Have seen a couple posts on here about fear of recession. Wanted to get some of you guys' thoughts on the greatest signs of foreboding in our industry. Obviously interest risks and sky-high prices in construction and assets can be worrisome, but I wanted to see what other major / minor indicators you guys look at when assessing the economic environment, and real estate specifically.
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In addition, what else would affect real estate the most heavily? Other than a significant tightening of debt markets.
Cap rate expansion which is caused by investor's perception of risk in the CRE space. They may demand higher returns for their capital allocations which expand cap rates. Disrupters that affect tenants like we are seeing in retail right now. On the flip side of that same coin- how Amazon and competitors have affected industrial assets. Hospitality assets, especially those focused on business hotels, are heavily affected by how companies are doing on their balance sheets.
Tightening of capital markets seems to be the major driver in real estate downturns though. Before was S&L crisis (in the 80's), then CDO/ CMBS crisis (2008), and next is what lots of people are expecting/ predicting.
Not really answering your question, but I personally think a small recession could be good for the industry right now. Pricing is way out of wack. A little bit of blood in the streets could create some better opportunities for those of us that are in acquisitions. Right now it is like searching for a needle in a haystack to find a deal that pencils out.
Someone is making them pencil. Not sure who
Probably Gandhi
every broker that has modeled 4% growth and solving for a 15% IRR over 5 years but can somehow convince some MORON with $$$ to buy VALUE ADD in the current stage of the cycle.... some people only see CASHFLOW without looking at leverage profile, growth rates and real assumptions. Any one can get 15% IRR on paper if you use sky high leverage and growths that aren't sustainable. the fucktards buying today will be the bargain tomorrow.
What are you buying, Trunk Yeti ?
Industrial, distressed to core. Primarily in the Southwest/Southeast.
Trunk Yeti is correct. Deal flow should pick up significantly after a correction occurs. It’s difficult to find good deals right now.
Same here. We provide LP JV development equity capital to seniors/student developments, and all of the developer's pro formas we see are showing average development spreads around 120 - 150 bps. By the time I inflate the exit cap a little and add additional contingency, there is zero room for error.
Not sure if this translates to the US at all, but in Canada, stricter mortgage qualification requirements implemented last year has made closing on new-construction projects significantly more difficult. Essentially, buyers who previously qualified and have already paid deposits on new construction can no longer qualify for a mortgage to close and pay off the balance owing.
It could lead to people walking away from deposits if no remedy is available. Canada has also seen a large influx in Condo/New Construction development in the past few years, with many of these projects coming online in the near future. As the new mortgage qualification standards were only implemented last year, the effects, if any, are far from being fully realized.
Are you saying home prices went down due to heavier regulatory requirements to get a mortgage?
They have fallen to some extent, coupled with a sharp decline in sales activity. More the fact that buyers have sunk deposits into new construction projects, and can no longer qualify for a mortgage when it comes time to taking ownership. The heavier regulatory requirements are relatively new, so the full effect has potentially not been realized. There are over 60,000 condo units under construction within the GTA alone, of which 95% were pre-sold. Many of these buyers may no longer meet the lending requirements needed to close. Development yields in Canada are already stretched incredibly thin within primary markets, and the inability for buyers to close could leave developers with an influx of supply on hand.
That sucks to not be able to generate new business although as the current inventory clears out, the heavy pending demand will give boost to prices and once again, a seller's market. But for now, gotta ride out the dry weather.
Hard to get deals done if interest rates rise above cap rates.
We actually just did one of those. It was kind of like a WTF moment looking at the model but we had 1031 money burning a hole in our pocket and the asset was a perfect fit for our portfolio so we did it.
Mind if I ask a little more context on that deal? Sounds like a quite interesting play.
Did you buy it un-levered?
The fact that this is even a possibility shows that the market is disjointed right now. Given the size of the warchest that has been built up by debt funds, rates seem to have remained competitive, meaning that in order for the cap rate to be below your coupon, it would have to be a distressed property, no?
