Late-cycle investing calls for close attention to all potential risk/reward scenarios.
By: Robert Brunswick
Markets develop their own momentum and when a feeding frenzy takes hold, undisciplined investors often throw caution to the wind. They want a piece of the action and fear being left in the dust. Even discerning investors can rationalize stretching on underwriting assumptions, figuring that if costs are slightly underestimated or income is overstated the rising tide will lift their boat, too.
Early in a recovery cycle, riding the crest has its place. When investments are underwritten based upon recent dynamics, it’s hard not to justify optimism, particularly if the preceding trough has been deep. When one identifies the swell, jumping on board, even with some level of abandon, can be rewarding.
Late-cycle investing, however, is much trickier. Will the wave deliver the rider gently to shore or crash on the rocks? In the real estate market, has a paradigm shift been created by exponential improvements in transparency and efficiency? Maybe we’re in for a soft landing this time around, with relative restraint in the lending and development arenas, as compared to the lack of restraint during the last recession.
It’s difficult to watch others playing the game while caution keeps you on the sidelines. This is particularly true for investment managers and operators whose corporate finances and compensation structures rely upon transactional activity and ever-growing assets under management to keep the organization afloat. Capital providers need to be wary of this investment motivator and should encourage management structures that neutralize this incentive.
By the same token, holding a market view that the cycle has some run left or that the landing will be soft doesn’t make an investor undisciplined. The foundation of markets is differing views on either side of the same trade. However, it’s critical to develop these views from an analytical perspective that identifies elements of risk and opportunity and forecasts their relative influences on the future. In the real estate capital markets, factors warranting consideration and analysis include but are not limited to:
- Spreads vs. non-real estate investment opportunities
- Institutional real estate allocations vs. targets
- Dry powder in private equity real estate funds
- REIT trading prices vs. NAV
- Foreign capital flows
- Impact of leverage
- Tax incentives
We all view these risks through different lenses. It’s amazing at times how divergent risk-return assessments can be. A property that is viewed as holding value-add to opportunistic risk early in the cycle often tends to become viewed as core/core-plus later in the cycle, with correspondingly diminished returns despite carrying the same actual fundamental/property risk as before. This “risk creep” can lead to misalignment between capital and business plans/expected returns. Capital seeking value-add returns may find itself locked in lower-yielding core investments if lofty growth expectations don’t materialize. The exit from these investments, while predictable, will be predictably disappointing. Conversely, returns for true core investments may become compressed below target ranges late in the cycle, forcing investors to take on greater risk to achieve yields attained earlier in the cycle…adding on risk at exactly the time it should be laid off.
A racecar driver holding a lead entering the final laps of a grand prix must calculate with his crew if he can afford to keep the pedal to the metal. If doing so causes him to have to make another pit stop, then net time might be lost, while sprinting to the finish might cause him to run out of fuel and cost him any spot on the podium. The pit crew will also have observed what his competition is doing. So, too, late in this real estate race, when mistakes are amplified and there is precious little time to make up for them, investors hoping to see the checkered flag must maintain the discipline of an analytical framework for risk assessment.
Robert Brunswick is co-founder and CEO of Buchanan Street Partners, a real estate investment management firm based in Newport Beach, Calif.Back to Top
Delving deeper into the geographical jargon of market tiers sheds light on investment trends and value-add opportunities that would have gone overlooked just a decade ago.
By: Robert Brunswick
The real estate industry is known for its shorthand captioning of complex topics, often assuming that industry participants share common background knowledge. Since this is not always the case, delving a little further into the geographical jargon of market tiers sheds light on investment trends and value-add opportunities that would have gone overlooked just a decade ago.
How are certain geographies designated into tiers? Many variables contribute to these groupings, including the size of a real estate market (think spread of risk and economic diversity), the historical volume of transactions (speaks to liquidity) and population and local domestic product (addresses work force availability and attraction to businesses). However, these variables should not alone dictate investment decisions. Housing affordability, regional tax status, workforce demographic trends, educational infrastructure and quality of life all contribute to the fundamentals that help define market segmentation.
Let’s put some numbers to these market tiers. Today, the greater U.S. has over 50 MSAs with populations over 1 million and 30 MSAs with populations over 2 million, yet there are only five to seven cities typically designated as core or primary or gateway markets. New York, Boston, San Francisco, Los Angeles and Washington, D.C. always appear on these lists, and sometimes Chicago and Seattle make the cut. The next tier, with a secondary moniker, numbers 15 to 20 cities (e.g., Phoenix, San Diego, Denver), with the remainder defined as tertiary or third tier markets (e.g., Pittsburgh, Salt Lake City, Las Vegas).
We often hear that certain institutions will or won’t invest in a city when it doesn't make their hierarchy ranking. While it is important to rely on research and an investment protocol, this grand standardization model leaves many opportunities untapped in an increasingly fragmented commercial real estate marketplace. Painting markets with a broad brush can lead to redlining that fails to adequately account for growing efficiencies in capital flows (both in the real estate industry and the broader economy), improved transportation/distribution infrastructure and greater workforce mobility. These factors have combined to fuel economic growth in secondary and tertiary markets, creating opportunities that will be missed by those constrained by traditional market segmentation.
An expanded universe of opportunistic buyers and sellers has taken notice, however, and in a big way. Commercial property transaction volume in the secondary and select tertiary markets grew from $2 billion in 2000 to $45 billion at the end of 2017. The potential for increased yield for those investors willing to consider non-gateway investments can be anywhere from 150 to 400 basis points on a levered basis, yet with how much more risk?
Certain risk variables in less liquid markets are immutable, including economic recovery that lags the primary markets, as witnessed in this current cycle, or a more rapid retreat when the going gets rough. This “last to rise, first to fall” phenomenon can create a shorter investment window and require a more precise timing play. Additionally, secondary and tertiary markets sometimes fall prey to industry concentration risks that drive a boom or bust profile, as we’ve seen in the past with Houston, San Jose, Orange County, Calif. and Las Vegas. Given these risks, investments in these secondary markets depend on strong property fundamentals— principally investment basis and durable cash flow—during periods of risk aversion and illiquidity.
We have found tangible value in not competing with the bigger institutions who might exhibit a herd mentality driven by their standardization models, and thus have found solid risk-adjusted returns in markets where sound and sustainable demographic and economic drivers underpin improved property fundamentals.
Robert Brunswick is the co-founder and CEO of Buchanan Street Partners, a real estate investment management firm that focuses on real estate investing through direct acquisition of commercial and multifamily properties in addition to originating and funding debt for third-party owners of real estate.Back to Top
Prudence dictates that we prevent our industry from going backwards and losing the credibility that we have worked so hard to gain.
By: Robert Brunswick
Real estate development in the U.S. has historically been driven by entrepreneurs with great ambition and visions of grandeur, but thin pocketbooks. Lacking their own controlled or discretionary capital, these developers needed to sell their ideas to banks, pension funds and other investors. This reality dictated more leverage, as equity was expensive and diluted the entrepreneur’s take-home profit. This was never more evident than in the 1980s-1990s when the S&L industry often provided close to 100 percent loan capitalizations. We all know how that played out, with a crashed real estate industry starved for the equity capital it was missing in the first place.
Today’s real estate industry has joined other institutional asset classes with improved discipline, protocol and process as demanded by both investors and regulators. Public debt and equity, an educated workforce, and transparent and standardized reporting all have enhanced capital’s confidence in real estate as an asset class. Investors’ real estate appetites have been further buoyed by their need to access alternative investments and the cashflow predictability of real estate in a yield-starved environment.
