One area of the economy that is seen as especially vulnerable in the wake of pandemic-related upheaval is the commercial real estate (CRE) market. In fact, even before Covid-19 struck, some had argued that the market had gotten ahead of itself, pumped up by ultra-cheap money and an aggressive hunt for yield by return-challenged investors.
In its November 2019 Financial Stability Report, the Federal Reserve noted that commercial property prices had risen substantially over seven years and capitalization rates — annual rental income relative to prices for recently transacted commercial properties — were at historically low levels. That same month, a commentator wrote in the National Real Estate Investor that low interest rates were fueling a CRE bubble.
As the pandemic has unfolded, some have moved aggressively to profit from what they see as a market ripe for a fall. Back in March, CNBC reported that famed billionaire and activist investor Carl Icahn established a short position on collateralized debt that backs shopping malls, hotels and corporate office buildings across the country, betting on broad defaults as some properties sit idle and others have tenants who have stopped paying rent.
Right So Far
So far, the bears have been right, at least as far as recent price trends are concerned. In mid-March, research and advisory firm Green Street Advisors noted that commercial real estate investment trust (REIT) prices had fallen 35% since Covid-19 hit the news three weeks earlier, signaling a potential 24% drop in commercial property values. Many believe that prolonged economic weakness — or something worse — will weigh on the sector for quite some time.
In fact, some are expecting we could see a decline as bad as what occurred just over a decade ago. In the wake of the global financial crisis, the prices of a wide range of assets declined sharply, with commercial real estate prices falling roughly 40% overall.
But even if things turn out to be as bad as they were the last time around, that doesn’t mean some won’t come out ahead. As in any business or industry, CRE investors who have consistently operated with the long term in mind will likely weather the storm better than others. Some will also be well positioned to sift through the carnage and acquire once-in-a-lifetime bargains.
The Right Frame Of Mind
In fact, based on what we’ve learned since launching our firm in 2008, those who’ve operated with what might be described as a “staying power” mindset — prepared for the worst and ready for whatever happens — may well find themselves in the driver’s seat going forward, even if we see another catastrophic downturn. In my experience, this perspective rests on four cornerstones:
• Location, location, location. It is something of a cliché, but location really does matter, especially when it comes to commercial property. In the office market, for example, it can seem appealing to target a stable but highly competitive urban market where growth is only likely to come from outmaneuvering sophisticated and deep-pocketed rivals. But we like to focus on well-trafficked corridors in fast-growing locales that have largely been overlooked by other CRE investors.
• Margin of safety. It’s long been said that when investing in commercial property — or any real estate, for that matter — you make your money go further. In our case, we look to acquire assets at 20% to 60% of their replacement cost, which serves as a hedge against the risks associated with new construction. Buying quality at a discount also allows an investor to beat overburdened competitors on rental rates.
• Conservative cash management. Markets that have been pumped up by low rates, high borrowing and an influx of yield-chasing capital are inherently unstable. While real estate investing has always been a highly leveraged asset play, it is necessary to have sufficient reserves and working capital to meet any demands that might arise. In normal times, cash is king. In times of distress, cash — and cash flow — are the “higher power.”
• Sustainable model. Premium-priced properties, cash-rich tenants in high-flying industries and frothy rental terms can seem like a CRE investor’s dreams come true. But in our experience, the real upside comes from buying diamonds in the rough and adding the kind of value that has a multiplier effect. It also means targeting investment-grade tenants who are in it for the long haul and agreeing to leases that reflect a similar way of thinking.
Preparedness Carries Promise
For some CRE investors, the big opportunity may come from buying well-situated assets from distressed sellers and transforming these properties to accommodate a more networked or technologically distributed way of doing business. For others, it may mean repurposing properties to accommodate tomorrow’s winners in an evolving economic and financial landscape. Whatever the case, as we have seen at other times of disruption and uncertainty, opportunities will likely abound for those who are prepared.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.