Investment strategies for 2023 range from selling overpriced industrial assets to taking a full accounting of the top Commercial Real Estate risks.
With the holiday weekend behind us, it is not too soon to look at what will be the top investment strategies for next year. They include:
1. Sell Overpriced Industrial Assets
The industrial market has been booming for the last few years and is the favored asset class among institutional investors. While demand for industrial product remains strong, the cap rate for single-tenant industrial product jumped to 4.96% in Q3 2022. An increase in cap rates was seen across all markets. Industrial assets continue to experience pent-up demand as supply lags absorption, constraining existing tenants in terms of expansion. The jump in cap rates for the asset class can be attributed to the anticipation of further increases in interest rates, paired with the perception that these cap rates were too low, and that “the party must end eventually.” With the cost of borrowing getting higher and construction costs remaining elevated, investors were facing potentially negative leverage when seeking deals in the asset class, which are becoming increasingly difficult to justify for some.
2. Sell Overpriced Multi-Family Assets
As house prices continue to climb despite the volatility in the market, an increasing number of consumers continue to turn towards rental housing. This demand is further driven up by the implementation of government support programs and increased immigration. Cap rates for suburban multi-unit residential assets increased in Q3 2022 to 4.33%. Cap rates rose across most major markets though remained steady in Calgary and compressed in Quebec City. This stems from the rising cost of borrowing, as experienced by the other asset classes. Lack of available inventory and increased demand is creating a “hot” market for this asset class as well.
3. Acquire Beaten up Retail Assets
The top three most preferred property types by investors in the third quarter of 2022 were food-anchored retail strip, industrial land and multi-tenant industrial assets. The food-anchored retail strip and industrial land assets had the largest upswing in momentum ratio. Food anchored retail continues to remain an attractive asset with its nature as an essential asset and potential for expansion. Enclosed community malls and tier II regional malls were the bottom two in terms of investor preference. This can be attributed to the perception of increased risk in these assets, especially highlighted by the pandemic. Furthermore, there is an anticipated impact on purchasing power as consumers face rising interest rates which in turn will impact the demand and use of retail assets. Thus, with interest rates going up, and talks of a potential recession, these assets were not highly preferred.
4. Invest in Data Analytics Companies
One of the key growth areas of CRE is in data analytics. Data analytics encompasses all aspects of big data for CRE including; demographics, ownership data, property data, historical value information, sales/lease data and financial analysis. The data analytics space is very fragmented with a few large companies like CoStar, RealPage, REIS (a unit of Moody’s) and many local and start-up companies. These larger firms have been acquiring smaller competitors to expand their service offerings and customer base. Recently, CoStar acquired Smith Travel Research, the leading hotel/lodging consulting firm, for $450 million and RealPage acquired Buildium, a property management software firm, for $580 million. As the industry grows, there will be more consolidation and an opportunity to acquire these smaller private firms and even establish a platform to consolidate these entities.
5. Sell Overpriced Core Assets and Reinvest in Opportunistic Assets
The risk and return for various CRE investment strategies range from the lowest risk, core investments, which are typically fully leased, institutional quality, Class A properties with little or no leverage, to value-added strategies which are higher risk strategies that involve some property redevelopment, tenant adjustment or leasing or with operational problems to opportunistic strategies, which are the highest risk category that involve a high degree of redevelopment, leasing, tenant relocation or change or may be in financial distress. Many core properties are still trading at 3.0% to 4.5% cap rates and should be sold. The proceeds should be reinvested in higher return opportunistic strategies, as discussed in #2 above, buying beaten up retail assets.
6. Provide Participating Mezzanine Loans
Even though there is a lot of capital sloshing around chasing deals, there is a dearth of debt/equity capital for the portion of the capital stack above the first mortgage at about 65%-70% and below the minimum owners’ equity investment of 10.0%. This slice of 20% of the capital stack is ideal for a participating mezzanine loan. The participating mezzanine loan may have terms as follow; the central bank’s risk free rate of interest 3.0% (comparable to 10-year bond yield) plus an additional interest rate spread to compensate for the risk associated with with the transaction. This spread in some cases varies between 4.0% – 10.0%+, loan fees of 1.0%-3.0%+ and 20.0% to 30.0%+ ownership of the deal. The mezzanine lender will typically not be secured by a second lien on the property but by an ownership guarantee and assignment of the owner’s interest in the property. The lender is entitled to the equity kicker because it is taking some of the equity risk of the project. Internal rates of return of 12.0%-20.0%+ can be delivered with this strategy, which is very attractive for a fixed income investment.
7. Perform a Systematic Review and Analysis of the 15 CRE Risks
As we have discussed before, there are 15 risks inherent in CRE investment as follows:
- Cash Flow Risk-volatility in the property’s net operating income or cash flow.
- Property Value Risk-a reduction in a property’s value.
- Tenant Risk-loss or bankruptcy of a major tenant.
- Market Risk-negative changes in the local real estate market or metropolitan statistical area.
- Economic Risk-negative changes in the macroeconomy.
- Interest Rate Risk-an increase in interest rates.
- Inflation Risk-an increase in inflation.
- Leasing Risk-inability to lease vacant space or a drop in lease rates.
- Management Risk-poor management policy and operations.
- Ownership Risk-loss of critical personnel of owner or sponsor.
- Legal, Title, Tax and Political Risk-averse legal, tax and political issues and claims on title.
- Construction Risk-development delays, cessation of construction, financial distress of general contractor or sub-contractors and payment defaults.
- Entitlement Risk-inability or delay in obtaining project entitlements.
- Liquidity Risk-inability to sell the property or convert equity value into cash.
- Refinancing Risk-inability to refinance the property.
All investors that own CRE should perform a detailed and systematic review of the above risks and their potential effect on an asset or portfolio.
As the 2023 year progresses, investors will continue to gravitate towards assets which offer minimum risk potential and provide opportunities for redevelopment. Therefore, industrial and multi-family assets, along with food-anchored retail strips, will continue to garner the most investor interest. With the cost of borrowing expected to continue rising, upward pressure on cap rates across all major asset classes is expected to remain throughout the remainder of the year.