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Top 15 CRE Investing Mistakes

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The CRE industry is different than all other industries in that it is a transaction-based model. The lifeblood of the industry is dependent on sale, financing, and lease transactions. The more transactions there are, the more money the industry and everyone in it makes and the more successful the business. 2021 was a record year for transaction volumes and a phenomenal boom year for CRE.

The most successful companies and individuals in the industry are usually adept at selling, financing and/or leasing CRE property. However, in pursuing these transactions the same key mistakes are made over and over again which usually results in poor performance, the loss of equity in a property or the loss of the property in foreclosure. Below are the 15 biggest investing mistakes in CRE that are the root cause of bad deals, according to Joseph J. Ori, Executive Managing Director at Paramount Capital Corporation, a CRE Advisory Firm.

  1. Acquiring properties at low cap rates. Cap rates below 5.0% are not justified even if the investor believes that future rent increases, which may not happen, will make up for the low initial return. Buying CRE at sub-5.0% cap rates is like buying a tech stock at a 100-price-to-earnings ratio.
  1. Not diversifying a national portfolio by property type, location, and industry. Many national firms diversify a large fund by type and location but forget about industry diversification. If an investor buys only apartments and offices in Silicon Valley, 70% of the apartment tenants work in the tech industry and 70% of the office tenants are technology or related companies. If the tech industry retracts in a downturn, many of the apartment tenants may be laid off and unable to pay their rent or may move home or double up with roommates. This will negatively affect the apartment market. Many of the office tech firms may default on their leases or shrink their space requirements, which will negatively affect the office market.
  1. Not performing property level and financial due diligence on all properties in a portfolio acquisition. Many institutional investors that acquire large portfolios consisting of dozens or hundreds of properties do not do sufficient property-level due diligence. They only look at the larger and more valuable properties in the pool or hire inexperienced third-party firms to do the property-level due diligence.
  1. Acquiring properties with negative leverage. Negative leverage occurs when the cap rate is less than the mortgage constant, which means the cash-on-cash return will be lower than the cap rate, which is a “no-no” in CRE. Many firms acquire properties with negative leverage believing that future rent increases will more than make up for the low initial return.
  1. Using short-term floating rate debt without the protection of a swap or collar to finance a long-term real estate asset or portfolio. This is what has occurred during the last two years as the Fed abruptly raised the federal funds rate from 0.0% to 5.25%. Many CRE investors were caught flat-footed by the quick increase in interest rates from floating rate debt and no interest rate protection and are now scrambling to lower their financing costs and risk.
  1. In underwriting an acquisition, using a terminal cap rate that is less than the going-in cap rate. This is often done by the acquisition or other internal group within a large CRE firm to “juice up” the internal rate of return on the equity in a deal underwriting.
  1. Institutional investors who commit capital to sponsors who have inexperienced senior management teams. The senior management team should have gray hair and have been through at least the last two secular CRE downturns of 1987-1992 and 2007-2012. One of the most important drivers of success in CRE investment is having individuals on the team with significant and long-term experience and knowledge in all property types, markets, and economic recessions.
  1. Using overly optimistic rent projections in underwriting a deal. This often occurs when  the acquisition or other internal group wants to make the deal look better and the deal to be developed or acquired.
  1. Not analyzing the sales volumes per square foot of retail tenants, a key metric when buying shopping centers. One of the most important metrics when buying shopping centers after the cap rate, is the sales per square foot of the anchor tenants. High sales per square foot means the center is in an A location, will remain fully leased and in high demand from tenants and shoppers.
  1. Using high leverage of more than 75%. One of the highest risks in CRE investment is using high leverage and this was one of the causes of the Great Recession from 2007 to 2012.
  1. Not giving senior-level employees an equity interest in the company, portfolio, or fund. This is what is known as the “golden handcuffs” in CRE. If you don’t take care of your key people, they will leave and become your competitors.
  1. Not incorporating the 15 risks of CRE in a real estate firm. The risks include cash flow, value, tenant, market, economic, interest rate, inflation, leasing, management, ownership, legal and title, construction, entitlement, liquidity, and refinancing into the firm’s investment strategy.
  1. Investing in property sectors like hotels and senior housing, which are more operating businesses than real estate deals, in which the investment firm has no experience. Hotels are typically 70% operating business, and 30% real estate deal and senior housing is 80% to 100% operating business and 0% to 20% real estate.
  1. Not obtaining the Kmart discount when acquiring a large portfolio of CRE assets. Whenever a large CRE portfolio trades it is typically made up of Class A queens, Class B pigs and average Class B deals, and the buyer needs a discount of at least a 1.0% higher cap rate for the risk of the Class C properties.
  1. Not checking the formulas in an XL underwriting workbook, as there is at least one formula error in every CRE underwriting worksheet. This is a common occurrence when preparing a complicated Excel underwriting workbook and firms should make sure that  all formulas are rechecked by an independent party.