I agree with everyone here on the pricing/acquisitions side of things. I'm most curious to see how our industrial assets do in the downturn. This is really the first time institutional money has a significant stake in the product-type for a full cycle and I could see a couple reasons why it would get hit particularly hard in a downturn. Tenants with razor thin margins (not so much for big-box tenants), natural reduction in warehousing/cargo-processing capacity needed if global commerce slows, abundance of institutional money all chasing the same product/tenants, demand isn't as deep/permanent as multi-family, etc. There's a couple of other, more granular reasons as well that I wont bore everyone to death with, but that's what I'm curious about in the next recession.
So I don't think that industrial will get hit that hard in a downturn. Vacancy remains at an all time low (even if all the supply under construction delivered vacant, we'd still be below the long term vacancy rate), talk to leasing brokers and the tenants in the markets remain robust - demand continues to outpace supply, it is becoming incredibly difficult to entitle sites - people are taking a NIMBY approach to industrial development/trucks, relatively restrained debt/equity markets for new developments and lastly i think that a big reason for the institutional rotation into industrial is the lack of cap ex drag. Releasing an office building crushes your cash flows vs. a 2nd gen space for industrial.
There are some submarkets in the big box world that worry me (Central PA/Berks County, South Dallas, Atlanta, Chicago) but overall the market is pretty resilient. Additionally, since the construction period is so much shorter for a warehouse it is easier for people to put projects on hold. The only other stuff that doesn't make sense to me is the multi-story stuff in the NY boroughs, but maybe i'm just too simple for that.
Last point - if you look at real estate costs as the total cost operations for a warehouse its about 6-8%. So even if rents jump 10%, it doesn't move the needle in the grand scheme of things in comparison to labor/transportation.
Good take, good take. There definitely are some prime-time industrial nodes that have so much pent up demand that they can stomach a downturn and probably still stay near full occupancy. I can think of one specific market on the West Coast that stayed below 2.5% vacancy even during the great recession. The trend towards e-commerce (which still makes up a shockingly low percentage of total retail sales) will probably offset the lack of consumer spending and other factors that would negatively effect big box tenants in a downturn. Data Centers and Self Storage, if you consider them industrial, are also two product types where the demand drivers for the product can offset the other side-effects.
I'm more worried about trucking terminals and or manufacturing centers with sub-quality credit tenants, out in weaker secondary markets.
What about Central PA/Berks County worries you? Asking because I am working on an industrial development in Berks.
Recession coming? Absolutely, but it could still be a couple years.
RE market wise I’m in several and have noticed a slight cooling in a couple spots so far and it’s mainly because things have been burning hot for years. Prices are high, deals are still out there. Until something bigger happens though, this is where we are.
I'm going to take a contrarian standpoint on the blood in the streets being good. Seems to me like there's so much cash sitting on the sideline hoping for 2008-2011 buying opportunities even a small blip will be fairly momentary. Unless there's chaos in which case maybe people wont wantto catch a falling knife.
I also think everyone here makes the inference that they'll be on the prosperous end of a distressed, sell-off. No one wants to consider that they may be the proverbial blood on the streets haha.
This is such a true statement.
+1 this is perfect.
Regarding that blood in the streets: most major real estate downturns have been preceded by over development and/or (but generally and) excessively loose credit. Over-development has been seen in pockets over the past 5-7 years (the outcry about oversupply of high-end apartments in coastal urban cores seems to have died down to a whimper?) but it certainly isn't to the extent of prior run-ups... Similarly with credit, I haven't seen anything too excessive - developers are still ponying up significant equity (even with pre-leasing), unlike previous cycles where 100% financing had been available, or when condo developers were using pre-sale deposits as their equity.
I'm not saying the everything is rosy, or that some people won't be burned, but the lack of risk in the system from the factors above leads me to believe that (generally) losses are going to be more on the order of missing your IRR target by a few points because you overpaid, not getting wiped out and the bank liquidating your assets for pennies on the dollar. If this bears out, the "blood in the streets" might be more of a series of paper cuts.
The first chapter of Howard Marks "Mastering the Market Cycle" comes to mind and is extremely relevant to this thread.
A few indicators I consider to be salient include Global GDP/Industrial/Manufacturing/Trade data, supply / demand dynamics in the tenant market and general investor attitude.
Industrial product optimism is teetering on the edge of overly exorbitant. Fundamentals continue to be fairly strong, but from a pure behavioral standpoint the asset class is seemingly ripe for a correction. The advent of e-commerce has done wonders for the asset class, but I expect a a reversion to the mean (or close to the mean). It's difficult for me to understand how 3.75% caps in the most core, infill markets results in an appropriate risk-adjusted return for any investor. Feels like herd mentality.
