Many investors in CRE are asking the question: “What inning are we in for the CRE investment cycle?” They are concerned about being late in the CRE cycle because they hear this question over and over.
This question about ‘what inning are we in?’ is too generic and not really the correct question. It’s like asking, “How is the weather is in the United States today?” It is not very helpful or relevant to anyone interested in their local weather. The same goes for real estate investing.
In this article we are going to focus on Commercial Office buildings.
Cycles versus Events:
Too many investors and consultants refer to the ‘real estate cycle’ when analyzing investments into CRE. Again, this is too generic to view all CRE in a cycle. Regions and cities have completely different dynamics and investment outlooks for different types of buildings. For instance, at any given time, the Austin, TX market can be completely different than the Seattle market. Certain parts of New York City can be very different than other parts of NYC. Portland can be very different than San Jose. Thus, to just ask ‘what inning are we in?’, assumes the investment ‘game’ is close to ending and that the ‘cycle’ will turn down. Now how many times have we heard ‘that the cycle was topping out’… three years ago (2015), two years ago (2016), etc.?
Events can cause downturns in a specific market or type of investment. Today is very different than the events that caused such sharp downturns in CRE back in 1990, and 2008. Today there is much less easy financing available to develop office buildings from the ground up. There is not a constant supply of office buildings coming online in various cites causing large vacancy overhangs. The speculative development of office buildings is greatly reduced compared to the late 1980s and mid 2000s.
So, what has changed? Investors must not confuse lower return expectations with the end of a cycle. The return profile that investors are hoping to achieve, when they invest into commercial office buildings, has come down in the past years. There are no ‘+15% returns/IRRs’ available in a Class A commercial office building where a building is over 85% leased. That spread has closed significantly over the years as many investors entered the market and paid higher prices for Class A buildings. There is a vast amount of money looking to invest into Class A office buildings and thus the return profile has come down significantly. Investors must adjust their expectations. But a lower return profile does not mean the end to the ‘cycle’. It may be disappointing for some investors to only achieve a 4%-7% return in Class A office buildings with high tenant occupancy. But that is the current market.
Don’t YIELD SHOP
When interest rates are relatively low, and return profiles for CRE decline, investors may be tempted to reach for high return targets for investments, not realizing the potential additional risk they are taking. Real estate is illiquid and not a short-term investment. The first question an investor should ask is whether the investor is investing for current yield and cash flow payouts, or is the investor foregoing current cash flow in search of higher returns when a project or asset comes online and begins to pay out cash and is then hopefully sold at a higher price to meet the target IRR of the investor.
Currently there are many small CRE deals being offered to individual investors via platforms and small sponsors. Individual investors may be tempted to shop for, and chase deals that have higher potential target IRRs. Just remember that a target IRR means very little. It is just a projection of assumptions made by the sponsor.
So what inning are we in for CRE Office Buildings?
We will refrain from using the other most used cliché in CRE: “Location, Location, Location”. CRE Investment is about the specific deal, which includes the location, the financing, the cash flow, and the vacancy and most importantly, the potential for exit at a higher valuation. Investors must look at the sponsor and its capability to add value to the assets and exit the investment in a positive manner for its investors. So, the cycle does not end for CRE. The market for CRE adjusts return profiles and yields, and thus investors must do the same. The right markets and right assets can still provide attractive relative returns if the investor and sponsor are willing to do the hard work of analyzing the risk and reward of a specific CRE investment.
Staying with the Baseball theme:
There are many CRE investment ‘games being played’, in specific markets, and specific assets. Each one of those CRE Investment ‘games’ are in their own specific ‘inning’. Now it is time to evaluate the ‘situation/investment’, and then execute on the investment plan for that specific ‘game/building’.