The Financial Crisis of 2008-2009 set in motion another factor that is very influential in today’s evolved real estate market - a greatly enhanced regulatory regime. Many industry participants would argue that such regulation has overshot its target, as is often the case in these dramatic cycles, thereby reducing leverage with more restrictive underwriting protocols for the banking industry. The benefit to those of us who invest in real estate, however, has been a marketplace that now requires, broadly speaking, more equity to satisfy the lenders’ current playbook. Aside from the benefits of a more prudent investment balance sheet, higher equity requirements have also boxed out less capable and undercapitalized players from participating in the industry. This new, less-levered real estate world was then further buttressed by a lack of yield in other conventional asset classes such as bonds and equities, prompting more capital flows to real estate given its comparatively favorable yield proposition.
Increased capital flows have naturally translated into property price appreciation and significant cap rate compression. We must ask whether real estate is overpriced, and whether investors should seek more leverage to offset this yield erosion. We are now seeing a partial rollback of the Dodd-Frank regulations, allowing community banks more lending flexibility. While we all would like to attain more yield, we should stay disciplined and realistic as to these trade-offs. Prudence dictates that we prevent our industry from going backwards and losing the credibility that we have worked so hard to gain.
The equity well is deeper than it’s ever been, with global dry powder for closed-end private real estate funds at their highest point in history. Foreign investment remains robust as many offshore investors seek the safe haven and favorable cash flow of U.S. commercial real estate. These trends bode well for our collective “sleep at night” quotient as we reassess the continual tussle between fear (more equity) and greed (more debt). Given our still fresh collective memories of 2009-2010 and our current stage in the property cycle, fear seems to be maintaining a slight edge…as it probably should.
Robert Brunswick is the co-founder and CEO of Buchanan Street Partners, a real estate investment management firm that focuses on real estate investing through direct acquisition of commercial and multifamily properties in addition to originating and funding debt for third-party owners of real estate.Back to Top
With concessions ticking up and rent growth slowing, is it time to question or finetune allocation levels and strategies in multifamily investing?
By: Robert Brunswick
The stability, durability and continued capital flows into multifamily investing permeate
today’s headlines, with industry pundits believing apartments to be the most popular product type with real estate investors in 2018, second only to industrial. Mixed signals abound among varying markets, and it’s important to dissect and triangulate the real data as the analytics don’t always tell the full story.
A first quarter report from Fannie Mae cited:
- Positive, but slowing net absorption in 2018 compared with 2017 (CoStar)
- Surging apartment development, peaking at over 440,000 units nationwide and up 16 percent from 2017 (Dodge Data & Analytics)
- Rising nationwide vacancy rate predicted to approach recent historical average of six percent by year-end (Fannie Mae)
With concessions ticking up and rent growth slowing , is it time to question or finetune allocation levels and strategies in multifamily investing? Two principal factors are worthy of consideration here: geography and investment horizon.
Nationally, development is projected to keep pace with net absorption, as Fannie Mae projects net rental demand of 380,000 to 460,000 units in 2018. However, parsing geographies more discerningly reveals that new multifamily construction has been heavily concentrated in America’s largest cities, where pockets of oversupply are projected. New York, Boston, Washington, D.C., Chicago, Los Angeles and San Francisco present some of the highest unit construction per capita in the country, yet are all projected by Moody’s Analytics to experience job growth in 2018 that lags the national forecast of 1.5 percent.
All markets do not bear these metrics though, especially in select secondary markets where Fannie Mae reports the ratio of projected population and employment growth to rising apartment inventory is more favorable. Cities such as Houston, Dallas, Austin, Texas, Salt Lake City and Portland, Ore., even while seeing brisk construction, are forecast to increase job growth between two to three percent amid continued rental escalation. Two markets worth investigating include Phoenix, where projected 2.6 percent employment growth forecasts the demand for 10,000 units against projected 2018 delivery of 8,000 units, and Las Vegas, where projected 2018 absorption is double the number of units under construction.
Development nationwide should peak in 2018, as planned units in comparison to those under construction taper off, even in cities with the most active pipelines. This suggests that investors with a longer hold horizon may see their patience rewarded when new supply is absorbed and vacancy rates level off. Several long-term demographic trends also bode well for multifamily absorption and rental rates:
- Householders continue to delay marriage and childbirth, thus tending to remain in apartments
- Population growth in many areas, particularly in the Southwest, is being fueled by immigrants who tend to be renters
- Real household income growth is occurring only in the upper 20 percent of earners, rendering home ownership less affordable for many
- Student loan debt, which doubled as a percentage of GDP between 2006 and 2012, stymies home ownership for younger households
- Conversely, the 65+ baby boomer generation, America’s most rapidly growing domestic cohort, is demanding more rental housing as they age out of owned homes and reevaluate their investment and retirement options
In our view, investors who choose their geographies wisely and take a long-game approach should see their properly selected multifamily investments buoyed by these market and demographic trends, while enjoying relatively predictable cash flows in the interim.
Robert Brunswick is the co-founder and CEO of Buchanan Street Partners, a real estate investment management firm that focuses on real estate investing through direct acquisition of commercial and multifamily properties in addition to originating and funding debt for third-party owners of real estate.Back to Top
We believe certain real estate investments will have enhanced after-tax yields in 2018.
By: Robert Brunswick
What better way to kick off the new year than to discuss the new tax law and the gift we all just received as real estate investors? The new tax legislation will impact investors and their investment strategies as we all continue to search for yield and source opportunities within the alternative investment landscape. As equities and bonds continue to demand outsized liquidity premiums we believe certain real estate investments will have enhanced after-tax yields in 2018.
Points to consider:
- The tax law changed the treatment for income from pass-through vehicles, including REITs and other vehicles that own real estate. The new law allows for a 20 percent pass-through deduction, which when coupled with a top tax rate adjustment from 39.6 percent to 37 percent yields a new top marginal tax rate of 29.6 percent on real estate investments.
- These benefits could, however, have certain limitations subject to individual investors’ total taxable income, resulting in additional hurdles involving wages paid by an entity and the depreciable basis of the underlying property.
- Capital gains treatment for developer/sponsor promotes/profits participations were left alone, with the exception that any long-term capital gain allocable to their carried interest now requires assets to be held for more than three years rather than the previous one year. While individual investors (non-sponsors) will still realize long-term capital gains treatment after one year, they might question the alignment with their developer/operating sponsor depending on the business plan and risk profile of a particular investment.
- 1031 exchanges have remained largely intact, creating a further advantage for real estate and its tax deferral benefits, save for certain personal property that no longer qualifies for tax deferred treatment.
There are other general considerations activated by the tax change which might impact the broader real estate investment climate within the housing sector. The adjustment of the standard deduction for married couples filing jointly moved from $12,000 to $24,000, making it more enticing to rent vs. own when compared to the prior law’s treatment regarding property tax and mortgage interest deductions. This certainly will prompt many to forego or reconsider renting vs. buying, potentially buoying an increase in demand for rental housing.
REITs may become a preferred investment vehicle due to their eligibility for a 20 percent deduction without any limitations, enhancing the appeal of REITs relative to other yield-oriented investments. It is important to remember that publicly-traded REITs don’t necessarily trade based on real estate fundamentals as they are non-correlated to the less-efficient private investment market place.
One might project that this legislation could help to break the impasse between buyers and sellers on pricing, a dynamic that kept a lid on transaction volumes in 2017, but now might create an increase in new investment opportunities.
Further, corporate tax reductions may fuel increased demand for commercial property as companies grow existing businesses or start new ones, providing for improved occupancy and income from real estate investments.
We believe these changes broadly suggest that real estate investing will continue to look attractive vs. other asset classes, the latter of which are unsheltered by depreciation and interest expense with its ordinary income taxed at the top rate of 37 percent. That said, happy continued hunting for your real estate investments and congratulations on your raise.
Tracking the trend of increasing alternatives allocation is worth a longer look, as it is indicative of a shift by HNW investors and will result in increased capital flows into real estate.
By Robert Brunswick
The rethinking of traditional investment allocations is causing high-net-worth (HNW) investors to seek ways to diversify their investment portfolios, especially given the current low yield environment. The increased allocation to alternative investments, such as private equity, hedge funds, commodities and real estate, is aiding HNW investors in achieving improved portfolio diversification, a hedge against future inflation and increased current yield, with certain tax benefits in the case of real estate.
