5 min read
Navigating the Changing Landscape of Commercial Real Estate
Navigating the Changing Landscape of Commercial Real Estate
5 min read
Crewcial Partners : Oct 2, 2024 2:46:43 PM
Commercial real-estate investment strategies generate returns by purchasing properties at attractive valuations, increasing or creating rental income, and/or reducing operating expenses. These strategies frequently increase revenue by conducting property improvements, using hands-on leasing strategies to increase the occupancy of a building and its rental income, or enhancing operational efficiencies to reduce operating expenses.
Strategy Types
The strategies are typically grouped across the following types: opportunistic, value-add, core +, and core. These categories broadly define the strategy’s expected level of risk and return, which varies based on factors such as the degree of leverage, expected occupancy upon acquisition, the extent of planned property improvements, and business plan.
Opportunistic strategies are characterized by a high risk/return profile (whereas, on the other end of the spectrum, core strategies are characterized by a low risk/return profile). Opportunistic strategies generally utilize 65-75% loan-to-value ratios and may involve a significant amount of vacancy; they tend to create value by leasing the space at higher rental rates, which is usually accomplished by conducting significant property improvements (sometimes intentionally facilitating vacancy to conduct improvements that could not be accomplished with a tenant in place). These strategies can involve some development or re-development, but typically the majority of assets in opportunistic portfolios demonstrate significant cash flow able to support debt-service needs.
Value-add strategies generally have higher occupancy rates, utilize lower leverage, and pursue lighter property improvements than opportunistic strategies.
Crewcial typically recommends strategies that fall in the opportunistic and value-add categories.
Notably, opportunistic strategies rarely involve ground-up development projects, which fall further along the risk spectrum, but typically involve building a property from the ground up and/or taking entitlement risk (for example, re-zoning land). Financing for these projects is typically higher cost and shorter term, and they do not typically have cash flow to support debt-service costs. Refinancing can become complicated, significantly higher cost than expected, restricted, or unobtainable during periods of market distress. Re-zoning/entitlement risk also involves binary political risk. Because of the nature of the capital markets, the performance of development strategies may demonstrate a high correlation to that of the broader macro environment.
Core strategies fall at the other end of the spectrum, investing in properties that require minimal renovations, are financed with low leverage, and have zero or near zero vacancy. Core + strategies invest in properties that have slightly higher vacancy and leverage and may invest in properties across a wider range of locations. These strategies offer lower returns than opportunistic or value-add strategies and are often utilized by investors seeking income and specific tax advantages from real estate. Endowment and foundations are typically targeting a higher return than those offered by core and core + strategies.
Opportunistic and value-add strategies are typically offered in closed-end private equity vehicles. Core/core+ strategies are typically open-end and meet redemptions through share-repurchase plans. Open-end real-estate strategies feature an asset/liability mismatch; the liquidity of the properties in the portfolio is less than the monthly or quarterly liquidity offered to investors in the strategy. These strategies may be forced to implement gates during periods of high withdrawals and therefore may not offer the intended liquidity when it is most sought by investors and/or be pressured to sell properties at inopportune times.
Sectors
The primary sectors targeted by institutional strategies are multifamily (apartments), office, retail, industrial (warehouse), and hospitality (hotel). Opportunistic strategies may also include ancillary sectors such as self-storage, healthcare, parking, gaming, and even cell towers and marinas.
Sector characteristics vary based on their tenant profile, lease terms, and tenant concentration. For example, a multifamily property with 200 tenants offers lower tenant-concentration risk than an industrial property with a single tenant; the credit profile of the industrial single tenant is particularly important for an industrial property, whereas the credit profile of a single multifamily property tenant is not. A single-tenant property is also exposed to a total loss of cash flow upon a lease rollover, whereas a property with many tenants may have a more diversified rollover schedule. That being said, a single tenant who has spent significant capital customizing the interior of their space may be more inclined to stay put than an apartment renter who can easily move their furniture to an apartment across the street.
Another example of varying sector profiles could be a strategy’s exposure to consumer spending: the hospitality and retail sectors have historically been more sensitive to consumer spending because of their tenant base and lease terms. However, hospitality can also offer inflation protection; for example, hotel rates can reset nightly, while office properties have long lease terms.
Geography
Commercial real-estate investment strategies can invest nationally, globally, or focus on a particular region or city. National strategies may focus on gateway markets, secondary markets, and/or tertiary markets.
Gateway cities are those with large populations, high GDP, diversified economic drivers, and high transaction volume. Examples include New York City, San Francisco, Los Angeles, and Chicago. These markets are the most frequently trafficked by commercial real-estate investors and therefore the most liquid. The rents in these markets are higher than those of other markets, and due to the lower perceived risk and higher demand, cap rates and financing costs are lowest in these areas. Additionally, the availability and cost of financing is generally superior in gateway markets relative to other markets; that being said, pricing is also higher in gateway markets to reflect this, and they can be subject to greater regulatory hurdles and higher underlying costs. Historically, during periods of distress, a ‘flight to quality’ often occurs, causing the value of properties in gateway markets to decline less and recover ahead of other markets.
Secondary cities are smaller than gateway cities, and while these markets have significant diversified economic activity, it is to a lesser extent than gateway cities. Examples of secondary markets include Seattle, Charlotte, and Austin. Some investors favor secondary markets due to their growth potential. Secondary market properties generally trade at higher cap rates and the environment can be less competitive than that of gateway cities, although institutional interest in secondary markets has increased over time. Financing for properties located in secondary markets can be more expensive or difficult to obtain during periods of distress than financing for properties located in gateway cities.
Tertiary cities are smaller, less dense, and have lower GDP and economic diversity than secondary markets. Examples of tertiary markets include Charleston, Kansas City, and Richmond. These markets trade at higher cap rates, have higher financing costs, and higher illiquidity risk, but attract lower institutional interest and therefore may be less competitive.
Such markets may be viewed differently by different market participants and the definition may change over time. For example, due to recent growth, Atlanta may be considered a gateway city (as opposed to a secondary market) or Nashville may be considered a secondary market (as opposed to a tertiary market) by many market participants.
Leverage
Commercial real estate is a highly levered asset class: it is rare for an investment strategy to pursue commercial properties without using leverage. Opportunistic strategies generally lever properties 60-75%.
Historically, banks, insurance companies, CMBS markets, and government agencies (specifically in terms of multifamily) were the primary providers of senior financing for commercial real estate. Over the last decade, the private market has increasingly participated, as bridge debt funds have become a widespread private real-estate debt strategy.
Bridge debt refers to a senior, shorter-term mortgage used by a borrower to ‘bridge’ the gap between the time of acquisition and completion of its business plan. Borrowers are willing to pay a higher interest rate for a shorter period until they are able to refinance into cheaper, longer-term bank or agency debt (or sell the property upon completion of their business plan).
Debt lower in the capital stack, such as mezzanine debt, B-notes, and preferred equity, can also be used by real-estate investment managers. Mezzanine debt falls below senior debt in the event of a default but offers higher interest. B-notes are similar in that they are subordinate to the corresponding A-notes, but secured by the same senior mortgage as an A-note. In the event of a default, the mezzanine lender may foreclose on the collateral and subsequently become the borrower; senior lenders may have a preference for specific mezzanine lenders for this reason.
The financing market for multifamily properties differs from that of other sectors because federal agencies play a significant role. Just as these agencies participate in residential single-family housing, they also serve as a steady source of funding for the residential apartment sector. The agencies typically finance highly occupied, cash-flowing properties and offer lower rates than non-government-related lenders.
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