Market Update

Dear Investors,

We hope you are enjoying the longer days of summer and spending quality time with friends and family.  More fun, less work, and a life of balance!  Of course to achieve this balance, navigating a challenging investment landscape with a sound strategy is paramount.  Money doesn’t buy happiness, but it can buy freedom.  To earn it, sometimes it pays to step out farther on the risk spectrum to take a swing at larger returns.  Other times it’s more prudent to take base hits and be patient.

Sticking with the baseball analogy, we continue to step to the plate.  Right now, we feel like we can reliably get on base via private real estate debt, backed by solid underlying collateral.

We’ve still been on the hunt for solid deals in which to deploy equity allocations.  While it is possible to find deals in every stage of the market cycle, we remain cautious.  We are identifying some common themes we are seeing in the market that are dictating our approach.

For one, rent growth has slowed significantly and/or gone negative in some markets.  For both industrial and multifamily, much of this slowdown is a result of increased supply from deliveries coming to market.   For property acquired today, very conservative assumptions should be modeled.  Slower rent growth over the coming years will result in more modest returns than we’ve seen over the last market run-up.

We are are also seeing variable expenses steady, but remain at elevated levels.  Higher insurance premiums, property taxes, construction costs, material costs, etc. are putting downward pressure across the board.  Flat, but higher, operating costs will result in more modest returns than we’ve seen over the last market run-up.

Additionally, sponsors are using lower leverage (LTV).  While its nice to think that this is due to learning from the excesses of the last market run-up, that’s not the case.  In the majority of cases, this is a result of the asset being “debt-service coverage restrained.”  While property values have declined due to decompressing cap rates, prices have not reduced at levels where the NOI can produce a DSCR of 1.25 or more using 75%+ LTV.  With much of the bridge/CLO market still paused, lenders are originating debt based on actual financials versus pro forma.  This means borrowers aren’t eligible for as high of loan proceeds.  Reduced loan proceeds, i.e. lower LTVs (depends on the situation/asset etc. but many times in the 60%), will result in more modest returns than we’ve seen over the last market run-up.

That brings us exit cap rate assumptions.  These crystal ball metrics are the most manipulated input on a spreadsheet, and for good reason.  From a sponsors standpoint, it’s the easiest lever to pull to get a pro forma to look more attractive, in the face of the aforementioned challenges.  We have seen that a number of sponsors have decided that we are at “peak rates,” and there will be cuts coming later in the year.  Subsequently they are justifying lower exit cap rates than where cap rates are today.  Huh?  What happen to sensitivity analysis and adding a 50 bps cap rate expansion to stress test the deal.  There’s a good chance The Fed will lower rates in September.  But that doesn’t mean lenders will.  Nor does it mean cap rates will start to compress any time soon.

There is absolutely zero justification here, other than it allows a sponsor to pay more to acquire a deal, which they can then advertise more aggressive returns.  Isn’t that what we all want as passive investors?  I know I do.  But not if it means throwing caution to the wind.

For perspective, Blackstone, one of the most respected real estate investment managers, has generated a 15% average return in its highest-yielding, opportunistic BREP vehicles over the last 30 years.  We find no reason to believe that in today’s highly competitive and macro-economically challenged real estate landscape this benchmark can be reliably beat.  A truly sound, risk-adjusted 14% return is very strong compared to a 18% pro forma IRR held together by duct tape and paper clips.  It’s imperative to understand what you are comparing and where there are pitfalls.

With low transaction volume and high demand, prices remain relatively elevated in our opinion at this time.  This is true even where some markets have seen 20% discounts to peak prices.  There’s still very little cash flow to enjoy on these deals.  Cash flow is the lifeblood of every business and each asset should be run like a business.

It IS a good time to buy if you have a very long-term horizon.  However, simply put, a long-term horizon and the syndication model don’t necessarily jive.  I’m talking 10+ years.  If a good deal does come together through a syndication, it might be a 7 year hold instead of a 3 year plan.  Since IRR accounts for the time value of money, longer holds will result in more modest returns than we’ve seen over the last market run-up.

To repeat on more time - expect more modest returns than we’ve seen over the last market run-up. Besides the aforementioned metrics, the syndicated real estate market is more efficient than it was just 5 years ago. More interest, more participants....lower returns.

To put a bow on it, we remain cautiously optimistic.  We are in search of deals where the sponsor has significant operational experience, has an unfair advantage in their local market, and has found an asset that has a unique story behind why NOW is the right time for it to be acquired and pull together investor capital to do so.  Otherwise, it doesn’t have to be NOW.  We will patiently collect our base hits and earn yield along the way.

We wish you a happy, healthy, and prosperous month.  Enjoy summer!  Challenging landscape aside, we are all blessed to live in the best country in the world!

-Paul

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