Robust transaction activity and a rebound in valuations means that sellers are no longer selecting buyers based solely on top dollar. In the current market, the timing and certainty of closing are becoming important considerations in winning transactions. Even well-known and deep-pocketed investors with high bids are losing out to buyers offering greater certainty of execution.
According to the National Council of Real Estate Investment Fiduciaries (NCREIF), investors in US commercial real estate have achieved double-digit returns for the past five consecutive years. Real estate fundamentals in many sectors are strong with declining vacancy rates, rising rents and limited new construction. Meanwhile, foreign investment in US commercial real estate continues to be robust. A recent survey by the Association of Foreign Investors in Real Estate (AFIRE) showed foreign investors continue to see the US as the country providing both the most stable and secure real estate investments and the best opportunity for capital appreciation.
Given the ample equity capital available for deals, many transactions in this environment have been attracting multiple bidders. Competition for deals is often fierce and is driving higher bids and prices. This is creating a seller-friendly market where sellers can more easily meet their return objectives without chasing the highest price.
Yet there is uncertainty on the horizon. News outlets are reporting that there is growing concern over a potential bubble in the office market. The effects of the Federal Reserve’s inevitable rate increases have not yet been assessed. Meanwhile, a lingering ‘wall of debt’ remains in pre-Great Recession commercial mortgage-backed securities (CMBS) trusts, and the effects of the looming new risk retention rules on the CMBS market are not yet known. Asset supply is growing, both as construction activity begins to ramp up, and as the current regulatory environment is driving some financial institutions to sell real estate assets. With these potential risks, some sellers are looking to lock in returns before the markets turn, rather than securing last dollar yields on sales.
Consequently, we are seeing an increase in commercial real estate sales where certainty and speed of execution are becoming key factors over price for sellers. This dynamic is heightened in off-market transactions, where regulated institutions forced to divest assets are also looking to limit distraction instead of squeezing the last dollar from non-core real estate assets and businesses. With values reaching or exceeding record levels, real estate sellers are becoming more focused on not missing the current market opportunity. Real estate funds, real estate investment trusts (REITs) and other investors with well-groomed reputations for quickly and smoothly closing transactions are beating out purchasers who are viewed as new to the market or have reputations as difficult counterparties.
This growing focus on certainty of execution is flowing through every level of the real estate market. Buyers seeking financing for their acquisitions are asking more pointed questions on lenders’ reputations for closing quickly and smoothly. Advisors are being similarly scrutinized on their skills in tackling complicated and fast-paced transactions. The ability to solve unexpected problems, rather than simply identify issues, is essential to buyers to get to closing with certainty.
Reputations are built on a track record. Are deadlines met? Are prices retraded? Does the buyer have equity capital in hand? Has financing been secured? Some fund sponsors can confidently answer ‘yes’ to each of these questions. Several fund sponsors have secured significant commitments to new discretionary funds, eliminating the need to raise equity capital to close deals. These fund sponsors also have deep lending relationships established over years of investing and have underwriting and acquisition platforms that allow them to move quickly. Once they strike a deal, they are known to close on those terms.
Other buyers that are newer to the US market or with reputations for closing ‘hiccups’ are having a harder time winning deals against the funds, REITs and investors with stronger reputations for closing certainty. Sellers’ increasing preference for certainty to lock in value appreciation means buyers with stronger closing reputations are also able to secure deals at lower prices. These buyers can monetize their reputations by acquiring assets at a lower initial cost basis, enhancing opportunities for outsized returns on sale.
Reputation matters, but it takes time to establish. To win deals in this competitive environment, newer investors in the US market and investors without strong reputations for closing with certainty have more limited options. These investors need to bolster their credentials for closing certainty or may underperform the market by being limited to deals where price is driven to the extreme.