Portfolio challenges for HNW investors
HNW investors have traditionally looked to stocks and bonds, with their market breadth and attractive liquidity, for the bulk of their portfolio allocations. While historically effective, the traditional approach to investing will be increasingly challenged as future equity returns are likely to be significantly lower and fixed income returns continue to be low in this “new normal” environment. HNW investors, and to a greater extent ultra HNW investors, are showing greater interest in alternative assets as a means to diversify their portfolios and achieve more attractive risk-adjusted returns.
Given the current liquidity premium characteristic of conventional equity and fixed income
markets, and the relative increased (liquid) cash positions among HNW investors, investment
managers, generally, are of the belief that most HNW portfolios are over-allocated by prior
standards. Further, many alternative investments now offer certain forms of liquidity, enabling
increased allocations in alternatives yet with flexible exit strategies.
The increasing shift toward alternatives
Until recently, alternatives warranted a roughly 10 percent allocation to the typical HNW
investor, perhaps even up to 20 percent. The move towards higher allocations for alternative
investments within a HNW investor portfolio is increasing, to a large extent due to the low
correlation when compared to traditional asset classes. Investment managers are commonly
advocating a much greater allocation to alternatives, ranging from 20 percent to 40 percent. For
ultra HNW investors, an alternative asset allocation in the mid-40 percent range is not
A considerable amount of new independent RIAs are being formed to allow advisors who are
leaving traditional brokerage firms to provide clients with an “open architecture” platform. This
creates increased flexibility in providing clients more diverse investments, including alternatives,
than the limitations incumbent with approved brokerage platform products.
Additionally, advisors are leaving traditional brokerage firms to avoid the perceived conflict of
earned commissions on proprietary products, as opposed to compensation for assets under
management in an open architecture platform. Not only does this diversification help HNW
investors, it eases the difficulty by smaller investment managers in accessing advisor platforms.
Tracking the trend of increasing alternatives allocation is worth a longer look, as it is indicative
of a shift by HNW investors and will result in increased capital flows into real estate. By
combining a variety of alternative assets in a HNW portfolio, notably real estate, a more optimal
diversification can be created, one that avoids the liquidity premium found in traditional asset
classes, benefits from low correlation and provides investors with enhanced portfolio returns
and current yield.
What are the market cues that can help pick opportunities that will generate returns that align with portfolio goals?
By Robert Brunswick
As high-net-worth (HNW) investors and family offices look to increase their portfolio allocations in real estate, the multifamily sector continues to offer attractive investment opportunities. HNW investors demanding predictable cash flows from core properties or value‑add yields on ground-up and redevelopment projects can meet these objectives in the multifamily sector. In this context, what are the market cues that can help pick opportunities that will generate returns that align with portfolio goals?
Risks and rewards of multifamily investments
While gateway markets such as San Francisco and New York City are attractive, they have also experienced significant multifamily development. That new supply can dampen rental rate increases, and when factoring in the high cost of entry in gateway markets, returns are more quickly impacted when rent growth stagnates. Conversely, secondary markets, like Salt Lake City and Denver, have seen comparatively less new development despite strong population and job growth. We think that these markets provide more predictable returns and a more attractive option for HNW investors.
Millennials are increasingly demanding more rental housing, and developers are responding with designs and amenities that serve their predicted behaviors. The increase in the development of smaller units in urban environments is one example of this. That said, investors need to exercise caution when too much of this type of product is being delivered in certain markets. Like generations before them, millennials will eventually look to purchase homes in good school districts for their families, and likely in more suburban areas.
Separately, growing contingents of older renters want higher-quality finishes and amenities. Many assets, even those just 10 years old, do not reflect the preferences of these renters, creating an opportunity for savvy investors to acquire and implement a redevelopment strategy.
Increasing ROI on multifamily investments
Multifamily can be a strategic long-term investment opportunity for HNW investors, but there are important things to note in the achievement of yield. Location, asset quality and strong market fundamentals must align with investment strategies and sound underwriting. The management of an asset is also a key driver for success.
Implementing upgrades to finishes, amenities and technology, including package management, smart thermostats and security systems, are additional means of effectively adding value and enhancing returns. As an example, energy-efficient upgrades can both reduce operating costs and result in financial savings when using agency debt.
Package management is another example of changing tenant needs. The growing adoption of e-commerce has tenants receiving far more package deliveries than just a few years ago, and successful communities will effectively manage this influx of deliveries. Enlisting third-party vendors that have developed innovative solutions to the problem of package theft is highly attractive to renters who shop online.
Multifamily investment mistakes to avoid
Is there too much capital in your target investment market? If so, unrealistic rental growth assumptions or underestimated increases in operating expenses will impact the integrity of the pro forma. Will cap rates hold? In markets where cap rates have dropped below 4 percent, the margin for error is magnified. Accuracy is a must when assessing risk in an ultra-low cap rate environment.
Adequate underwriting of capital costs is another area for caution. The old standard of $250-per-unit capital reserve may not hold up in the face of changing tenant preferences, especially when considering the costs of keeping up with advances in technology.
There are a variety of factors that we believe will result in increasing opportunities—in the right apartment markets—for HNW and family office investors. As construction lenders reign in new lending and equity investors become more cautious, we expect the current development pipeline to shrink. When combined with the changing demands of renters by choice, we believe that there is an increasing opportunity to improve existing apartment assets and generate attractive returns.Back to Top
A compelling case is made for investing in secondary and suburban markets, which remain below peak valuation and present protection against a possible market correction.
By Robert Brunswick
Ultra-high net worth (HNW) investors and family offices remain challenged to achieve acceptable risk-adjusted returns amid the current robust economic cycle. U.S. commercial property prices have broadly surpassed the previous peak, impacting yields on core, core plus and value-add assets, especially in primary markets.
Trends in capital flows and property fundamentals suggest strong support for this pricing. Looking deeper into the post-recession recovery reveals that all markets are not created equally; appreciation has been uneven.
A compelling case is made for investing in secondary and suburban markets, which remain below peak valuation, offer room for rent growth and present favorable protection against a possible market correction. Assets in these markets that have healthy supply/demand characteristics and opportunities to add value can deliver risk-adjusted returns that align with investment portfolio goals.
Enhanced value-add yields in secondary markets
An arbitrage opportunity exists for HNW investors in non-major markets and in non-core properties. Safety-minded institutional investors flock together and drive up prices for trophy assets in the early stages of recovery, then grow dissatisfied with the resultant low yields as economic and property fundamentals strengthen. As the institutions branch out to secondary markets in search of higher returns, savvy HNW investors can reap the benefits.
The positive influence of these capital flows can be augmented if non-core properties can be repositioned into the core investment channel. Repositioning value-add activities in this case may include lease-up, renovation, portfolio aggregation, re-tenanting, rebranding and other actions that increase cash flows and diminish risk. These activities can enable investors to realize a “double lift” in yield from value-add properties in secondary markets.
Middle-market inefficiency, investor opportunity
Segmenting the market based upon asset size also contributes to strong risk-adjusted returns. A disproportionate share of capital has been raised in the post-recession cycle by billion dollar “mega-funds.” These funds symbolize institutional investors’ desires to invest with the largest managers, effectively consolidating more capital with fewer managers.
This concentration of capital has manifested itself in the rapid appreciation of the highest-value core U.S. properties. With so much capital to deploy, these mega-funds skew capital flows toward $100-million-plus properties. Foreign investors share a similar bias for investments of this size. The outgrowth of this larger-is-better trend is comparatively less capital seeking assets valued below $75 million, thus creating opportunistic pricing inefficiencies.
