Each quarter I see increased late cycle behavior in the real estate world. From vast amounts of SFR home flipping at an institutional level (see Door/Zillow/Redfin) to development sponsors needing to farm out their 10% equity pieces due to insufficient cash at the operations level plus the reemergence of unsecured and interest-only debt at record high leverage points this cycle, irrational exuberance seems to be inundating the space. Multiple sponsors have approached us seeking opco level investment to recapitalize their firm because they have become so overextended chasing promote despite lengthening construction periods, high costs, higher opex, and weaker than expected rents. Much attention is paid to healthier CMBS performance this cycle, but the debt fund and mezzanine space seems to a real issue.
How do you all feel about the current state of the market in the space and MSA you work in?
God damn it, I had a nice reasonably long response which had an error when I hit submit and lost it.
Long story short: with 15 trillion dollars of negative yielding debt and more downward pressure than upward on treasuries I dont see there being a good alternative for this cash to turn to (to create this "crisis") when you can still buy Class A coupon clippers with RET abatements for 4%+ caps.
Not to sound callous, but I'm not too worried. Underlying mortgages seem strong, which should buffer the wider market from the effect of defaults. Mezz lenders who have been making 8-12% returns are taking all that risk knowingly. Overeager developers going bust won't have much an impact either. That's business. If you get greedy and overextend, you kind of deserve to go bust. Deserve is perhaps the wrong word. But chasing returns should bring a commensurate amount of risk.
I'm in NYC and while this is a bit of unique market, I don't think there is a major issue. Plenty of GPs syndicating out their equity pieces, but that seems less like desperation and more like operators realizing that they can reduce their exposure because there is so much money desperate to pour in. Smaller shops without good institutional relationships will get hammered when condo and office pricing doesn't match aggressive underwriting. But CRE is a risk business at heart, so I don't mind seeing developers who are playing roulette with the market on every deal take a bath. Not everyone should survive, and the guys who think/thought that paying thousands of dollars a foot for land was justified are exactly who should be getting f**ked.
The typical data points on the debt side look strong such as CMBS and balance sheet charge-off rates, but there has been some pretty irresponsible construction lending this cycle despite dramatic construction cost growth, lengthened construction periods, slowing absorption periods, and lagging rent growth. For example, assisted living overall occupancy dropped nearly 10% over the past 5 years as senior citizens simply cannot afford to pay the rates. Instead of marking rates down, the properties just tread water at 80% occupancy - this is the new normal in many markets, Despite this, money seems to continue funneling into the space per the NIC conference I went to; people hardly even commented on the record low occupancy levels particularly in Texas.
You're obviously more educated on this than I am, and I don't disagree in general anyway. That being said, these properties treading water at 80% occupancy or whatever... I don't know the business or the individual deals (obviously), but my gut reaction is that this isn't catastrophic. Those kinds of occupancy levels will murder owners/operators but the underlying asset doesn't seem to be underwater and the lenders will easily recoup principal balances. If assets need to be marked down 15-20% to be viable, it's the sponsors who suffer. That isn't bad in and of itself - markets occasionally need correcting and as I said, these guys are making a ton of money building and operating these assets, this kind of risk is the other side of that coin. I don't have pity for folks who stretched to make deals work because they wanted to keep the gravy train flowing. If you can't make your numbers work, the responsible decision is to scale back operations, retrench, and either focus on managing assets more efficiently or finding new business/product lines to pay the bills until the market turns back in your favor. Not blow out your core underwriting assumptions to justify borderline deals.
More often than not, I've seen principals keep money on the sideline for the dips. So the contrarian in me says we are not going into one soon. I'm not seeing a lot of over leverage, granted as someone mentioned the mezz space is still active, but those lenders are getting compensated. JV equity is moving lower in the capital stack to pref equity.
Everyone says we are about to go into a recession, but everyone in acquisitions is so very cautious right now, with money socked away. Also, clearly on a macro-level more and more people are moving from rural areas to dense urban areas. As long as this demand keeps up, real estate will do OK.
Right but my gut feeling is that people have that cash socked away because they're fighting the last war, so to speak. In 2008/09 and beyond, developers and sponsors with dry powder made a killing because you had all these basically viable assets that we're being sold at deep discounts because the former owner was so badly overlevered and banks were so desperate to get all their NPLs off their books.
That clearly isn't the case this time around. I feel (and only feel, I have no data to back this up except anecdotal data with folks in the market) that all this liquidity is waiting for a shoe to drop that doesn't even exist. Waiting to buy at 75 cents on the dollar when deals can be had now at 90 cents. I know we're looking at the MF market in NYC and thinking that we can lock in long term cheap debt and buy assets at real 6 caps. The 200+ bps spread is really attractive; yes, there is risk that expense growth outpaces rent growth (though the Rent Guidelines Board has been making noises about higher increases than we've previously seen under deBlasio), but the same way that regulatory change screwed a lot of owners in June, could easily swing partway back in a future legislative session. Even if it's only an increase in IAIs or a return of a modified vacancy bump, that gives you the potential of unlocking additional upside on what's already an extremely enticing spread.
There have been a bunch of RE topics lately, with good information throughout. I'm a fan. That's all, thanks.
Lot's to digest here...
I'm generally in Ozymandia 's camp. Dry powder levels reported by Prequin and the like are taken out of context. A meaningful percentage of that reported capital is comprised of value-add / opportunistic investors that are waiting for the "correction". It's very unlikely that real estate is the crux of the next recession as it was in the last so this subset may be unsatisfied when they do make their move. Also, typically when everyone is waiting for it, it doesn't come. These guys have to deploy that equity eventually. Also... a significant amount of that capital is BX and Brookfield... A BX acquisition is not an accurate temperature of the market as they are playing a game within the game (I've talked about this before).
What is concerning, especially in the industrial landscape, are the new capital market participants, in both the wholly owned and LP space. The entrance of unsophisticated players in a marketplace can have (is having) serious impacts to valuation levels. Cost of capital is alarming low for some groups at the moment, which effectively prices out the investors that rode the meteoric rise of industrial as an investment. So what happens? Those guys seek cheaper capital and it is a vicious cycle which lowers returns in the marketplace while risk (theoretically) is at an all time high considering stage of the expansion. This is a dynamic largely ignored and worrisome.
I suspect this trend is pervasive across product types. To be expected as the cycle matures and to an extent a function of the global interest rate environment. On interest rate front, and this is what a lot of guys miss, real estate is not a bond. Although it is reasonable to benchmark to global bonds, relying on this methodology is silly and ignores the inherent risk of real estate: you don't always get your principal back. This is a risk that I see overlooked at this junction in the cycle. Yield premia for real estate are risk premia...
Now I'm done rambling. To Ozymandia 's point, there are overzealous developers and repositioning guys out there. I see some initial signals of an overbuilt market in a couple markets I cover; however, developers/risk takers get burnt all the time regardless of cycle.
In short, I don't feel. I may be smart, I may be an idiot, idk but I KNOW for a fact there are SOME idiots playing in my space right now. idiots = f'd up returns and cause of concern. Licking my chops at the opportunity to eat their already decomposing corpse like a maggot when the time arises.