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Investment Strategies for a Mature Market

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The first rule of investing is to buy low and sell high—but that’s easier said than done.  Today, commercial real estate prices are high and cap rates are low because investors are more motivated to buy than to sell.  With an overabundance of capital in the market, strategies that have served investors well for the past five years are no longer as viable as they have been. Fortunately, there are still prudent real estate plays for investors with market expertise, focus -- and patience.


The real estate market is healthy and the economy is strong, but there’s no question that we are late in the investment cycle.  Property sale prices per square foot are at an all-time high—27 percent higher  than a decade ago, when prices were at their pre-recession peak. Capitalization rates are in the 6 percent range for properties overall, but as low as 4 percent for Class A properties in some cities.


The U.S. economy is entering its ninth year of uninterrupted growth, and despite few signs of a recession soon, investors are naturally concerned about downside risk. In the apartment market, where rental increases have outpaced inflation by about 20 percent over the past 10 years, the worry is that the high levels of rent and occupancy can’t be sustained.  Investors are also closely watching the office market, where net absorption levels and occupancy rates are rising in some major markets but falling in others.


Uncertainty about the market’s future hasn’t kept investors away, though -- real estate offers better current yields than traditional investment alternatives like bonds.  Spreads over 10-year Treasuries are at 4 percent, which is low by historical standards but mostly unchanged in recent years.  Institutional allocations to real estate are as strong as ever.  The question is, how to invest wisely when the market is in a mature phase.


Dry Powder


There’s no question that investment capital is being raised faster than it can be prudently spent. Investors haven’t gone off the deep end to make acquisitions that they might come to regret if the market turns sour. The wounds inflicted by the global financial crisis haven’t been forgotten.


Some $246 billion in investment capital earmarked for real estate remained unspent at the end of June, according to a recent report from Preqin.  Known as dry powder, the number has been rising for several years, and it isn’t limited to real estate:  all told, the private equity sector has $963 billion in dry powder looking for deals. Everyone is looking for places to invest that offer good yields with relatively low risk.


The good news is that such deals do exist in real estate—they’re just more difficult to find than the core assets in major markets that have fueled real estate investment growth over the past several years.  In the first phase of the recovery, investors focused on trophy asset in “gateway” markets like New York and San Francisco.


As competition in those cities ratcheted up, investors filled their allocations by turning to value-added opportunities like infill development and redevelopment opportunities. Now that competitive field is crowded as well. So, what’s the next step for ahead-of-the-curve investors? Here are three approaches we’re seeing from investors:


  • ·         Extend the search to secondary markets and non-standard property types.   Cities that have been slow to recover, or that lack live-work-play submarkets that bode well for job growth, offer higher cap rate and current yield opportunities. The trick is not to spread yourself too thin. Pick a handful of cities that others have overlooked, understand the local market dynamics, and compete aggressively for deals you like.  The same idea applies to niche property types, like cold storage industrial space or student housing—if you believe in a market and understand it better than other investors, you can spot the opportunities that offer decent yields and limited downside risk. 
  • ·         Move down the capital stack. Traditional lenders like banks and CMBS issuers aren’t offering the high loan-to-value (LTV) and loan-to-cost (LTC) ratios that they used.  Owners that are refinancing existing properties often must come up with additional equity or refinance with a subordinate debt structure.  That opens opportunities for investors to supply preferred equity or mezzanine debt.  The downside is that these structures generally carry additional risk in the event of a default.  But a savvy capital source can limit the risk by focusing on stable borrowers and resilient properties for investment. 
  • ·         Don’t give up on value-add opportunities.  There are still a lot of good deals out there waiting for someone to put the pieces together.  This usually takes a highly targeted approach and a lot of specialized expertise.  For example, an industrial infill site can be a home run for an investor that can redevelop the property as a modern distribution space—but such deals often require experience with environmental remediation in addition to the usual construction and leasing challenges. Similarly, suburban garden apartments in some markets may be ripe for repositioning, if an investor understands the local market well enough.


There are no slam-dunk investment strategies at this stage in the cycle.  But real estate is still a viable investment option, with favorable yields compared to alternatives. To maximize the upside potential while minimizing risk, investors and advisors need to sharpen their focus and leverage any special expertise they have. And when a deal just doesn’t work, it may be best to walk away and keep your powder dry for the next opportunity.


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