Follow the jobs
Another primary driver favoring secondary markets is employment. Non-gateway cities have outpaced gateway markets markedly in terms of percentage job growth, with the primary exception being the San Francisco Bay Area, where prices are at all-time highs. Notably, many of these second-tier cities also boast strong job growth in absolute numbers (e.g., Dallas, Atlanta, Phoenix and San Diego).
Citing the Bureau of Labor Statistics, job growth from the third quarter of 2015 to the third quarter of 2016 was fastest in the lower-density suburbs of large metropolitan areas, with populations over one million. Employment grew 2.2 percent in those counties, slightly ahead of growth in higher-density suburban counties (2.1 percent) and in urban counties (2.0 percent) of large metropolitan areas. Concurrent with this shift is slightly higher population growth in the suburbs as well.
We believe commercial property fundamentals are solid and are projected to remain so for some time. Barring unforeseen exigent events that could shake up the U.S. economy, supply and demand should remain well-balanced, leading to steady occupancy and rental gains over the next several years.
Employment factors, domestic capital flows (both debt and equity) and the inflow of foreign capital are projected to buoy asset values and keep a lid on cap rates. Within this environment, we believe premium risk-adjusted returns can be realized over the next several years by playing to the edges.
Appreciation of larger properties in gateway cities has been so dramatic that they may carry more risk of price declines than under-appreciated assets that tend to be smaller properties in secondary markets and submarkets. These smaller assets, mostly suburban office buildings, generally offer strong yields to investors, are comparatively insulated from supply risk and present compelling rental economics to tenants. Investors in these middle market properties may find less competition on the buy side today and are likely to benefit from capital flows trending towards these secondary cities down the road. Those who reposition non-core assets in secondary markets into core-quality investments may also realize a “double lift” by combining income gains with increasing buyer demand.Back to Top
Private lenders may have the solution for the sector’s ‘sweet spot’ projects
By Matthew Doerr, vice president
Chatter within the commercial real estate industry suggests we have reached, if not surpassed, the crest of the current market cycle, but the industrial sector is stronger than ever.
According to JLL’s 2017 industrial outlook report, vacancy rates on the West Coast are between 1 percent and 5 percent. With no signs of oversupply, or any economic, retail or logistical trends that point to a reverse in course, investors and developers continue to seek construction loans for industrial projects, while lenders remain open to working with commercial mortgage brokers and their clients within this space.
Industrial demand has unveiled attractive lending opportunities, especially given the sector’s abbreviated construction timelines. Quick completions allow borrowers to minimize whole-dollar interest costs on industrial-based construction loans, compared to an office or multifamily project of the same size.
This demand for industrial space creates a win-win situation, right? Unfortunately, not for the middle-market industrial sector, in which construction projects range between 50,000 to 250,000 square feet and costs range between $10 million to $30 million. It is in this “sweet spot” where banks, brokers and borrowers have experienced increased execution risks, especially if they are seeking conventional leverage on a nonrecourse basis. In many cases, an apparent funding gap has formed as banks, brokers and borrowers search for creative ways to capitalize these projects.
Prior to the recession, banks were the largest source of nonrecourse construction financing. Today, they have returned to the market — albeit on a limited basis. Implementation of the final regulatory capital rules for institutions under the supervision of the Federal Deposit Insurance Corporation (FDIC), which took place in early 2015, caused banks to tighten lending standards, which led to increased execution risks for borrowers when securing construction financing, thus diminishing access to predictable capital solutions.
To mitigate risk, most banks are generally willing to provide nonrecourse construction loans at about a 50 percent to 60 percent loan-to-cost (LTC) ratio, and these terms may only be available to existing bank clients. If a qualified borrower is willing to provide recourse, the bank may increase the leverage up to 60 percent to 65 percent. Many developers simply do not have — or may find it too expensive to invest — 40 percent to 50 percent equity to complete the project capitalization and, consequently, seek a creative solution to meet their financing needs.
Borrowers may turn to a mezzanine lender to fill the gap between a bank loan and the typical 15 percent to 20 percent equity to complete the capital stack. Many mezzanine lenders, however, may find this type of structure unattractive because the mezzanine portion of the capital stack for a middle-market industrial construction project is about $5 million or less. For some lenders, this falls short of their targeted transaction size.
If a mezzanine lender agrees to provide a loan of this size, it would require an intercreditor agreement with the bank lender, which can result in a lengthy, complicated and often costly exercise for the developer. Further, intercreditor negotiations pose added risks for the developer and mortgage broker in closing a deal. Smaller mezzanine loans, when available, likely bear above-market interest rates and fees to offset the small transaction size.
In addition to the aforementioned nuances, banks may avoid lending on any projects classified as high-volatility commercial real estate (HVCRE) because of the increased loan-related costs they may face. For a loan to avoid being classified as HVCRE, the borrower must contribute at least 15 percent of the appraised-as-completed value of the asset before receiving bank financing, and the loan-to-value (LTV) ratio cannot exceed 80 percent.
“ Intercreditor negotiations pose added risks for the developer and mortgage broker in closing a deal. ”
There are very real situations, however, that may cause a loan or property to be classified as HVCRE that may not be immediately apparent. If a borrower has owned a piece of property for an extended amount of time, for example, or acquired it below the appraised market value, the actual cash investment is small and often far less than the required equity piece for bank financing.
Beyond the difficulty of securing funding from banks for middle-market industrial construction projects, many developers and brokers have witnessed a lack of predictability around HVCRE and have become reluctant to arrange capital from multiple sources.
Risks of partnership
There are qualitative and quantitative reasons why mortgage brokers and developers are reluctant to secure multiple sources of funding to meet the 80 percent LTC target for middle‑market industrial construction loans.
First, integrating two pieces of capital through an intercreditor negotiation increases the risk for deals to fall through because of senior-lender requirements that are often strict. A mortgage broker must tediously tend to the negotiation of multiple agreements that govern the partnership between the two lenders to ensure certainty of execution.
Furthermore, borrowers recognize risk that can potentially impact their business plan when securing a loan from two capital sources. The perceived lack of certainty of execution presents borrowers with heightened risk if:
- They are ready to secure permits to prepare the land for development;
- They need to begin construction immediately to respond to market demand; or
- They have a pre-signed lease or purchase agreement that requires a specific construction start date.
Regulations, tiresome negotiations and increased transaction costs have created an apparent barrier in lining up construction funding for middle-market industrial projects. Although obtaining capital for attractive industrial deals in a tight market can be challenging, some borrowers can find success if they turn to private lenders who are responsive and can provide custom solutions for a project.
For many mortgage brokers, opportunity may exist with the “one-stop shop” private lender that can execute the entire capital stack — minus borrower equity — and take a borrower up to 75 to 80 percent of the project cost with certainty of execution.
Within this framework, the cost of a nonrecourse construction loan from a private lender can be on par with the blended cost of a bank loan and mezzanine loan. This can be a win-win situation in which mortgage brokers are able to close quality transactions and borrowers can strike with flexible, nimble capital to accurately and swiftly respond to the healthy industrial market.Back to Top
Robert Brunswick | Aug 03, 2017
Real estate investing today vs. in past cycles is buoyed by a predictable debt and equity market and transparency.
Commercial real estate has been used effectively in ultra-high-net-worth (HNW) and family office portfolios as a means to enhance yield in a return‑starved market. This enhanced yield has not been lost on the greater institutional marketplace, however, where sovereign wealth funds, domestic pension funds and life insurance companies have flooded the market with capital, prompting concern over the potential for a pricing bubble.
So why does real estate remain appealing to high-net-worth investor portfolios?
It is important to remember that real estate still functions predominately within a private marketplace, and with certain inefficiencies that, when properly priced and sourced, can provide returns in excess of comparable benchmark indexes. Real estate still offers predictable cash flows, tax benefits and a hedge against inflation, and thus remains highly appealing; most HNW’s and family offices are targeting as much as 10 to 15 percent of their investment portfolio to real estate.
