What the current market exhibits is simply evidence of the cyclical nature of the industry. There are no out-of-the-ordinary concerns in the market at present; however, participants should be prepared for some ripples ahead. They should sharpen their focus and invest in as many attractive deals as possible, which are present in every market.
Investors are preparing for opportunities to invest in debt positions and managers are ambitiously deploying capital. On the other hand, owners are preparing to restructure current debt positions, and in many cases, finalize portfolio recapitalization.
D22 is advising clients at every stage along the way, in all markets.
Recent Volatility
The last six months have been tumultuous and choppy for all commercial real estate classes; however, multifamily and industrial have proven to be more resilient. According to Collier’s 2022 National Market Report, investment in multifamily has reached new heights with sales volume reaching $340 billion.
Investment sales have begun to pick up, property owners are continuing to maximize cash flows with record-high residential rental rates, and the industrial sector continues to digest demand from e-commerce last-mile shipping.
However, a swath of concern contributes to mounting pressure on returns: inflation and recent interest rate hikes.
Market Opportunity
Real estate capital markets have continued to play a pivotal role in supporting cash flow as real estate owners seek to diversify sources of capital.
With increasing concerns about rate hikes, cheap capital dissipating, and its residual effects, creative capital placement will continue to position debt investors throughout the capital stack in order to help them achieve their real estate investment objectives.
Historically, investments that garner outsized returns are made at the bottom of the cycle; hence the uptick in new debt funds and managers. This investment strategy comes at an opportune time when large pools of capital need to be deployed: current debt is nearing its maturity date, and owners and managers are expected to restructure current capital pools.
Managers will continue to raise additional equity to support refinancing for assets that still have significant debt expiry, as well as additional equity by quality managers in support of new transactions as opportunities arise.
We have created solutions for GP-level principals to weather the difficulty of raising fresh capital and counter debt covenants while funding higher interest costs, restructuring, and recapitalization portfolio exposure.
Managers that do not have strong interconnected capital relationships, lack communication with investors and bankers, and don’t have the ability to negotiate complex investment structures will face difficulties maintaining cash flow and positive returns in the coming periods. The market will reward managers who adopt diligent capital management strategies, including diversifying their sources of capital, in efforts to respond with grace to future opportunities and weather the current instability in the market
Market participants with strong banking relationships do not appear to face major hurdles with attaining new funding or when refinancing maturing debt. At this time, lending conditions are stricter, and pricing remains higher than it was six months ago. Thus, managers are advised to cushion more time than usual to finalize transactions. While rates continue to fluctuate, rate locks have been highly sought after, yet introduce more exposure.
Solutions for Borrowers and Opportunities for Lenders and Debt Investors
At this point, there is an opportunity for lenders and debt investors. Given the significantly increased cost of capital for the banks, this results in sustained higher rates for borrowers. In other words, the real estate sector has outgrown the capacity of local banks.
Debt Investor Opportunities
The injection of hybrid debt has proven effective in completing the portfolio recapitalization process. Structured from a combination of capital types including equity, preferred equity, bond issues, convertible notes and secured lending, this offers institutional investors a few positions throughout the capital stack.
Seasoned investors have recognized the value in these hybrid structures, given that they provide capital protection with relatively high returns during volatile periods. However, they still allow investors to benefit from the upside market growth during recovery. Thus, having real estate debt exposure in the portfolio can boost performance and suppress volatility.
Addressing Concerns
Are we entering a market where property cash flows are constrained? If not by inflation, by labor costs and rate hikes? Either way, a defensive strategy of capital preservation will continue to drive investment decisions.
Managers have started to take the defensive stance as income restraint mounts and demand falters to the remaining supply. So, will structuring safe capital in wake of increasing rates provide some protection against weaker returns?
Real Estate Remains Attractive
Real Estate remains a key component of institutional investment allocation given the following attributes:
- Hedge against inflation
- Diversification to stocks and bonds
- Attractive total returns
Debt investors remain creative in approaching opportunities across the capital stack, both with debt and equity to generate risk adjusted returns.
Inflationary effects: increased costs fuel volatility and drive down returns; more importantly it fuels transactions, great for the brokerage community; household and business are evaluating budgets, consumers may allocate spending toward necessities.
Thus, real estate remains a potential hedge during inflationary periods. The draw to commercial real estate at these times strengthens since the value of physical assets are more durable as overall price volatility prevails.
Over the past 18 months, investors have shown a bullishness towards these deals, with sales prices for most property types increasing during this period.
Looking ahead, the properties with shorter leases may become investor targets, including both apartment buildings and self-storage facilities.
At the same time, hotels have shown resiliency following the pandemic, at an average daily rate in May ‘22 that is 13% higher than the 2019 average rate. However, mounting pressures on consumer spending can flatten future occupancy rates. In addition, office and industrial properties that have approaching lease expirations could be a large investment opportunity.
Moving Forward with D22
In preparation of the market upswing, investment strategies for either debt or equity are far more effective when implemented at the bottom of the cycle, TODAY, rather than at the top of the cycle which is when the largest transactions are inevitably completed.
Owners and managers will need to possess excellent capital management skills and diversity their sources of capital beyond dilutive equity raising and bank debt–all in efforts to maintain cash flows. As rates continue to raise, debt structure, duration, basis, fixed rates, matching of asset and liabilities, and the prudent use of leverage are the key to avoiding a repeat of issues experience in 2008/09. Owners are working to wean themselves off lower interest rates and focus on cash flows and shaving on expenses
D22 Capital Advisory has raised equity predominantly to manage the short duration of debt exposure that many managers are preparing to face. Many managers are focused on mortgages with maturity dates scheduled in 2022/2023, while some are still focused on outstanding debt with 2021 maturity dates and the several billion dollars worth of REO assets that will soon be liquidated. Thus, the recent equity raised will help to offset the 2023 scheduled maturities, anticipating loan extensions and potential prepayments.
At D22, we are helping clients to weather the storm regardless of the aforementioned concerns. In any market, we can help new clients achieve great returns and offset the increasing debt rates.