 

Source:  GlobeSt.

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Commercial Real Estate Investors Continue To Bet On Interest Rates Coming Down

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Challenged by rising interest rates, a sometimes staggered economy, and empty office space buildings, commercial real estate (CRE) investment has become a game for the haves and the have-nots. If you have cash, there are opportunities across the country, and if you’re looking for funding, there are still some deals out there if you’re counting on rates dropping later.

The value-added strategy is always popular, whether it’s office space, commercial, or a warehouse. The real value comes when interest rates go down and first-time developers get in. Unfortunately, because the rates are higher, a lot of people are trying to get out, so that’s where someone with cash who understands the market steps in and gives them that out. Single-use properties, which are less risky, are also being sought after. If they find a tenant, they proceed, and if not, they can easily back out. A single stand-alone property like a warehouse or industrial site with a single tenant has the potential to double investment.

Despite the presence of empty office space, there are still deals to be found. If you can get a good deal and have a good team in place, there are still companies willing to occupy them. Transitioning to residential or mixed-use properties depends on obtaining zoning relief. Apartments can be a profitable option, but only if the municipality allows for it. Certain locations offer land and buildings for nothing, while in others, potential rents make the investment worthwhile.

The warehouse and industrial sectors are outperforming all others in the CRE market. Warehouses are being built everywhere, but the expectation of securing Amazon and FedEx as tenants has not materialized.

In Philadelphia, various property types are in demand. Warehouse and industrial spaces, as well as single-tenant buildings, are in high demand. Some clients are also buying office spaces but with specific-use in mind and companies ready to move in. Investors are not buying properties solely to enter the market.

In summary, CRE investors with cash continue to bet on interest rates coming down. They see value in the current market conditions and opportunities in different property types such as warehouses, single-use properties, and specific-use office spaces. Despite the challenges, there are still deals to be found, especially when considering potential future corrections and market fluctuations.

 

Source:  Gillett News

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Here’s What CRE Investors Are Thinking As Inflation Ticks Up

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A recent investor survey by Marcus & Millichap reveals that while CRE transactions may level out this year, investor sentiment remains strong.

The mid-year survey’s headline index value of 159 is “somewhat reminiscent of the trend we saw in 2016,”in which sentiment declined a bit as higher interest rates bit into the market, says Marcus & Millichap’s John Chang.

”But they’re not down by as much as people might expect,” he says.

In 2016, the index declined 12 points and the number of CRE transactions flattened. This year, the index has declined 11 points and that could deliver relatively similar results, in what Chang calls a “relatively modest softening.”

“Yes, the market is going through a recalibration as investors rework numbers based on the rising costs of capital, but the survey respondents aren’t telegraphing a significant market change,” he says.

According to the survey, the top two investor concerns are interest rates and inflation. About two-thirds said interest rate increases aren’t affecting their investment plans, and almost 9% said they’d buy more commercial real estate because of rising interest rates. On the sell side, 77% said the rate increases haven’t caused them to change plans and 11% said they plan to sell more.

Respondents were even more dismissive of inflation, according to the survey. Twenty-four percent of respondents said they’d buy less CRE but almost 12% said they’d buy more. The buying intentions with respect to more inflation-resistant property types like apartments, hotels and self-storage indexed higher, with about 14.4% of investors overall saying they’d buy more of those assets because of elevated inflation.

Cap rates are expected to rise as a result of rising interest rates as well, with 14% of investors surveyed saying they think cap rates will rise by 50 basis points or more over the next year. About 35% think they’ll go up by less than that, and 27% expect no change. And Chang says  since there’s still a lot of capital coming into CRE, yields and stability look compelling.

“Consider that the last 12 months ending in the second quarter of 2022 was by far the most active commercial real estate investment transaction year on record,” Chang says. “Even if activity steps back a bit over the next 12 months, it will still likely rank as the second most active year.”

 

Source:  GlobeSt.

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CRE Investment Money Is On The Move Among States

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“Follow the money” has for decades been a popular phrase in investigative journalism. But for far longer it’s been a de facto principle in business and investing. A new Marcus & Millichap video addresses the increasing movement of capital between the states.

“Investment into smaller cities has risen sharply and the volume of interstate investment has surged,” says John Chang, senior vice president and director of research services. 

In other words, investors are spreading their money out geographically for a number of reasons, including diversification, the search for higher yields, state tax policies, and retirement strategies, “to capitalize on unique market dynamics like migration and demographic trends.”

The firm suggests looking beyond gateway cities at secondary and tertiary markets. In 2011, 46.6% of the dollar volume of capital went into these areas. In the first quarter of 2020, before the full onset of the pandemic, that amount had climbed to 53.1%. Now, the share is 58%, the largest ever, leaving 42% in primary markets.