Real estate investing today vs. in past cycles is buoyed by a predictable debt and equity market, a greater educated real estate workforce and transparency of reporting with access to immediate valuation. Taken together, this permits sophisticated investors to continue allocating capital to real estate with predictability of performance.
The sphere of real estate investment opportunities for HNW investors is widening
Today’s real estate investment landscape has broadened for HNW investors with the ability to customize their investments regionally, by product type, by sponsor and within both debt and equity investments. Further, HNW investors can tranche their real estate investments across varied risk-return scenarios for appropriate diversification. Often, these investors deploy capital without competing directly with institutional investors.
Interestingly, these non-gateway cities display many positive demographic trends, including continued job growth that enhances property rent rolls and income performance. In the West, these demographic trends have provided certain supply and demand imbalances that produce attractive market rental increase opportunities and enhanced exit liquidity.
There are always challenges. What are the solutions?
Most HNW’s and family offices succeed in sourcing a consistent pipeline of opportunities through regional and relational sponsors, who in turn are sourced directly or through third-party investment management firms, and thus create a diversified basket of real estate investments.
Many in this investment group have also become more active in their sourcing by investing in debt transactions, taking advantage of the tightened banking regulatory environment to access a real estate product more akin to a fixed income investment.
Both of these approaches require sophisticated investors to be more active in sourcing and underwriting their real estate investments to ultimately recognize this increased yield opportunity. For sponsors, the ability to deliver sound investment opportunities is met with consistent demand for a higher real estate allocation among HNW investors and family offices.
Robert Brunswick is the co-founder and CEO of Buchanan Street Partners, a real estate investment management firm. He also currently serves as a board member of the Hoag Hospital Foundation, founding member of the UC Irvine Center for Real Estate and his professional affiliations include membership in the Urban Land Institute (ULI), Pension Real Estate Association (PREA) and Young Presidents Organization (YPO).Back to Top
By: Robert J. Dougherty
Expect millennial workers to return (if they ever really left) to where they were raised
- Housing affordability and quality public schools are driving factors
- Millennials will favor submarkets that offer elements of the CBD’s they are leaving
- Transit-oriented communities allow workers to keep a foot in both worlds
- Workspaces that replicate contemporary urban style will be preferred
Much has been written about the so-called “Millennial” or “Generation Y” worker. Demographers have failed to pin precise dates on when this generation of people begins and ends, but generally the millennials are considered to be those born between the early-1980’s and the late-1990’s. The term “millennial” is believed to have been coined to refer initially to those graduating from high school around the turn of the millennium. Today, the millennial office worker ranges from those preparing to graduate college and take their place in the workforce to vice presidents in their mid-30’s.
Millennial workers are undoubtedly a powerful cohort in the U.S. labor market, representing the largest single generation employed today, so it is important for real estate investors to understand how their traits and desires will influence space utilization trends. Naturally, the millennial generation is heavily tech oriented and thoroughly plugged in online. They have also become tagged with a reputation for being entitled, needy, and self-centered. Whether or not these labels are appropriate is an assessment better left to the sociologists. However, the savvy real estate investor will seek to determine what this generation will demand from commercial and residential properties because, according to the Bureau of Labor Statistics, millennials will comprise nearly 75% of the U.S. workforce by 2030.
Flocking to the cities?
A widely held view in the real estate community is that millennials have migrated to U.S. central business districts (CBD’s) in droves, a trend which is believed to have accelerated as the economy emerged from recession in 2010-2011. Proverbially, the millennial worker emerged from his/her parents’ basement in Reston or Irvine (if Irvine had basements) and found a job again - some for the first time. Attracted by the vibrant arts and social scenes that downtowns offer, America’s professional youth took up residence in flats from New York to San Francisco and showed up to their desks in DC and Los Angeles. These children of the suburbs were becoming urbanites.
Of course, the last two sentences above could have been written as accurately in 1972, 1987, and 2002. Twenty-something’s have gravitated towards cities for generations, maybe even centuries. Data does, in fact, illustrate that younger Americans are more urban-oriented [chart] than their elders, but does this come as any surprise? Are they more city-loving at their current ages than their parents were 30 years ago?
Some say yes. They believe that millennials are, in fact, signaling an important demographic shift towards urbanity. Being connected to a large online social network, they value integrated community living, as well. They are concerned about their carbon footprint so they shun the automobile in favor of mass transit and laying down actual footprints on city sidewalks. They crave the pedestrian lifestyle of the corner coffee shops that they knew in college and look forward to posting on Instagram or Snapchat about dining at the hot new restaurant in town and hitting the coolest clubs afterward.
The real estate corollary is that absorption of office space since the Great Recession has favored CBD’s over the suburbs. Conventional wisdom holds that employers were forced to compete for talent as the economic recovery took root, compelling them to rent downtown offices in order to attract millennial workers living nearby. Ping pong tables, bike lockers, wired internet lounges, and stocked cantinas . . . even climbing walls and massage rooms became necessary accoutrements for drawing in the desired millennial worker pool.
So goes the accepted narrative. But is it accurate and does it tell the whole story? Consider that companies may have chosen to rent space in the CBD’s as their employment needs expanded because it was comparatively cheap coming out of the recession. The dramatic rise in office rents that has been witnessed recently really began in 2014. From 2009 – when landlords would have given away space if they had any takers – through 2013, downtown office space was comparatively inexpensive on a constant-dollar basis versus historical rents. Of course, suburban space was even cheaper but, if one can get a Lexus for the price of a Toyota, the “luxury” choice is often made. Maybe accommodating workers’ desires was secondary to cost considerations in companies’ expanding downtown?
But will they stay?
Some sociologists are debunking the notion that millennials are more city-loving than generations which have preceded them. For instance, demographer William Frey argues that many millennial workers have mentally “aged out” of the cities in which they dwell. However, they’ve been “trapped” downtown as victims of economic circumstance since the Great Recession. Declining real wages, poor job prospects in a tepid recovery, and a larger load of student debt than any prior generation have left millennials unable to afford to buy homes in suburbia. Even those whose fortunes have improved in the latter stages of the current job expansion may have missed their window to buy an affordable home in the suburbs given the sharp rebound in housing prices in major U.S. metropolitan areas.
But are millennials really pining for the “home with a white picket fence?” Perhaps the younger generation does not covet home ownership to the same degree their parents did. This thinking argues that millennials would rather rent in the cities versus buying in the suburbs. (Buying in the cities has basically become a “one percent” proposition.) Proponents of this view point to a rate of U.S. home ownership that reached a 50-year low of 63.1% in the second quarter of 2016 and, more particularly, the low rate of home ownership amongst persons aged less than 35 years – 34.1% as of 2Q16 according Census Bureau data. The latter rate has also declined markedly in recent years. At the end of 2010, the ownership rate amongst sub-35 year-olds was 39.2%, so it has fallen off over 500 bps while home ownership for all Americans declined only half as much, by 260 bps, from 80.5% to 77.9% over the same period.
However, the preponderance of research seems to run contrary to the reputation of the city-loving millennial. One researcher recently wrote, “Millennials presence in the city should not be confused with a preference for the city.” Nearly all consumer surveys indicate that Americans still greatly desire home ownership. For example, a recent survey conducted by the National Association of Realtors (NAR) indicated that 87% of Americans believe that home ownership is part of the American Dream, and a similar survey by Ipsos asked consumers if they agreed with the statement that home ownership is a dream come true … 86% agreed. Instead, it seems far more likely that the decline in home ownership across the board and amongst millennials has much more to do with the inability to afford a home versus lacking desire to own one.
