June 12, 2012
“Where the Yields Are”
The Current Landscape
Looking across the current financial landscape is a very scary proposition. The U.S. economy continues to stop and start, and now the European economy is starting to crack under its massive amounts of non-performing debt, which they failed to recognize in 2008.
The Greeks restructured their debt (a nice name for a default) and they continue to struggle. We expect they ultimately will leave the Euro.
Spain is now recapitalizing its banks, and we expect more Euro zone countries to do the same.
The plan to date has been, give these debt laden countries more debt and hope they cut expenses.
But, Europe is trying to solve their debt problem, with more debt. We at JCR have seen this at the asset level, and we know it does not work.
How this effects the United States real estate market
In a word volatility. Large amounts of volatility is not good for U.S. investors and for institutional providers of capital. For example, this volatility makes hedging CMBS positions difficult, CMBS lenders must build in higher pricing, to counter balance the lack of hedging. This higher pricing leads to less competitive product, which already has a black eye.
We think more capital will flow to the United States seeking the safety of core U.S. real estate. This will be positive for owners of core real estate, and will provide them an exit from their overleveraged debt positions. But we expect these inflows to do little for the middle market commercial real estate. Be cautious of a bubble forming on core U.S. real estate.
What are investors to do?
When most institutional investors don’t know what to do, they buy treasury bonds. Thus, as of this date, the 10-year T-bill sits at 1.64%. Yet it’s hard to make a case for fixed income, with yields at all-time lows. It’s hard to make investments, as they know there is more downside risk than upside potential.
Investors cannot take much comfort in the equity markets either. They have seen 2011 gains wiped out in a matter of days. In addition, recent IPO debacles just reinforce how the small investor loses in the now highly automated stock market world. This has caused many to feel that the “buy and hold” strategy that the financial community has been selling for so long, it is no longer the answer.
What Do Investors Want
Today most investors are not greedy, they simply want to get a decent yield on their capital with a very low risk of principal loss. Seems easy enough – So where do these investments exist?
The word itself sounds scary, unstable, and only for those out of the mainstream. But for those investors seeking high returns at lower risk, these investments must be explored.
Real Estate as an Alternate Investment
While there are other alternatives beyond real estate, this asset class does present a variety of alternative investment strategies.
- Core Real Estate: You’re too late. These assets have been bid up so much in the last two years, that the yields and prices no longer reflect real estate risk, but have become proxies for dividend yield. Buying and building at 4% unleveraged cash on cash return, is no longer a real estate play, but a dividend hope certificate. We believe a bubble is forming at core properties and the downside risk is much greater than the upside potential.
- Land: You’re too late. 2010 was the time to buy this asset class. The best of these assets have already been bought by distressed buyers. Land play now will be platted lots. While this may provide good investment returns. It comes with no cash flow and will require additional cash to make the lots ready for sale. Not an investment for everyone.
- Condominiums: You’re too late: Again, 2010 was the time to buy in this space. Today the market is more fully priced. One-off bargains may be found, but they will be small in size and in secondary markets.
Where the Yields Are
It’s clear that best risk adjusted returns, and for uncorrelated investments class remains middle market commercial real estate.
We define the middle market as one or more of the following:
- Assets under $25 million in cost or
- Assets in secondary and tertiary markets
This asset class has the most opportunity due to the following factors:
- Prices have dropped up to 40% from the peak of 2007
- These assets have not been bid up for yield because they are smaller and harder to aggregate
- Capital inflows into this market are less efficient
- The larger capital players do not have infrastructure to go into this market
- The capital that traditionally supports this market: community banks, regional banks, credit companies, and private lenders, were the most hurt by the financial crisis of 2008 and many have failed, exited the market, or have changed their focus.
A Wave of Maturing Debt
While many in the mainstream media will have you believe that the mountain of maturity debt ($1.7 trillion over the next five years), is an urban myth, we can definitely say its not, as JCR sees the evidence on a daily basis.
Thus, our conclusion is the best risk adjusted return investments are middle market commercial real estate asset.
The question now is, how does an investor play this opportunity?
- Buying Property Direct: It’s difficult to deploy capital efficiently and effectively in buying these assets. This is a highly opportunistic and nitchy play and requires an operational skill set. That is why the big funds have not been able to participate in this space. Small funds may provide exposure to this opportunity.
- Investing in a distressed real estate acquisition fund: There are many funds that have formed and are forming to buy distress. Yet again, the flow of these assets from legacy balance sheet lenders is slow. They will be selling them over the next five years. So building scale is difficult.
- Providing capital to the middle market commercial real estate space: Being a capital provider to middle market commercial real estate is the best risk adjusted return strategy for the following reasons:
- Custom structuring: The ability to individually structure each deal and find the risk/return apex and invest at that apex
- Flexibility: The ability to play in all parts of the capital structure and create better risk adjusted returns
- Diversification: This strategy allows diversification, by using different investment structures such as debt, preferred equity, mezzanine debt, pari parsu equity
- Deal flow: The ability to create extraordinary deal flow via a finance model and thus have more opportunities to close from. As a financer, buyers seek you out, so you are never chasing the price of an asset up
- Liquidity: A finance model allows you to match investment terms at your discretion. This could be six months to five years depending on your investment horizon.
- Cash Flows & Capital Gains: A finance model allows the investor to balance cash flow and capital gains. Have some of both provide additional diversification.
Making the right investment decision today is harder than ever. All investors are highly focused on principal protection, while at the same time seeking some yield. This relatively easy request has gotten very difficult, but there are few asset classes that provide yield and safety, without correlation to interest rates or the stock market. That would be middle market commercial real estate.