Concentrate that much money into existing markets and a number of things will happen. One that Chang mentions is that the increased flow is a component of yield compression in the secondary and tertiary markets. The cap rates edge that these markets have over primary markets is only 1.1 percentage points, “the tightest spread since 2009.”

Marcus & Millichap saw its clients in 2021 acquire almost $26 billion in commercial real estate outside their home state. The dollar pace has picked up in the first half of 2022 (though it’s good to remember that dollar comparisons can be misleading given that CRE prices rose, making properties more expensive and potentially totaling higher even if the volume were roughly equivalent). And it means that local buyers increasingly are facing competition from other states. The considerations of out-of-state buyers might include moving to a state with low or no personal taxes, meaning they can likely afford a price premium.

Texas has seen the highest inbound volume of capital going to purchase CRE properties. The firm said the amount it saw customers putting into Texas over the last 12 months was more than four times higher than in 2019, which was previously the peak year. Northeast, Southeast, and Mountain regions saw almost double the amount of inbound capital compared to 2019.

The biggest region for buying out of state was the Mountain one, tripling the amount in 2019. California, too, saw a tripling of moving capital out of state over 2019, reaching $11 billion. Another $7 billion came out of the Northeast, with $4.1 billion hailing from New York.

All the data is from Marcus & Millichap, so can’t be seen as statistically representative of national investment trends.

 

Source:  GlobeSt.

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CRE Investment Volume Climbs 10% In Q2

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U.S. commercial real estate investment volume rose 10 percent year-over-year in the second quarter of 2022, to $167 billion, with industrial and logistics investments providing nearly $32 billion of the total and office $24 billion, according to a recent CBRE report. Trailing four-quarter volume totaled a record $881 billion.

The industrial sector saw its investment volume drop slightly, down 1.3 percent year-over-year from $31.6 billion in the second quarter of 2021. The office sector saw a bigger decrease—down 9.5 percent—from the second quarter of last year, when office investments reached $26.6 billion. Multifamily was the leading sector, with the total at $78 billion, a 32.4 percent year-over-year increase from $59.1 billion in the same time frame last year

“While we expect sales volumes in 2022 to end the year at a healthy level from a historical perspective, we do see some weakening in the remainder of the year amid higher interest rates and uncertainty as the macroeconomic landscape evolves,” Darin Mellott, senior director of capital markets research for CBRE, told Commercial Property Executive.

While portfolio transaction volume increased 41 percent, entity-level transactions fell by 17 percent year-over-year in the second quarter, largely due to higher borrowing costs. The Federal Reserve began raising interest rates in March, the first rate hike since the pandemic began—with a 25-basis-point increase, followed by a 50-basis-point increase in May and the three-quarter percentage point increase in June, the largest since 1994.

On a trailing four-quarter basis, New York was the top market, with $67 billion, up a strong 104.3 percent year-over-year. Los Angeles followed with total investment volume of $65 billion, up 61 percent. Rounding out the top 5 were Dallas-Fort Worth, at $50 billion, for an increase of 91.9 percent; Atlanta, at $40 billion, up 88.3 percent; and the San Francisco Bay Area, with just under $40 billion in volume, up 44.4 percent year-over-year.

Houston had the biggest year-over-year increase in trailing four-quarter volume, at 150 percent, with about $29 billion in total investment volume. Other markets with big year-over-year increases in trailing four-quarter volume were: Orlando, Fla., $15.4 billion, up 136.8 percent; Las Vegas, Nev., $11 billion, up 132.5 percent; South Florida, $34 billion, up 117.3 percent; and Nashville, Tenn., with $12.1 billion in total investments, up 116 percent.

Prices, Cross-Border Investment Up

Institutional investors were net buyers last quarter, while private investors, REIT and cross-border investors were net sellers, according to the CBRE report. Private investors accounted for $102 billion, or 61 percent of the total. It was a 19.3 percent increase from the private investors’ volume of $85.4 billion during the same quarter last year. Institutional investors had a total investment volume of $39.9 billion in the second quarter, down 7.9 percent from $43.3 billion in 2021. REITs and public companies clocked in at $9.2 billion, a 5 percent decrease from $9.7 billion a year earlier.

Inbound cross-border investment volume increased by 16 percent year-over-year, to $6.5 billion, but was down by 9 percent from the first quarter of the year due to the strengthening of the U.S. dollar. Multifamily was the leading sector for inbound cross-border investment, at $3 billion, followed by industrial with $2 billion and office at $1 billion.

Canada was the top country for U.S. inbound cross-border investment, with $24 billion in investments. Singapore followed, with $14 billion, and South Korea at $5 billion.

