil price fall is basically ‘good for the economy’. It is deflationary. All of a sudden, there is now the combination of low oil prices on top of a feeling that interest rate rises might be less aggressive than previously thought. And so, low oil prices are allowing fund sponsors to contemplate more GDP and perhaps more job growth, outside of the energy sector of course, and ultimately improved NOI (net operating income) in one or two years’ time. So they don’t want to sell now.

Make no mistake, this is a big shift in sentiment from a year ago. As everyone will attest, the talk was all about the effect of rising interest rates. Some fund sponsors said to themselves; ‘I’m going to time this perfectly. I want to sell my building in order to escape any potential cap rate expansion.’ But now, all of sudden, the whole economic overlay has changed and fund sponsors wonder if they can earn more carry by selling later.

Oil is undeniably currently an important part of the overall thinking going on now. Sure, core investors out there with a long term perspective might see oil prices as simply volatile and rightly place much more importance upon interest rate movements. An interest rate hike will indicate a strong economy with rental rate increases, after all. Consequently, they should want their fund sponsors to ride out the cycle. Opportunistic investors, on the other hand, have shorter time horizons. In the short term, they should lean towards the fund sponsor selling an asset that has been successfully repositioned now.

But it has to be acknowledged, timing is often one of the hardest things to do perfectly in any real estate cycle. Oil prices have introduced another level to that uncertainty. The PERE house view? Do nothing. Sit tight and wait for any further upside.