In fact, according to the U.S. Census Bureau, 78% of households earning above the national median income owned their homes while only 48% earning below the median were home owners at the end of 2Q16. The Great Recession put a major dent in potential down payments of many would be home owners. Despite historically low interest rates, some have yet to see their incomes fully recover enough to afford the ongoing mortgage service. Reduced wealth – households headed by persons younger than 35 years saw a 30% decline in net worth between 2010 and 2015 – is causing many life decisions to be delayed out of necessity and adds to the notion that some millennials are stuck in the cities. Marriages are happening later in life amongst the younger set, and millennials are far less likely to possess a car or a driver’s license than prior generations. The latter presents a conundrum. Some don’t own cars by choice because it’s expensive and unnecessary in America’s largest cities, but those who can’t afford to own a car are truly beholden to urban dwelling.
Still other potential buyers are saddled with credit problems and debts racked up during the recession and face a more stringent lending environment in which banks and other mortgage lenders are far choosier in selecting borrowers and documenting qualifications. One-third of millennials fail to satisfy the minimum average credit score of 620 which Fannie Mae requires for mortgage purchases, making it difficult to obtain a conventional home loan.
Nonetheless, time heals all wounds, and America remains a society that values and promotes home ownership. It is engrained in our national ethic, embodied in our financial system, and codified through material benefits in federal tax laws. As the bank accounts of millennials eventually recover and as they age and expand families with more children of their own, it is reasonable to expect that they will seek to plant deeper roots just as their parents did. But where will they settle down?
If one accepts affordability as the principal impediment to home ownership, then it’s hard to believe that family roots will be established under city streets. According to a recent study by Zillow, homes located in urban U.S. ZIP codes appreciated by an average of 7.5% in 2015, while suburban homes appreciated 5.9%. Over a five-year period, between 2010 and 2015, city homes are up 28.4% compared with 21.1% growth in suburban home prices. Notably, the differential is much more pronounced in America’s largest cities, especially coastal markets. In Los Angeles, the value of urban homes rose a whopping 42.1% between 2010 and 2015, while homes in LA’s suburbs appreciated by 33.9% over the same time frame. A similar story has played out over the past 5 years in Boston (37.1% city home price growth vs. 20.5% in the suburbs), Washington, D.C. (23.8% vs. 14.4%) and San Francisco (65.3% vs. 58.7%).
How can the typical millennial, who has faced declining household wealth afford a home in the heart of San Francisco when it costs 65% more than it did in 2010? Furthermore, if a buyer still values space, it is also worth noting that city homes are getting smaller at the same time that they’re getting more expensive. In Washington, D.C., for example, urban homes in 1996 cost 6% more per square foot than suburban homes. In 2015, they cost 41% more per square foot.
A case can be made that this increase in urban home prices, particularly in America’s largest coastal cities, needs to be viewed through the lens of rising income, which is taking place in major U.S. cities even while income growth is tepid across the country as a whole. Housing affordability is more important to assess than absolute pricing. However, the nation’s largest coastal cities also remain challenged in terms of price-to-income ratios. As the chart below reflects, East Coast metroplexes Boston, New York, Washington, and Miami all have price-to-income ratios above the national mean. San Francisco, Los Angeles and Seattle all tell a similar story of challenging affordability on the West Coast, as well. Granted, these ratios are well-below the credit-fueled bubble of 2005-07; however, with fewer cheap mortgages available except to the most creditworthy clients, true “affordability” may be worse even while price-to-income ratios are lower. [it should be noted that the map reflects the entire metropolitan areas, both suburbs and downtowns. The available data does not allow one to determine whether downtown incomes have kept pace with the rapid rise in city prices].
Evidence is mounting and more articles are being written which suggest that the reputation of the city-loving, permanently renting millennial may be apocryphal. Given that millennials seems to harbor home ownership aspirations, and the cities in which they are living are unaffordable, is their return to the suburbs preordained?
Reverse migration has begun
Actually, it appears that millennials have already commenced a return to the land of their upbringing. Population statistics released by the Census Bureau at the end of 2015 show a continued outmigration to the suburbs. In fact, the ballyhooed urbanization of America may have been nothing more than a blip or, at the most, a short-lived trend. Census data indicate that growth in urban areas was greatly outpaced by suburban population increases during the mid-2000’s housing bubble, as rising suburban home construction attracted buyers from all walks of life.
Emerging from the financial crisis, both suburban and urban areas gained population. The supposed preference for urbanity seems to have been drawn from the slowing of a decades’ long trend of suburbanization. The differential in the rate of population growth between U.S. cities and their outskirts narrowed markedly after the housing bubble popped. However, only in one year – 2011 – did the population in cities actually grow faster than in the suburbs, and in 2015 urban growth actually slowed to its lowest level since 2007.
CBRE analyzed the Census data and concluded that approximately 30% of millennials reside in cities but noted that “the other 70% do not appear to be rushing to move downtown.” CBRE also pointed out that so-called “midrange” U.S. millennials - age 25 to 29 – migrated more frequently from the cities to the suburbs (529,000) in 2014 than into downtowns (426,000). This outmigration was even more pronounced for persons 30 to 44 years of age. In 2014, 1.2 million of them left cities for the suburbs while only 540,000 headed in the opposite direction.
This suburban trend is more likely to grow than abate because the population peak of the millennial generation has not yet reached prime home buying age. Sociologists peg 1990 as the peak birth year for the millennial generation. While this ignores the impacts of immigration, U.S. births did decline markedly after 1990. Thus, the peak millennials are now 25 years of age and will be “maturing” economically into potential homebuyers over the next 10-15 years.
Many demographers believe that the credit and housing bubble substantially distorted U.S. migration trends. Massive homebuilding fueled growth in the suburbs during the mid-2000’s. After the crash, America experienced a migration into the cities in search of higher paying jobs and more plentiful rental housing during the depth of the recession. The developing school of thought is that, now that the effects of the housing bubble are becoming normalized, the U.S. is reverting to its inexorable 60-year-old suburbanization trend.
Will the jobs follow? As with the millennials, they already are . . .
Of course, just because more heads are resting on suburban beds, doesn’t mean that jobs are also migrating to the suburbs. However, the post-recession trends in office absorption seem to mirror the population trends outlined above. Emerging from the global financial crisis, America’s downtowns enjoyed their day in the sun. From the beginning of 2010 through mid-2012, Class A CBD space led all categories of space in the rate of net absorption relative to inventory. Notably, the flight to quality referenced above was also in evidence, as only Class A space – whether urban or suburban - enjoyed positive absorption in 2010 and 2011. However, since late-2012, suburban Class A space overtook all other office categories as the relative net absorption leader and has remained the leader since.
Of course, higher office space absorption in the suburbs has likely been a function of greater availability. In fact, suburban office buildings of all quality levels (Class A, B, and C) continue to remain less occupied than their downtown counterparts. However, expect this occupancy differential to narrow as CBD office space becomes increasingly expensive. As the chart below illustrates, cumulative rent growth since 1Q 2010 for downtown Class A office space (29.0%) has been more than double that of Class A suburban space (14.4%).
As Class A CBD office rents continue to reflect a rapid ascent, the overall gap between CBD and suburban rents has widened to a post-recession high. According to Jones Lang LaSalle, CBD office rents were 62% higher than overall suburban rents at 3/31/16. If the U.S. economy softens, will belt-tightening cause employers to look more closely at this rent differential? If their workers are increasingly moving to the suburbs, perhaps relocating more jobs nearby would carry a “double bottom line” of lower costs and improved employee morale. This seems, if not inevitable, more likely than not.
Winners and losers . . . implications for commercial real estate
What will be the effects of this emerging suburban “renaissance” and what strategies can smart real estate investors employ to take advantage of it? The following are a few possible takeaways:
- Emphasize housing affordability – In what seems an obvious implication, investments which pursue areas of housing affordability should fare well. These include residential projects which themselves offer affordable housing or commercial properties presenting proximate employment opportunities. In a similar vein, properties in cities with cheaper housing for millennials – whether urban or suburban – should benefit from millennial migration. Millennials have demonstrated that they are mobile and can move between metropolitan areas just as well as within them. The prevailing exodus to Western and Sunbelt cities is resuming. Cities with a high quality of life, strong employment growth, yet more affordable housing should benefit from long-term migration trends. Austin, Denver, Dallas, Atlanta, Charlotte, and Phoenix have already experienced this type of growth, seemingly at the expense of places like Detroit, Cleveland, and Pittsburgh. However, don’t be surprised if growth slows in high-cost Tier I markets and the second-tier Western and Sunbelt cities begin to siphon people from Boston, New York, and Seattle, too.