Prices were up across the board in the second quarter, the report showed. The RCA Commercial Property Price Index increased by 18.5 percent year-over-year. The industrial sector marked the biggest increase, up 27 percent year-over-year, followed by multifamily, with a 24.3 percent increase. Office property prices rose 10 percent for the second quarter year-over-year.

Read the full CBRE report.

 

Source:  CPE

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What CRE Investors Should Consider When Contemplating A Recession

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Investors “shouldn’t be afraid of an impending recession” and should instead consider what the economic picture will look like over hold times of three, five and ten years, according to one industry watcher.

“It’s hard to say if or when the next recession will be because there’s a wide range of economic crosscurrents in play. That makes it very difficult to predict,” says Marcus & Millichap’s John Chang, adding that while “the risks are rising, a recession is not a foregone conclusion.”

On one hand, Chang says, job creation is robust, with an average of 488,000 jobs added per month this year. Unemployment remains low at 3.6% and wage growth strong at 5.2%. And while retail sales have flattened recently they are still up nearly 8% over last year.

“Those are all positive economic readings pointing to a steady growth outlook,” Chang notes. “On the other hand, we have exceptionally high 8.5% inflation, rising interest rates, a falling stock market and falling confidence levels. In many ways there’s a fear factor coming into play that could cause people to slow their spending, and that could induce a recession.”

So does it really matter if the US undergoes a recession? That depends, according to Chang.

The Great Financial Crisis involved a liquidity crunch that curtailed real estate investment, which Chang says is unlikely in the current scenario. And while there are a variety of causes and effects for recession periods, Chang predicts the US is likely looking at a recession along the lines of the 1981 or 1990 downturns. Both periods were preceded by strong growth and rising inflation that pushed the Fed toward the same types of aggressive rate hikes we’re seeing today. Yields softened in both recessions, but nothing like the 2009 decline, and Chang noted considerable variation among property types, with apartments, for example holding up well in the 1980s and dipping mildly negative in 1991 – though “nothing like the hit the sector took in 2009,” he says.

Much of the risk to CRE investors will depend on asset and location.

But “in general, real estate has delivered positive returns through most recessions,” Chang says. “And even when returns dipped, it was usually followed by strong steady growth. So yes, recessions matter to commercial real estate – but not nearly as much as people may think.”

 

Source: GlobeSt.

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CRE Investment Performance Has Been Sizzling

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If you’ve been invested in commercial real estate, you’ve had a superb trailing four quarters—on average. But that depends on what properties your money sat. As for the future, that’s looking uncertain.

Aegon Asset Management, in its June 2022 US CRE market insights, gave the initial data credit to the National Council of Real Estate Fiduciaries (NCREIF) Property Index. For the four quarters that ended in March, try a 21.9% total return: income return of 4.2% and capital appreciation, 17.2%. That’s better than the previous 17.7% in 2021.

Aegon called it “a continuation of the extraordinary total returns produced during 2021.” Hard to argue with the wording. But, depending on the property type, things split out quite differently.

Industrial was on top with a total of 51.9%. Multifamily, which has been second mentioned by many in the field, saw 24.1%. But remove those standouts from the average and the returns of other property types didn’t have the pizazz. Retail only managed 7.1%, and office, 6.8%.

Time for a breath, because after “these stunning results … investors are eyeing the challenges above,” Aegon noted.

The big and immediate elephant in the room is the Federal Reserve’s response to inflation. The agency is trying to manage a double challenge in its mandate: cool inflation without sending the economy into a recession and setting unemployment numbers sailing.

But the ongoing strength of the jobs market, with roughly 2 empty jobs for every person looking, likely means, as Fed watchers are saying, a higher interest rate hike than the 50 basis points that had seemed to be in the cards. Back in January, Fed Chair Jerome Powell said at a Senate Banking Committee hearing, “If we see inflation persisting at high levels, longer than expected, if we have to raise interest rates more over time, then we will.”

With the increasing pace of inflation, there’s a strong chance that the Fed will raise its benchmark interest rate by 75 to even, yes, 100 basis points.

“Commercial mortgage lenders are absorbing some of the rate increase by squeezing spreads but borrowing costs are increasing albeit with ready availability,” Aegon wrote. “The increase will make it tougher for investors to hit performance targets if historically low borrowing costs had been assumed to continue indefinitely.”

A faster increase in interest rates could also set off a so-called hard landing, especially considering ongoing supply chain problems, the war in Ukraine, and ongoing Covid problems in some major manufacturing areas, like China.

Then there’s also uncertainty about whether companies will use office space the way they used to, what will happen in housing as prices continue to rise faster than household incomes, and how some big industrial space users are backing off from what had until recently been a warehouse acquisition mania. And, of course, if consumers are being hit in the wallet, retail will eventually share the pain.

 

Source:  GlobeSt.
 

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