“Where are we in the cycle?” It’s a question that investors across a range of asset classes repeated over and over again in 2017, but those who raise and deploy capital in the commercial real estate industry arguably had the most pressing reasons for asking it. As Goodwin and Columbia Business School held their 11th Annual Real Estate Capital Markets Conference in January, the more than 500 participants had just left behind a year that saw transaction volumes decline and REITs significantly underperform for a second straight year. One of the more puzzling aspects of the contraction in 2017 was the fact that it occurred at a time when the economy and financial conditions remained incredibly supportive.
“Did we get a correction in the cycle or was it the result of all the other things that happened?” asked Eastdil Secured Chief Executive Officer Roy H. March, who ticked off a number of other geopolitical issues that could have held up deals, such as the aftermath of the U.S. elections, saber-rattling from North Korea, and the fallout from Brexit. “We real estate folks keep looking over our shoulder for the next shoe to drop. We’re so focused on the cycle. The question is, should we be?”
The economic backdrop is certainly favorable. Economies around the world are finally growing in sync, with all 45 countries tracked by the Organisation for Economic Co-operation and Development (OECD) growing at the same time for the first time since 2007. The U.S. continues to be a shining star among them, featuring high consumer confidence, low debt levels, full employment and modest inflation. What’s more, the commercial real estate sector emerged as a winner under tax reform, as the Tax Cuts and Jobs Act preserved key benefits such as the tax exemption on private activity bonds and allowable deductions for property taxes.
Meanwhile, private capital is piling up on the sidelines waiting to be deployed. Closed-end private real estate dry powder is at its highest point in more than a decade, with sovereign wealth funds and global pension funds significantly underinvested in real estate and investing instead in other asset classes that provide better relative value. Another problem is a significant disconnect between buyers’ and sellers’ expectations, particularly in the opportunistic space. “Who’s going to capitulate?” March asked.
Market Adjustments
Ronald Kravit, co-head of North American real estate and senior managing director at Cerberus Capital Management, warned during the first panel that the standoff in the opportunistic space could linger for a while.
“It’s pretty tough to find deals that make sense,” he said. “You have to have the fortitude and discipline not to put out money just to put out money.” Cash flow is rising in importance, with investors looking to recoup most of their capital in the near term instead of relying on greater long-term returns from a future exit, he said.
Capital flows show investors moving to the middle, away from core and opportunistic strategies, and focusing more on core-plus and value-add investments, said Bill Thompson, managing director and co-head of Capital Advisory at Greenhill & Company. In addition, they’re giving capital to two types of managers, one or several of the large gps, and, with smaller niche or sector-specific managers. “We’re also seeing a number of investors getting more defensive with their investments given we are a little long in this cycle,” he said.
One niche that has gained favor in recent years as a defensive play has been student housing. Avi Lewittes, chief investment officer at The Scion Group, said that the sector delivers high risk-adjusted returns, geographic diversification, and benefits from positive demographic trends, constrained on-campus capacity and an appreciation by foreign investors of higher education in the U.S. Despite all of this, the market has remained highly fragmented, with only two publicly traded REITs focused on it. “It’s one of the few sectors in which public sector REITs are not leading the consolidation,” Lewittes said.
The lack of public REITs in an attractive space such as student housing might be a facet of a new market reality. “In the public markets to be in a ‘niche’ strategy is kind of a dirty word,” said panel moderator Wendy Silverstein, president and CEO of New York REIT. “The REIT sector was told for many years by its investors not to be too diversified, but rather to simplify and stay geographically focused instead. Today, what I’m hearing is all the capital is going 180 degrees in the opposite direction.”
That’s because investors are looking for broader exposure that can respond to changing conditions in different markets, said Ivo de Wit, manager of the Global Alpha Fund at CBRE Global Investment Partners. “Different markets are in different cycles,” he said. “The big shift we’re seeing is that investors are moving into private real estate for the long-term income.” He added that the trend began with large pension funds but now smaller funds and family offices are following suit.
Mega and Micro
One thing that hasn’t changed is that investors still reward vision, according to Stephen M. Ross, chairman and founder of Related Companies, which is developing the largest real estate project in U.S. history in New York’s Hudson Yards. Ross said the genesis of the project came out of an awareness that people were tired of commuting and wanted a work/life experience that solved for congestion. The visual centerpiece of the $25 billion mixed-use mega project will be a giant lattice made of 154 interconnected staircases temporarily called “The Vessel.”
“As a real estate developer, to be a success you have to have some vision and thinking about what’s coming on and what’s next and where the world is going,” Ross said. Hudson Yards was a reflection of “how people want to live in cities.” Today, Ross spends a lot of his time considering the impact driverless cars will have on urban development, asking himself questions such as “what will life be like?” or “where will the jobs be?”
Affordable housing is another area Related is keenly focused on, as it has been since its founding. About 60 percent of the 50,000 rental units Related owns are some form of affordable housing, and it continues to buy affordable housing from other developers at a time when many others are converting those units over to market-rate rents. “Affordable housing is the foundation of our company,” Ross said. “It’s an asset you can’t replace and there’s unfortunately a greater need for it. We remain committed to never converting an affordable housing unit to market-rate.”
Another panel at the conference focused on technology and innovation introduced a new solution to affordable housing on a much smaller scale. Jeff Wilson, founder and CEO of Kasita, talked about his company’s approach to the problem: micro housing units inspired by trash dumpsters. Wilson lived in a 33 square-foot dumpster for a year to test the limits of habitable space. Today, Kasita builds inexpensive stand-alone manufactured homes that fully integrate Internet-of-things technologies and can fit on small and even irregular lots.
Technology is similarly disrupting the business of financing commercial real estate. Online lending has transformed the business through cloud computing, blockchain, big data, and digital signatures and appraisals, but almost all of the CRE transactions that occur in the U.S. everyday take place offline.
Yulia Yaani founded RealAtom.com, a marketplace for CRE loans, to pair borrowers with relevant lenders increasing the certainty of closing debt transactions. She credited three developments for making RealAtom possible: technological proliferation, availability of CRE data, and a generational shift in which new generation of CRE players demand innovation and have no patience for laggards.
Zach Aarons, co-founder of MetaProp and a project manager at Millennium Partners, said the varied nature of the ways technology is being used in the real estate sector will require new financing approaches. Some tech-enabled real estate service providers are being financed as if they are pure-play technology companies, and this is creating “misalignment,” he said. Aarons said a new class of investor needs to emerge “somewhere in the middle” of the risk spectrum between venture capital and traditional real estate investors to better align risk-and-return expectations for everyone. “The next few years will be about figuring this out.”