The commercial real estate world is not coming to an end.
It’s back to basics. Fundamentals matter. Really.
An industry colleague of mine and I were recently catching up; he mentioned that he was looking to hire a head of investments for a new lending program. I asked him, “as an originator, or an investor, what is the most important characteristic are you looking for in the hire?”
He didn’t even hesitate. He said, “I want to hire someone who has been through a cycle. Or two. Because, if they haven’t, how can they really put themselves out there as an experienced investor?”
Why does this matter? Because someone who has been through many cycles will know:
- Inflation is good for commercial real estate. It drives rental increases (hopefully more than expenses).
- Basis matters. The Total Project Cost per square foot and its relationship to debt service per square foot matters. Per square foot basis is more easily compared to market comparable rent per square foot and sales price per square foot. “Appraisals don’t pay debt service!”
- Negative leverage is a thing. Leverage is a two-edged sword; Michael Milken in the 80’s posited that as long as negative leverage is applied to appreciating assets it works. We, today, are faced with an industry in massive price discovery. Maybe even globally. If cap rates move from 4% to 5%, values are dropping 20 to 25% all else being equal. Assets are deflating in value today. Really? IF so, for how long? The punch line here is that in today’s current micro and macro environment, sponsors need to be able to create value. Find an asset, at an appropriate basis, where value can be created and extracted.
- With the end of free money, and easy money, value creation is NOT: buy asset, finance on short term line of credit at lower interest rates (and positive leverage), raise rent, hold long enough for cap rates to drop, sell at profit. Value creation is about enhancing the “enterprise value” of the asset built or bought based on a prescriptive business plan that works because the sponsor executes it properly.
- Opportunities across the industry will for certain surface. The “right” geography, property type, basis due to distress – all will present opportunity for those who are aware to capitalize upon. Be in the game, stay in the game, focus. One thing has always been true: all real estate makes money; the only question is who owns it at the time! Winners and losers are made on basis and execution on solid sponsor plans.
- The “game” is to identify, assess, mitigate, and price risk, in search of excess return on a risk adjusted basis.
- It has been said that in good times real estate ownership shifts to weak hands; in bad times those same assets find their way to strong hands.
- There is no crying in baseball! IF it were easy, everyone could. Er, uh, wait… It WAS easy; and they DID! It’s the end of “easy.” It’s the beginning of “worth it.”
Wishing everyone a wonderful holiday season AND all the best for a happy, healthy and prosperous 2023!