When speaking with investors, and at real estate investment conferences, the common theme from participants is the fear of investing in commercial office buildings and other income producing CRE, currently, when there is a perceived ‘top of the cycle’ for commercial real estate.
The term ‘cycle’ implies that once CRE reaches the ‘top of its cycle’, then there will be a downturn to CRE assets and thus lower returns or incur losses for investors.
Debunking certain terms for CRE:
But what if the term ‘cycle’ is an inaccurate description of the dynamics for performance of CRE assets? Some investors and consultants may be making a mistake to use the term ‘late cycle’ for ‘Real Estate’. That is a generic characterization of all real estate.
Let’s take commercial office as an example. Do commercial office buildings share the same economic dynamics as retail malls, residential homes, multifamily rentals, etc.? The answer is no. Within the commercial office market, do Class A office buildings in major markets share the same economic dynamics as a Class B suburban office building in a second-tier market? No, it does not.
So, the word ‘cycle’ assumes that investment in CRE will peak and then turn down or trend negative. At many investment conferences, consultants will put up a chart showing a curve with a cycle that turns negative for CRE, at certain point. In actuality, there is not a smooth cycle for CRE sponsors and investors. What has happened to the consultants and their charts when they predicted the end of the ‘cycle’ for CRE investment in 2015? 2016? 2017? 2018?
Confusing ‘Cycle Downturn’ with lower return expectations
One should be careful about confusing a strong and tight CRE market, with a pending ‘downturn in the CRE cycle’. These are not the same things. One example of this is where fully leased Class A office buildings have experienced gains in their value due to tighter markets, low supply and little to no new construction in the market. This scenario should not be confused with a consultant speaking at a conference about the top of the cycle and thus a downturn for the ‘cycle’. This is not how sponsors and investors view the market. These top assets are kept for their cash flow and ‘in-place’ tenant leases in an area that is experiencing job growth and economic expansion. This is not necessarily the beginning of a downturn.
The difference in this example is that there is no cycle to the specific asset/building if the in-place tenant leases are long term and there is little to no supply of comparable buildings in the immediate market. The return profile for a new investor investing in that type of asset will be lower, but that does not mean that the cycle is turning down. If the market for Class A office is tight and returns to investors are 4% – 8% depending on leverage used, then that is the market. It does not mean the end of a ‘cycle’. This is a common mistake made by some media pundits and bloggers, and some consultants, when they describe a strong/tight CRE market as ‘late cycle’ just because the return profile is lower than a previous period when the markets were less tight and not as strong as they are currently. There were some ‘experts’ talking about late cycle investments being made in 2015 – 2017. They advised investors to avoid these types of investments because of a pending ‘downturn in the cycle’. So far those ‘experts’ have not been right, and the institutional investors who made those investments are holding their investments and collecting their cash flow as the assets remain stabilized in a tight market.
Publicly traded REITs and the confusion they cause for Private/Direct CRE investments
Publicly traded REITs have many investors and media analysts who follow them. All too often publicly traded REITs are confused with private CRE investment. Both modes of investment into CRE are completely different. But since publicly traded REITs receive more of the media coverage than private CRE investment funds, statements like ‘late cycle investing’ and ‘the CRE cycle is poised for downturn’ get picked up in the media and are promoted by many media consultants and advisors.
If one looks at the media coverage of publicly traded REITS from 2018, there was plenty of reporting and coverage of publicly traded REITs that discussed significant volatility, loses in share price due to market liquidations and fear, and concern of retail CRE imploding and going bankrupt. These headlines for publicly traded REITs had very little to do with the strong performance achieved in the Class A commercial office sector and other CRE strategies, and more importantly, the stability of the pricing and asset values of private CRE investment. While many bloggers and newsletter writers spoke about how the publicly traded REIT index out performed the S&P 500 index in 2018, very few articles mentioned that the vast majority of publicly traded REITS were down on the year.
For the institutional investors who focus on private CRE investment, their returns had very little crossover or correlation with the negative returns of publicly traded REITs. Many people just equate the negative performance of publicly traded REITs with all CRE investment, and that is completely wrong. In the private CRE investment world, savvy institutional investors do not pay a market multiple for liquidity, whereas retail investors buying publicly traded REITs, do. The worst part for these investors in publicly traded REITs is they can suffer the losses of the REITs trading at discounts to the actual NAV of the RE assets due to swings in the market, and in some cases, the discounts to the NAV can be at significant levels, with very little chance of ever recovering to the true NAV. There are only two ways for publicly traded REIT investors to recoup losses due to heavy selling pressure: 1) many new investors enter the market to purchase that specific REIT, thus closing the negative discount spread, or 2) a takeover and purchase of the entire REIT at a value close to the real NAV.
Don’t be misled by inaccurate generic terms for CRE
CRE investors of all types should not be misled by terms that don’t really pertain to actual direct investing into incoming-producing CRE. Private/direct investment in to Class A commercial office buildings outperformed publicly traded REITs in 2018. Don’t be misled by ‘experts’ talking about how bad things were for generic CRE investing. That just was not the case. Every deal and market is unique with specific economics and targets. There is no generic ‘cycle’ to all real estate. Do your own analysis of the specific investment opportunities and try not to pay any commission to make an investment into professionally managed CRE.