Acquisition Guidance
At my shop we have slowed the pace of our acquisitions to a bare minimum and our only acquisition targets are heavy value add/opportunistic . We are now almost exclusively focusing on new development opportunities in the multifamily space. The few guys who are still working on acquisitions continue to complain that competition for all classes of deals in almost every market is still very competitive. We have been burned before and it seems like management has made a conscious decision to start pumping the brakes a bit.
How are firms justifying acquiring properties at these historically low cap rates? Do they just need to deploy all their capital? Do they think that this business environment is sustainable? I would love to hear everyone's thoughts on this.
The second Yellen increases the rates is the second the public REITS correct (at least the ones who haven't switched to ground up development strategies). When a 10 year T note is 7%, the institutional investors / core lovers in at 4.5% caps are going to be hard pressed to squeeze their tenants to double their rents. I'm not sure what happens that point. Would like to hear people's takes as well.
*Cue the 'contrarians who believe interest rates have limited affect on cap rates/institutional real estate
How are firms justifying acquiring properties at these historically low cap rates? Depends on the investment strategy. If you're TIAA-CREF you have billions to deploy and will not hesitate to overpay since they are long term holders. Opportunistic shops, on the other hand, are a bit more cautious. If they're looking for double digit returns they won't feel forced to buy just because debt is cheap. It's about delivering strong returns at the end of they day.
Do they just need to deploy all their capital? Depends on the firm. Institutional investors may feel pressured because they have to deliver returns by a certain date. Don't forget, many investors are also sitting on a pile of cash or raising capital and getting ready to go on a shopping spree once the market begins to tank). My firm (we focus on the opportunistic side of the spectrum) has slowed its acquisition activities a bit and shifted more to selling some of our best assets. You just don't know what foreign investor is willing to pay big bucks. Good time to be a seller and get ready for the next wave.
Do they think that this business environment is sustainable? The market has to correct itself at some point. So many condo towers along Central Park. It's very hard to believe most will sell. Foreign capital has played a role, but the real question is what will happen once interest rates rise. A lot of investors are slowly ignoring the fundamentals in some markets. It's getting crazy.
Interesting to hear. We're multi-family value add and we're honestly very busy in both buying and selling. Our friends/competitors are doing the same. Rent increases market-wide are absurd right now.
Isn't it more about the spread between cap rates and interest rates? You have historically low cap rates because of historically low interest rates. Investors can still justify buying because the spread isn't too far off the historical norm. And yes, guys absolutely do try to push capital out the door to up deployed equity, AUM and, subsequently, their fees.
Yeah, that's an excellent point.
But when those interest rates change, those ROA's stay the same (monetarily) and you're caught with your pants down. Want to sell? Well you're now selling at an 8 cap and your residual projection gets trampled on. If you're not LONG term like Teachers, and you plan on chucking in say 6 years--then you probably made a mistake buying that core asset at a 4.5 cap.
The competition for properties we are interested in is more intense than ever. We have also begun to sell off some of our best assets and are realizing some favorable returns. It seems like we are in no rush to redeploy that capital. I guess I wanted to see if other firms were also beginning to consider pumping the breaks or at least contemplating how they might adjust as rates increase and the markets adjust. A changing business climate certainly would present new opportunities, but I can see how firms could run into trouble in a hurry. Yellen has promised to slowly raise rates which might alleviate some issues. Interesting stuff to think about...
So you're taking the capital gains tax hit and not using a 1031? Did the fund close? Whose money is it?
And, positive leverage will only get you so far if you have a 10 year term amortizing over 25. The positive leverage soon becomes negative leverage when and if you refi.
How violently do you expect interest rates to rise? A core 4.5 cap going to an 8 cap in 6 years? I guess anything is possible. But I am of the belief that there is a 'new normal' (Bill Gross) where slower asset growth and inflation is the new normal and interest rates will reflect that...who knows though
there's a lot of positive leverage out there still, and if you assume conservative cap rate expansion on exit and returns still make sense, then buy it?
Also, in the right markets there will always be value. assets bought in our fund in 07, a pretty good case study for buying at the top of a market, have ended up proving to return more than our initial projections....we have started to be more selective, but still feel generally bullish into 2016
http://www.morganstanley.com/assets/pdfs/articles/FrozenontheRates.pdf
MSREI research showing little correlation between interest rates and cap rates (historically). However interest rates affect credit availability and supply & demand... thus the market which in turn can affect cap rates.
Ultimately ends saying it's too hard to make a firm conclusion... still interesting.
The article suggests that there is little correlation between the movement of the 10-year Treasury and the cap rate, but that's because interest rates have steadily declined over the last 30 years, so making any kind of mathematical connection is very difficult given that cap rates have moved all over the place through recessions and booms (what's interesting is that the author's own chart shows a long-term decline in both interest rates and cap rates, just not a direct correlation in movements). But there is an obvious intuitive connection between cap rates and interest rates. If one could buy a 10-year U.S. T-bond at 5% there's no way an organization would buy an investment property at 5% cap because the risk-adjusted returns would be all off. A perfect correlation can't be made because the state of the economy impacts an investor's desired spread between the cap rate paid and the risk-free rate.
In addition, since 2008 there's been a fairly strong correlation between cap rate and interest rate declines. Given the greater sophistication of software and analysis, more abundant information, and institutions taking over commercial real estate, I would guess that in the future there will be a very direct correlation between cap rates and interest rate movements. Commercial real estate is an entirely different animal today than it was just 15-20 years ago, so an historical analysis is pretty much useless.
I was just reading an article from Amherst Pierpont yesterday regarding the off-set effects of rental rate growth and interest rate growth. At least in the office environment, in many markets with virtually no new supply coming online-Amherst believes that the increase in rental rates would more than offset the increase in interest rates.
But institutional buyers who buy downtown product sub 4 cap, I have no idea how they will escape any market correction.
You must work for an opportunistic/value add shop since its hard to find a core fund nimble enough to go directly to development opportunities. There is still opportunity in the next 6-12 months prior to the supposed interest rate hike to invest in development. When financing costs rise due to the interest rate hike, and if there is no correction in land values, and no slow down in construction costs, expect to see new development stall, both in acquisition and projects in development. Distressed assets/rescue capital will become part of many people's investment strategy.
Opinions are like assholes is the saying but my group's asshole is saying that we are in a new normal regarding long term rates until you see the Eurozone and China recover, even India is continuing to cut rates. We've been borrowing significant 5 year float rate debt in the past 3 years and its paid off so far. That being said I wouldn't mind seeing short term rates bump up and maybe clear out some of those cranes all over cities we own stabilized assets in.
+1 Virginia Tech
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