There has been much discussion about the performance trajectory of commercial real estate. Strong tailwinds, including inexpensive debt financing, limited new supply, poor physical stock and strained capital structures, have characterized the opportunity set since 2010, particularly outside of core strategies.
As a result, strong income and appreciation growth have been enjoyed across most markets and property types. In particular, value-add and opportunistic funds of the 2009-vintage to 2013-vintage have generated high relative returns with low leverage, little to no development or entitlement risk and high stabilized spreads. But the sun has now set on this stage of the recovery and investors are now operating in commercial real estate investment stage 2.0.
Today, the investment landscape is much more uncertain and we are all seeking a bit of direction. In the first quarter of 2016, there was an estimated $200 billion in private real estate fund dry powder sitting on the sidelines.
Broad and attractive investment pipelines have dwindled due to high valuations, slowing income growth and greater volatility in the availability and pricing of financing for new transactions. At the same time, managers large and small are reluctant to turn off the fundraising spigots to better align their pools of investible capital with the size of the opportunity.
This uncertainty has many people thinking back to the height of the last market peak, when exuberance and the mistakes that resulted were numerous, but a few themes were endemic: (1) high leverage, (2) a reliance on terminal value to generate returns and (3) business plans that were poorly suited for the private fund structure. In the current market cycle, there has been a noticeable shift in manager portfolio construction, driven in part by investor discomfort with these features. Arguably, leverage is at moderate and sustainable levels, albeit driven as much by lender restrictions as by investor conservatism. Current cash yields are also contributing more significantly to total performance, as record low cap rates are aided by an even lower cost of debt, providing wildly accretive debt positions.
Finally, given the two aforementioned features, experienced fund managers have not yet been required to take outsized duration risks through ground-up property development or multi-stage business plans to achieve higher returns. This has meant that property redevelopment and repositioning strategies, which are clearly better suited for closed-end, limited life vehicles, have been dominant. Overall, this has resulted in strong risk-adjusted returns for non-core investments.
In the near to medium term, a convergence of performance among those marketing core-plus, value-add and opportunistic is likely to develop. No matter what the marketing foot soldiers of Wall Street or the local retail or multifamily experts would have you believe, nomenclature is no longer as meaningful when assessing strategy risk or return expectations in the world of real estate equity. Aversion to high concentrations of ground-up development and the meager returns from prime core properties means that real estate equity investors are more or less executing the same strategies within a narrow range of variation: the use of low cost debt to finance minor to moderate cap ex programs.
Those of us who spend countless hours each year evaluating hundreds of core-plus, value-add and opportunistic offerings have become numb to the hair-splitting argument that 70 percent occupancy is risky while 85 percent occupancy is unassailable, or that 70 percent leverage is a time bomb while 55 percent leverage can withstand any downturn. The fact of the matter is that so-called opportunity funds have lowered return expectations, and rightly so, as the low-hanging turnaround fruit has now been bid up by a powder keg of dry capital. Additionally, business plan risks of value-add and core-plus managers are virtually indistinguishable from one another, as anything that can truly be labeled ‘core’ has an associated cap rate that looks more like long-term inflation and a desirable investment return.
So back to basics. Strong management and investment teams, alignment of GP and LP interests and pools of capital which are right-sized for the opportunity should be the emphasis of today’s underwriters, not labels.
Despite an environment of strategy convergence, a growing number of managers across the risk spectrum are executing novel strategies in the pursuit of alpha generation. These include core and core plus strategies with ODCE-bucking product concentrations and property-specific strategies with sub-product targets. While many of these niche strategies remain unproven, they represent a departure from the status quo and manager conviction as to the direction of the market. Given the lack of differentiation that we are seeing today, the direction of these strategies may be telling.