Roundtable – November 2018: How will private and/or institutional capital change its strategy in 2019?

Carrie Rossenfeld Roundtable

From SoCal Real Estate’s November 2018 issue:

Insights from industry leaders

Rich Walter, EVP, Investment Properties Group, SRS | Courtesy a representative of SRS

Regarding institutional investors, these allocations to real estate have increased over the years. We expect that this will continue. There is a lot of “dry powder” ready to be deployed, so finding desirable assets is difficult. Most institutional investors are seeking core or core-plus assets, which in retail requires high historical tenancy, quality tenants, and consistent tenant sales with predictable cash flow.

Transaction volume overall is down, so combined with the funds already waiting for investment, the market will likely continue to maintain its pricing levels into institutional-grade assets.
Over 45 percent of the international deal flow is still targeted for the United States. Retail is 20 percent of that deal flow.

With the investment environment so crowded, some institutions will move up in the risk curve either by opening up to secondary markets and/or value add-opportunistic transactions. Other institutions will stick to their current risk profiles and be selective as they see the maturing phase of the cycle and want to cover any downside.

In the private sector, many investors are positive about expanding their asset purchases because the economy continues to do well, with low unemployment and tax relief. We feel that this positive trend will fare well for the retail sector overall as tenants are expanding, especially in major markets; new concepts are developed in all retail sectors; and rents are stable or growing.

The appetite of the private investor is driven by the relative yields that retail investments can produce. In addition, the 1031 market will continue to thrive, and volume can be maintained going into 2019. The single-tenant market is, and will remain, vibrant even with some slowing in 2018–2019 in overall transaction volume.

Private investors will maintain and potentially grow in seeking larger transactions whereby they can rely on syndicators to identify and operate these prime opportunities. The debt market, especially CMBS, is growing, and 10-year-fixed loan products are readily available in large sums for the right deal to the private market. Therefore, smaller private investors can invest in more diversified properties that offer entertainment and other growing retail components.

One deterrent will be the expected interest-rate environment. As the rates increase, there will be pressure on cap rates — especially where debt is needed to transact. As we have been in a long-term low-interest-rate market, we will need to see where the break point will impact the cap rates overall. With political pressure to keep rate increases slow, investors will slowly roll into new yield requirements throughout 2019 but always based against other investment alternatives.

Overall, the leasing activity in major markets continues to be good, with many big boxes being occupied by new tenants such as value-priced retailers, gyms, entertainment tenants, and other expanding concepts. The news surrounding retail and the “Amazon” effect has not negatively affected these key markets at this point. Internet-focused retailers are seeking “brick and mortar” to complement their growth and market share.

Finally, for 2019, care should be taken by all investors to focus on quality income streams or opportunistic deals where there are “boots on the ground” to assist in the selection, leasing, management, and operations of the asset.

John R. Williams, President and Chief Investment Officer,
Avanath Capital Management | Courtesy a representative of Avanath Capital Management

We anticipate that we will see increased allocations of private and institutional capital to the affordable-housing sector in 2019. Many investors, especially institutional investors, are increasingly recognizing the role affordable housing plays as a stabilizer in their portfolios and the downside protection it offers in times of economic volatility or uncertainty.

Regardless of current economic conditions, demand for affordable housing continues to outpace supply rapidly. Each year, rents throughout the United States continue to climb, and wage growth fails to keep up, further deepening this need. At the same time, affordable supply continues to diminish throughout the nation as affordable units are lost due to obsolescence or are converted to luxury market-rate apartments.

This significant lack of supply and ever-growing demand create an environment where investors can diversify portfolios and achieve risk-adjusted returns that are on par with market-rate investments.

Beyond this, an increasing number of private and institutional investors are placing an emphasis on investments that are also tied to social impact. This is another reason there will be increased allocations to the affordable housing sector in 2019. Investment in affordable housing provides investors with the opportunity to impact local communities, neighborhoods, and residents.

Mitch Paskover, president, Continental Partners | Courtesy a representative of Continental Partners

Capital markets and lending this year have been defined largely by the fact that activity has remained strong and steady despite uncertainty caused by stock-market volatility, the current political climate, and rising interest rates. The question now is: Will this healthy activity continue into 2019?

The good news for those seeking commercial real estate financing and for the industry as a whole is that there is no lack of capital available, from both private and institutional providers. All traditional institutional capital sources — including banks, agencies, and CMBS — are actively pursuing deals, with private equity filling in the gaps. Private capital is increasingly bolstered by alternative avenues for raising funds, such as crowdfunding platforms.

We will see some banks continue to change their strategy in 2019 due to the scaling back of some Dodd-Frank provisions, with the Economic Growth Act signed into effect this May. Among the revisions is a significant increase in the threshold at which banks are required to face increased regulations and stricter capital requirements — from $50 billion to $100 billion initially, and to $250 billion by the end of next year. As a result, there are dozens of mid-size banks that could be hungrier for growth and thus more aggressively pursuing commercial real estate loans.

Additionally, the act allows for the reclassification of loans that would have previously been considered high-volatility commercial real estate loans. This means that some banks that had shied away from riskier construction, development, and acquisition projects under Dodd-Frank will be more open to providing these loans.

We also anticipate that next year, capital increasingly will be interested in projects that involve the adaptive reuse and repositioning of existing properties. Due to the complexity in the underwriting of some of these projects, they tend to attract more private equity rather than institutional. With construction and land costs continuing to rise, and value-add redevelopment presenting lucrative opportunities, we could see more institutional investors pursuing these loans.

We do not believe that stock-market volatility, the current political climate, or rising interest rates pose any significant threat to the pace of originations through the next year. That said, borrowers will need to consider the psychological impacts of this uncertainty and potential effects over time when they are seeking financing and competitive leverage in 2019. Presenting sound, comprehensive investment strategies to a range of lenders will remain the key to securing optimal terms.

Tim Lee, VP of Corporate Development and Legal Affairs,
Olive Hill Group | Courtesy a representative of Olive Hill Group

Institutional capital has traditionally focused on urban core and primary markets. In 2019, we anticipate that we will see more institutional and private capital flowing to secondary markets and suburban outlying markets of major metros throughout the country.

We will see an influx of capital to these regions for two reasons:

1) Many of these regions continue to experience a strong migration of both residents and tenants and provide investors with stronger opportunities for yield compared to their urban core counterparts.

2) The recent repeal of Dodd-Frank, which will loosen regulations on mid-size and regional banks, will provide opportunities for increased capital to these secondary markets. The initial Dodd-Frank legislation increased the cost of capital to a point where smaller regional banks and credit unions could no longer participate in the market. By reducing these regulations, this opens up more opportunity and access to capital for investors and in markets that have traditionally been viewed as a bit riskier.

In addition to increased allocations to secondary markets, we also anticipate that institutional and private capital will shift away from high-rise office properties and focus more on mid-sized product. This type of office product is more conducive to the demands of creative-office space as many creative office features are focused on outdoor amenities on the ground floor.