- Replicate urban amenities in the suburbs - Even if millennials are pining for the suburbs for the primary reason of cheaper housing, it makes sense to think that they still love their coffee bars, clubs, and communal living. Successful real estate developments and renovations in the suburbs will recreate elements which attracted millennials to the city initially. This might include an on-site barista lounge, ping pong or fussball tables, wifi-enabled common areas, and more contemporary office layouts and finishes. Other amenities, such as sand volleyball or bocce ball courts – one building in San Diego’s Del Mar Heights even has a wetsuit locker - might be unique to the suburbs but reflect millennials’ desires to mix work and play.
- Seek urbanity in the suburbs – Places which are the “next best thing” to living in the city will be coveted by millennials. Provided that the public schools are good and soccer and baseball fields are plentiful, having some acclaimed restaurants, shopping boutiques, and semi-cool clubs nearby will make “going suburban” a less bitter pill to swallow for many. If these shops, gyms, and studios are pedestrian-friendly, that’s even better. Semi-urban suburbs like Alexandria, Bellevue, Walnut Creek, and Bethesda offer many of these attributes. Granted, real estate there is by no means inexpensive, but these edge cities should be the beneficiaries of millennials’ wishes to – incomes permitting - have their cake and eat it, too. If the reputation of the millennial generation holds true, they’ll figure out how to do just that in “hipsturbia.”
- Public transportation is valued on multiple levels – Building or acquiring projects close to public transportation in the suburbs should pay off by catering to the next generation worker. Even if this worker will increasingly be living and working in the suburbs several factors make convenient access to public transportation very valuable. Although the recent trend favors suburbanization of millennials, several factors may keep them tied to the cities and wishing to commute frequently between downtown and the suburbs. As indicated above, jobs may or may not out-migrate. Commuting on LA, DC, and Bay Area freeways is more grueling than ever, and millennials are more inclined than their parents to be concerned about their cars’ emissions contributing to climate change. They are likely to place a higher value on the option of public transit. Additionally, even if their job has followed them from downtown or they found a new position in the suburbs, many millennial suburbanites will have left friends, dentists, hairdressers, or their favorite bars and yoga instructors in the city. They will value a convenient commute. Lastly, a few die hard urbanites simply won’t be able to bring themselves to leave the city. In this case, placing employment centers near public transportation will allow the city dwellers to reverse commute to jobs in the suburbs. This is a phenomenon that is growing more abundant.
- Exploit the value gap – Given the attention paid to CBD properties, their appreciation has far surpassed that of suburban assets since 2010. Some of this is owing to investors’ risk aversion, favoring the long-term price performance of downtown assets (see figure at right). However, a belief in the transformative power millennials would exert upon downtowns surely played a supporting role in driving down CBD cap rates. These factors have resulted in a 15-year record price gap between urban and suburban office properties. Although it appears that downtown office buildings have outperformed their suburban counterparts, their price volatility has been more severe. Furthermore, given the dramatic post-recession appreciation in CBD assets, what will drive further price increases? It is hard to fathom cap rates declining further. Also, if the millennial workers are looking to abandon the city at the same time that new buildings are being constructed to house them, can one rely upon income gains from downtown properties? In the same manner that demographics appear to be reverting to long-term prevailing trends, suburban commercial properties are a safer bet, banking upon a reversion to historical norms through a narrowing of the price gap to more typical levels.
All in all, it appears that the conventional wisdom that millennials are initiating a permanent trend towards urbanization is too simplistic and overblown. While it is clear that metrocentric millennials have sparked a resurgence of the urban core, the idea that they’ve permanently forsaken the suburbs doesn’t jibe with the data or stand up to closer scrutiny. CBRE speculates that the notion that downtowns are surging while the suburbs are sinking derives from recent trends in several high-profile cities such as Washington, DC and San Francisco, along with the few anomalous post-recession years in which downtowns actually did outperform their outskirts. The pendulum swings between the suburbs and the city, often in keeping with the economic tides. It is now swinging back in favor of the ‘burbs’. Perhaps it will swing less far this time, but the savvy investor will recognize and benefit from these evolving demographics.
Back to Top
By Robert Brunswick, CEO of Buchanan Street Partners
NEWPORT BEACH, CA—As the CMBS market continues to slow, how will the capital markets sector be affected? Buchanan Street Partners’ Robert Brunswick weighs in on the subject EXCLUSIVELY with GlobeSt.com.
Much has been reported about the CMBS market continuing to slow, plateau, freeze—fill in your own verb. GlobeSt.com spoke exclusively with Robert Brunswick, CEO of Buchanan Street Partners, to get his take on how this trend is affecting the capital-markets sector now and in the future.
GlobeSt.com: As wider spreads translate into higher costs for borrowers on CMBS loans, what alternative financing solutions are coming available?
Brunswick: When we talk about CMBS, we first need to frame what it has brought to the real estate markets and where it might be lacking. The advent of CMBS brought much-needed liquidity and additional participants to the debt markets—both improving liquidity to the market and further validating real estate as an asset class in terms of investor fluency and their ability to assess risk and return. In turn, real estate debt through CMBS now competes with capital flows to other asset classes and the greater volatility of the liquid markets. Geopolitical issues, market cycles, rating agency moods, increased regulatory requirements and past CMBS performance all affect the day-to-day pricing of new origination and resale and purchase of existing bonds. Therefore, we need to be careful to not overreact when CMBS goes down or up since it is not an indicator of the demise of CMBS but instead recognition of the variables that impact its daily pricing.
In the past few years, we have seen a reduced volume of new issuance of CMBS, due in part to what happened with prior performance of CMBS and in large part due to real estate’s devaluation in the last cycle. Rating agencies were questioned as to their objectivity and the bond’s ultimate performance. Where are we today? CMBS bonds now have to compete with all other asset classes and types of bonds, and with that there is a more disciplined assessment of its associated collateral and cash-flow predictability. It’s currently difficult to provide borrowers with a predictable rate within the CMBS market until the loan is ready to close, thus limiting current origination volume. Further, banks and life insurance companies are much more active in their availability today, offering borrowers more predictability of outcome. Additionally, there is a trend for many buyers of real estate to de-lever (or bring in more equity to) their acquisitions and real estate, which plays more into the hands of the life- insurance companies and banks.
A majority of CMBS originations have catered to those borrowers seeking higher leverage to satisfy a refinance, a secondary or tertiary market consideration, or reduced equity position on assets that might not fall into a bank or insurance company’s lending parameters. CMBS has historically financed riskier assets, and with rating agencies starting to now see slippage in underwriting quality, and with the pending new risk‑retention rules for CMBS taking effect in December under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the bond-buyer market has become skittish, limiting originator capabilities.
With this uncertainty, many private lenders (shadow banks) are being formed and/or becoming more active to provide capital for the potential shortfall. We ourselves have set up a private-lending vehicle to provide a predictable capital source for those transactions that have good sponsorship, are properly sized, might require some structure but couldn’t go through a conventional CMBS underwriting or do not have the necessary time to wait. The private-lending market can be an interim source of capitalization for many borrowers, but it’s not a long‑term solution. As people fix their assets’ problems or buy assets and stabilize them, interim financing can be a short-term solution, but not a long-term one because the property cannot withstand the higher yield associated with these types of loans. This ultimately creates a lower-priced source of capital available to those buyers. To fuel this type of lending, many investors are eyeing the debt space since it affords a more predictable yield with tangible subordinate equity.
