Kelly McCann
M.S. Real Estate candidate, University of Colorado and licensed attorney
In the last three months, providers of equity capital, including institutions and high-net-worth individuals, are becoming increasingly less active, according to Essex Financial Group’s chairman Jeff Riggs. Recently, Riggs offered his insight on the current state of the equity market for commercial real estate in Denver. He reflected on the latest actions of institutional investors, real estate investment trusts, private equity, international capital, family offices and crowd-sourced investment pools with regard to equity investments. He finds a salient difference between the current inning of this real estate cycle and the same inning of the last cycle.
Despite an increased appetite for core-plus, value-add and opportunistic investments, institutional investors show an increasing concern regarding the potential downsides of a real estate investment. “In the last 90 days, pricing has become more challenging,” said Riggs. “Some general partners have found institutional investors’ terms to be so stringent that they are unable to meet their yield targets on those terms.”
Although transaction volume across property classes is less today than it was a year ago, Riggs has not seen a material amount of systemic selling by institutional investors. He believes this lower transaction volume reflects a belief held by institutional investors that the ideal strategy to employ at this time is to hold their current assets.
The first half of 2018 saw massive capital outflows from the REIT sector. This capital outflow could be the result of the narrowing spread between REITs and bonds. Narrower spreads make bonds more attractive relative to equity REITs as bonds generally are perceived as less risky. While Riggs said he believes the net asset value ratios of some REITs may be appealing to certain investors, he cautions that investors may be leery of long holding periods for their REIT assets as unexpected changes in interest rates could adversely affect the asset class.
Private equity capital continues to seek opportunities in the value-add space. Despite the dearth of value-add opportunities, several private equity clients recently informed Riggs that they are unwilling to accept less than a 15 percent internal rate of return on a five-year hold. For now, it appears private equity investors continue to conservatively underwrite investments with an increasing eye toward the downside.
International investors continue to perceive Denver as a promising market without any material change in activity over the last 12 months, according to Riggs.
Whether high-net-worth individuals and family offices will continue to invest in commercial real estate depends on which of two major investment strategies they employ. Investors employing a value-add strategy are increasingly investing in assets other than commercial real estate. Alternatively, high-net-worth individuals and family offices employing a buy-and-hold strategy continue to invest in commercial real estate assets.
He cautions general partners of real estate syndicates to be wary of the potential risks inherent in crowd sourcing. Specifically, he cautions general partners of the significant risk to which they may be exposed if the real estate investment fails to perform as they had hoped and if the syndicate’s limited partners do not fall within the definition of an accredited investor. Generally speaking, an accredited investor is one who can demonstrate adequate experience and has the financial capacity to withstand losses. As a famous quip has it, “It’s only when the tide goes out that you see who has been swimming naked.”
Although myriad differences exist between the tail end of the last real estate cycle and this one, one major difference is particularly salient. At the present time, the level of debt as a percent of the capital stack is much lower than it was in 2005 and 2006. Although banks, CMBS lenders and others are increasingly aggressive in their underwriting standards, they are much more cautious than they were 10 years ago. Riggs believes lower debt levels will help prevent significant price reductions in properties should rent rolls fail to perform as forecasted.
