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June 1, 2023

Forecasting Commercial Real Estate: What Investors Should Know

We are currently in a time where the commercial real estate industry is heading into unchartered territory. However, when facing headwinds in commercial real estate, this shouldn’t mean that you come unprepared. Your priorities and focus should stick to the four fundamentals: location, cost-basis, asset class, and sponsor quality.

These are the factors with the highest correlation to overall project success. Let’s break down each essential so you won’t be left out in the dust when it’s all said and done.

Location
This is probably the top consideration out of the four. Successful investors focus on growth states. Take a look at Texas as well as the Southeast region. This area continues to see positive net migration and favorable conditions such as cost of living, low taxes and business-friendly government that ensures the trend continues for the near future.

Cost-Basis
The cost of living is another factor that is creating this unprecedented net migration. This demand gap is further exacerbated by the current difficulty in obtaining debt and equity for new projects, and the overall cost of that capital at a time when construction costs continue to increase. These fundamentals will significantly slow the building process, which inhibits the ability to create the supply to meet the ever-growing demand. As a result, consumers will likely continue to pay a premium for quality housing as the imbalance between supply and demand continues to expand.

Asset Class
The market is also currently bullish on other asset classes such as drive-to-leisure hospitality, extended stay hospitality and RV resort conversions and developments. Investors should realize the highest risk-adjusted returns in all things housing related in Texas and the Southeast. These sectors of real estate should continue to be a sound investment as the fundamentals remain resilient. Nobody anticipates that supply will catch up with the demand anytime in the foreseeable future elsewhere, but the economy in this region continues to grow.

Right now, we have a real housing shortage in the United States, so asset class is just as important because you want to focus on sectors where demand far exceeds supply. The winners will be those developing multifamily, single-family for rent, single-family lot developments in master-planned, highly amenitized communities.

Sponsor Quality
Most seasoned developers and sponsors will continue to be able to source capital (debt and equity) for their projects, albeit at a higher cost. Banks are currently being extremely selective in their debt offers and underwriting has become much more stringent and conservative with lower loan-to-cost percentages and a much higher focus on the quality of the developer or sponsor. As a result, top tier developers and sponsors with well-located projects have the ability to command the best terms.

Private debt capital has also increased its market share of the debt markets to help fill the void being left by the traditional community and regional banks. These private debt options typically come with a much higher cost of capital, which could lead to potential stress on a development. It is critical for today’s investors to fully vet the sponsor in any real estate project and make certain the sponsor has a proven track record in the asset class in which they are contemplating investing and a well-thought-out business plan. It’s equally important to make sure all parties understand the debt and equity being sourced for a particular product. This of course, is more important than ever in a more challenging real estate environment, such as the one the industry is currently experiencing.

The bottom line is that the transaction volume should be significantly down in 2023 as lenders pull back and underwrite much more conservatively. With the rapid increase in interest rates, controlling cost of debt, and cap rates remaining below that cost of debt, thereby creating negative leverage, it is less likely buyers will be able to buy. If a seller is not forced to sell, they will likely hold the asset until the market comes back into equilibrium.

With the above in mind and knowing where we’re currently at in the markets, remember this:

  1. Know your Sponsor – Picking the right sponsor can make all the difference for the outcome of your investment. While many sponsors perform at a satisfactory level in a strong economic environment by following the basics, sponsors who have a proven successful track record and have weathered multiple real estate cycles should be the ones to turn to. In addition to experience, mind the sponsor’s position on fixed-rate debt vs. floating-rate debt. By understanding the sponsor’s portfolio and mindset, you will understand the strength of that sponsor should the need for support arise for a particular project.
  2. Location Location Location – When deciding where to invest, consider whether the asset is in a market that is exhibiting growth. Look into whether the demand for a particular asset class exceeds supply and whether you believe that supply can meet that demand over the projected life of the investment. Demand is on target to outpace supply in all things residential and drive to leisure hospitality throughout the south and southeast region of the United States as positive net migration remains unabated. For example, Texas and Florida should continue to show the greatest net population gains with demand exceeding the supply for the foreseeable future.
  3. Asset Basis – As important as it is to have the right sponsor with an asset in the right location, understanding the business plan for the asset is equally, if not more, crucial. Looking to acquire an existing asset? Consider if the sponsor can reasonably exit on a cap rate that exceeds the current cost of traditional debt. On the flip side, looking to develop from the ground up? Consider if the sponsor can reasonably maintain a 250+ basis points spread on cap on cost vs. market cap once stabilized. Similarly, with respect to ground-up development, the investor should consider whether the sponsor can evidence a total cost of not less than 250Bp above the current market cap rate for the asset.

 

Kip Sowden is the chairman and CEO of RREAF Holdings LLC (“RREAF”), privately held, vertically integrated commercial real estate company based in Dallas.

This article originally appeared on Nasdaq