There are roughly $250 billion of CMBS loans maturing between 2016 and 2018. If the property is not sold, the refinance lender is either the new CMBS market or a private lender who might accommodate the transitioning nature of the asset. Interestingly, though, a lot of prior CMBS borrowers have defeased their loans early given the attractive refinance markets, brought in more equity and are now refinancing through banks and insurance companies. We have to recognize that CMBS, for most borrowers, has never been the first choice.
GlobeSt.com: What does the uncertainty in the CMBS market mean for buyers and sellers of commercial assets? What does it mean for asset values?
Brunswick: For every transaction, only 10% of the market uses CMBS. I would draw the conclusion that CMBS by itself is not going to drive down valuations or cause them to pause. There are other factors, such as the greater economy, the lack of significant growth in rent rolls, the over-exuberance of pricing as investors are wanting to put their money to work and get some yield. But this is a levered asset class, and as leverage is reduced, that will mean less yield on your equity. You’re either going to be willing to accept lower leverage with less yield on equity, or sellers will have to be more realistic on pricing their assets given the reduced leverage that is available to buyers. A slowdown in sales is not solely attributed to the debt markets; it’s a variable. You can put your money to work in other asset classes that might be better priced to get the yield you thought you were getting in real estate. Real estate appreciated too quickly.
GlobeSt.com: What does this turmoil mean for borrowers as originators stop making CMBS loans because it’s now dramatically more difficult to price loans due to the inability to predict the future cost involved?
Brunswick: Most borrowers who use CMBS either have a relationship with a particular lender or they have a higher-leverage requirement, and CMBS is their only option vs. going to a bridge lender who might charge more. Spreads have actually reduced recently as the bond buyers have come back into the market a little bit. They were in the 350 range, and are now 310 to 320, depending on the asset. It’s becoming a known reality that if you do a CMBS loan, you have to live with the volatility of not knowing what your rate is going to be until you close. That’s a tough presentation for borrowers as they want certainty of pricing. It’s creating volatility on the buy/refinance side, and it means that these borrowers will have to put more equity to work and accept some volatility.
GlobeSt.com: What else should our readers know about alternative financing solutions and CMBS?
Brunswick: A lot of folks are now saying they’d rather be in the debt seat than in the equity seat. They will put more in debt until they get comfortable with the valuations of CRE or debt yields are driven down on the private side. There will be varied debt players who will start to backfill the capital markets as their investor base reconciles this mispricing and opportunities present themselves, and investors recognize that the risk-adjusted yield is more attractive on the debt side than the equity side at the moment. CMBS is not going away. It will come and go as capital does and as the market adjusts. The market is pretty smart and will price and adjust accordingly.Back to Top
By Robert Brunswick, CEO of Buchanan Street Partners
Last year, the Federal Deposit Insurance Corp. (FDIC) implemented its Regulatory Capital Rules, a new set of directives intended to address regulatory deficiencies that contributed to the 2008 banking collapse. The regulations impose significant limits on bank acquisition, development and construction (ADC) loans, and create an opportunity for loan originators, specifically nonbank lenders, to expand their ADC offerings.
The most notable change requires banks to increase the amount of capital set aside for ADC loans that exceed loan-to-completed value standards or do not comply with minimum real-cash equity investments. The nonconforming loans affected by these regulations are characterized as High Volatility Commercial Real Estate (HVCRE) loans. The new laws were first released in October 2013 and implemented at the start of 2015.
The new reality
Banks that were major players before the recession have returned to the market, but on a limited and inconsistent basis. Lenders have been producing ADC loans at a significantly lower volume than the peak in 2007, causing a decline in the market share of ADC loans originated by regional and community banks.
Under the Regulatory Capital Rules, banks must categorize an ADC loan as HVCRE if it fails to meet several conditions. Chief among them are the following: The borrower has contributed at least 15 percent of the appraised-as-completed value of the asset before receiving bank financing; and the loan-to-value ratio of the financing does not exceed 80 percent. Also, loans for land development must not exceed 75 percent LTV.
This new ruling affects bank offerings on HVCRE loans nationwide, limiting borrowers’ access to capital — and leaves the door open for private lenders to swoop in, especially those able to serve unmet demand with flexible loan structures and efficiency.
Clarifying the rules
The FDIC has issued clarifications of the law over the past year. First, if a loan is initially classified as HVCRE financing, it remains so until the acquisition, development and construction loan is refinanced with a permanent loan. Nonetheless, a loan cannot be classified as permanent if it is based on the “as completed” value of the project. Furthermore, these clarifications included a distinction between the “as completed” and “as stabilized” values, so that the latter value cannot be used to determine whether a loan meets the definition of HVCRE financing.
Clarifications also established that borrowers may not withdraw capital generated internally by a property during the term of an HVCRE loan. Neither unrelated real estate assets nor grants from state, federal or municipal governments, or nonprofits can be included as part of the borrower’s 15 percent equity contribution; and preconstruction deposits on condominiums cannot be counted as a borrower-equity contribution.
Also, junior liens collateralized by the property, cannot be considered part of the 15 percent contribution. It is not clear yet whether mezzanine loans secured by partnership interests and originated by a lender unrelated to the bank will circumvent this rule. Borrowers are, however, permitted to include land contributed to a development project as a part of the required capital. The value of this contribution must correspond to the borrower’s real-cash equity in the land. For example, if a borrower purchased a site in 1980 and since entitled it, the cost basis is the original land purchase price plus the entitlement expenses. This is a major shift in bank regulations, creating a void that can only be filled by nonbank construction lenders.
A borrower’s contributed capital can include soft costs, such as brokerage fees, marketing expenses or costs of feasibility studies. Project costs paid to related parties for developer’s fees, leasing expenses and brokerage commissions, and management fees may be included in the soft costs — provided they are reasonable in comparison to fees paid to third parties for similar services.
The new regulations do not preclude banks from originating HVCRE loans. In the wake of their implementation, however, some banks may determine that HVCRE loans will not generate sufficient returns as compared to alternative investment options because of the additional costs associated with higher reserve requirements. This situation presents greater opportunities for flexible, nonbank lenders to move into the space.
Impact on Lending
The regulations have created a competitive advantage for private lenders in funding high-leverage construction loans, construction mezzanine loans, and highly structured bridge and land-acquisition financing.
A study by Joseph Rubin, Stephan Giczewski and Matt Olson of Ernst & Young LLP pointed to several significant effects of the new regulations:
- Higher capital requirements from the borrower could result in banks shifting assets away from the commercial real estate sector;
- Interest rates could increase to account for the increased costs; and
- Borrowers may be forced to shift to higher-cost private lending sources.
Although the new capital regulations impose limits on bank lending, banks are not out of the picture. According to the Ernst & Young study, a minority of commercial real estate loans are likely to fall into the definition of HVCRE because banks already avoid loans with LTVs of 80 percent or above, and most borrowers acquire development sites simultaneously with, or just prior to, the closing of the acquisition, development and construction loans.
Even among nonbank institutions, there are relatively few lenders that specialize in loans with LTVs above 80 percent. But there is demand for such loans, as well as opportunities for nonbank lenders. Their biggest advantage is the ability to structure flexible debt more quickly than banks, and commit to deals while banks are still evaluating them.
Some other situations where nonbank financing is a good fit include:
- A borrower has owned the land for a significant period of time, but has a very low real-cash basis;
- An asset has increased in value because of rezoning, or the entitlement process;
- A borrower seeks more than 80 percent of cost-construction financing for a preleased, investment-grade, credit-tenant building;
- A borrower requires cash out from unit sales to fund unrelated projects — for example, a situation in which a condominium developer previously arranged an 80-20 percent split of unit-sale proceeds to pay a principal or dividends; and
- A bank rejects a borrower’s assertion that developer’s fees included as part of the contributed equity are justified by the market (a standard that has yet to be defined by regulators).