Other worrisome market phenomena are negative leverage deals, abundance of credit begging for a home and unbalanced available capital across the risk spectrum.
Apologies this post took basically no form... Just spitting out ideas as they came.
When banks/lifecos/Debt funds whoever, look at negative/positive leverage? Or is that metric typically an afterthought?
Good question. I am unsure. From the lender perspective, the presence of negative leverage should be of significant concern I would think, and not an afterthought.
Negative leverage typically signals a value-add play where NOI will grow substantially over the hold. The issue is - especially at this point in the cycle - growth assumptions may be a bit optimistic in order to make a deal pencil. So, the deal's inherent risk is essentially multiplied.
Risk 1: Market turns in the near-term before value can be unlocked = troubled borrower (always a risk with value-add plays, but exposure limited by debt proceeds) Risk 2: Opportunity to realize value is reached; however, growth has moderated/languished completely (surely a risk consideration, but its risk grade is multiplied by what is presumably significant leverage and therefore the persistent inability for the asset to claw out of negative leverage = very troubled borrower)
Had this convo with a buddy over many drinks so would love to hear if I am thinking about this incorrectly...
The argument is counter intuitive. If all the acquisitions guys are waiting for a slight dip in the market then there will be no dip. There is still plenty of buyers with a ton of cash ready to buy and eventually on each deal, a buyer caves in and overpays. The market doesn't dip when there is a ton of liquidity, but when it all dries up and returns are no longer attractive. I think you still got quite some time unless interest rates continually rise to the point the current caps dont make sense. Other issues could be the removal of IRS 1031, which has been a huge reason for prices staying inflated.
There are a lot of markets though, especially coastal, where the cap rate/interest rate relationship is already upside down.
Coastal San Diego like many coastal markets has been upside down almost since I got here 20+ years ago. Some were snagging up 4.5+ caps here and there pre 2013 or so. Still today, with rates in the mid 4's, most markets like Pacific Beach, Ocean Beach, La Jolla, and north to about Carlsbad are still sub 4 caps.
I was looking at comps in Pacific Beach over the weekend. We got 2br town home buildings trading for 500k a door. That's nuts. Then again, the exit sales price on a few dozen studios in PB I'm working on right now is 325k a door and over $1000sqft.
Your money does appear safe on the coast though. Big equity gains with not so big cash flow.
The main issue has been seller pricing expectations, which I think will be the turning point. There's going to come a tipping point where people that are now thinking of selling (coming up on the 5 year hold for things bought in 2014/2015) won't be able to get the numbers they want, so will be forced to either refinance or accept marginally diminishing returns. That's when I think it will turn. Then some groups will be forced to sell-off in some cases due to fund maturity, tax reasons, etc. and that's when the supply will start to flood the market and put downward pressure on pricing.
Its already happening as far as sales. I have seen so many high quality assets coming to market this year and we are only one month into the year. Once supply of assets for sale exceeds demand for them, these assets will sit longer on the market and thus cause them to cut their prices in order to offload them.
The fact that this is even a possibility shows that the market is disjointed right now.
Hasn't NYC been like this for years?
Typically, a recession creates a buyer’s market where cash is King. The deals and properties acquired during the down turn should serve as your sales inventory during the next economic upturn. Buy in a buyer’s market and sell during a seller’s market. You will make money, coming and going.
Fuckin A, that simple all along
With all of the talks about recession risk, i'm more and more intrigued to learn about how people who have gone through the last cycle have seen changes in career/compensation, etc.
Who were the ones to lose the jobs? Where did they go from there? How did that impact their ability to get back into the market?
I often wonder how a lot of these smaller equity/private debt shops will be able to whether any storms.
Disclaimer: Was in school during the crash
I think I'd rather be at a small shop during a downturn. At a small shop I might be the only analyst, spread between multiple important functions. A very necessary cog in the wheel.
At a megafund, I'm probably one of 10-20 analysts and I likely have much narrower responsibilities. I'm much less essential.
In the unfortunate event I do get fired, then yes the brand name should help me land somewhere else desirable vs the small shop which no one has heard of...
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