All Forum Posts by: Greg Barrett

The capital stack relates to the layers of investment financing for a real estate deal. The capital stack creates a visual representation that helps investors understand where they fall in terms of the priority of repayment and where the stand on the risk premium continuum.

Most real estate investments are financed through a combination of debt and equity. Typically, the sponsor of the deal will contribute equity, as will a number of limited partner investors. The equity raised between the sponsor and investors will typically be between 30% to 45% of the capitalized value (Purchase Price + Acquisition Costs). The sponsor will secure debt to cover the remainder of the capitalized value; typically between 55%-70%. A capital stack with just two layers--common equity and senior debt--is the most common financing structure. This capital structure is typical when investing in stable assets. See the figure below outlining a typical debt and equity financing structure.

The capital stack becomes more complex--with added layers--when the project becomes more nuanced. Value add projects--where the sponsor intends to renovate the property--or more risky investments may require another layer or two added to the capital stack. In these types of investments, the senior lender typically doesn't want to loan the amount needed to cover the construction costs; therefore, a gap between the senior note and the common equity exists. This is when the sponsor will seek to obtain preferred equity or mezzanine debt. See the below figure.

Below I break down the common layers of the capital stack. Note that there is no limit on the layers of the capital stack for a given project; however, the four layers below are the most widely used in commercial real estate.

Common Equity

Common equity sits at the top of the capital stack. As indicated in the image above, common equity sits higher on the risk premium continuum--meaning that their investment is at greatest risk in the event that the investment doesn't turn our as expected. This means that common equity investors will be paid last. However, being at the highest position means that the returns could be the greatest. Due to assuming added risk, equity investors will benefit the most from the upside. If the property generates strong cashflow and appreciates over the life of the investment, then equity investors will stand to benefit more than the debt investors. Typically the upside is uncapped.

Repayment Priority: Last

Risk Profile: Highest

Potential Returns: 10%+

Preferred Equity

Preferred equity sits in between common equity and debt; it is a debt/equity hybrid. Therefore, preferred equity holders require a higher rate of return than debt holders, but a lower return than common equity holders. Preferred equity will generally have a hurdle rate--which means that the preferred equity holders must achieve a predetermined return before common equity holders get paid. Preferred equity has a hybrid risk/return profile. In some cases the preferred equity holders may have recourse in the event that the borrower defaults.

Repayment Priority: Third

Risk Profile: Medium - High

Potential Returns: 7-10% +

Mezzanine (subordinate) Debt

Mezzanine Debt is very similar to preferred equity as it is also a debt/equity hybrid. The main difference is that Mezzanine financing is a form of debt that can be converted to equity in the even the borrower defaults, whereas preferred equity is a direct ownership stake in the property. Mezzanine debt is typically used when the developer needs to fill a gap between senior debt and equity. Mezzanine debt sits in between equity and senior debt on the capital stack. Mezz debt is subordinate to senior debt--which is a fancy way of saying that they get paid after the senior debt holders. However, mezzanine debt holders have payment priority over all equity positions (preferred equity and common equity). As such, they typically receive a rate of return lower than preferred equity holders but greater than senior debt holders. It's typically a flat rate of return similar and does not participate in the upside.

Repayment Priority: Second

Risk Profile: Medium - High

Potential Returns: 10-20%

Senior Debt

This is the most secure position in the capital stack--which is why it sits at the foundation. Senior debt gets paid first until fully repaid. In other words, the interest on the debt gets paid before mezzanine debt and before equity investors receive a return. Therefore, if the investment were to fail then the senior debt position is the best place to be. The other benefit of being a lender in the senior debt position, is that they typically have the right to take back the property (become the owner) in the event of a default. The downside to this position is that the senior debtholder will not participate in the upside. They typically receive a flat rate of return (aka as fixed coupon or interest). Even if the investment is a grand slam, the debt investor will only achieve the interest rate stipulated in the loan documents.

Repayment Priority: First

Risk Profile: Low

Potential Returns: 3-8%

Conclusion

Commercial real estate offers investors a wide array of positions in the capital stack to help investors achieve their objectives. Some investors prefer to only invest in the common equity position because they seek outsized returns. Others prefer the preferred equity or mezzanine debt position. Banks and other financial institutions with ample cash prefer to be the lender (senior debt) due to the security of being in the first position, the ability to take back the property, and the predictability of interest payments. Understanding the risks and rewards of each position in the capital stack is crucial to understand before investing.

Every real estate investment involves risk. Some investment properties have substantially more risk than others. Real estate development is generally more risky than purchasing a stable core asset in a large market. In this post, I will list many of the common types of real estate risk. It is helpful to think back to your entry level economics class in which you studied supply and demand, because many of the risks involve a disruption to one or the other.

The overall riskiness of the investment directly correlates with the Discount Rate you intend to use when evaluating the opportunity.

Not each type of risk is necessarily applicable to each investment, and conversely, there could be additional types of risks that I have not outlined here. For example, most people didn't consider a global pandemic to be a risk associated with their real estate investment. Clearly, that risk was always there, even though it was never considered.

Tenant Credit/Default Risk

The financial position and operating ability of tenants determine their ability to meet the rental obligations outlined in the lease. The stronger the tenant credit, the more likely the tenant is to make it's rent payments.

Property values are determined by future cash flows. Properties with credit/investment grade tenants are much more likely to collect those payments than noncredit/local operators. Tenant credit is particularly important when a lease term is greater than five years. Note that in recent years, many "credit tenants" quickly lost their investment grade status due to high levels of debt, technological disruption, poor management, and other forces. You need to think about how these tenants will do relative to current trends. NNN lease investments are particularly sensitive to tenant credit because they behave like bonds--the only difference being that the investor should also consider the value of the property if vacant.

Vacancy Risk

Returns are directly correlated to occupancy and rental revenue. Vacancy erodes those figures. It can be quite challenging, costly, and time consuming to backfill a space or building that has been vacated. A large vacancy in a retail or office project could jeopardize the success of the investment.

Industry Exposure Risk

Too much exposure to a particular industry or sector within a portfolio can result in risk. If many of your tenants operate within the same industry, and that industry encounters some challenges, then much of your tenant base is at risk. For example, I was once looking at buying a portfolio of industrial properties in Midland, TX (Oil country). The buildings were all leased to oil-related service companies. When we were under contract to buy the portfolio, the industry took a major hit because of OPEC issues and reduced demand because of COVID-19 (the price of oil tanked). In short, we were fortunate to be able to back out of the deal do to this material change, but if we hadn't, then this portfolio of properties would have been exposed to substantial industry-related risk.

Also, buying properties in markets without a singular economic driver is risky. For example, suppose you are looking to buy an apartment complex in a town with one huge manufacturing employer. This would be risky, because if the company decides to shut down the manufacturing plant, then most of the renters will leave to find jobs in other cities. This was a recurring theme in many rust belt cities in the mid west that have seen population and real income decline for decades.

Operating Expenses Risk

Unanticipated increases in operating expenses result in a reduction in NOI. Operating expenses consist of utilities, landscaping, maintenance salaries, insurance, snow removal, and many other costs associate with running a property.

When tenants are under NNN leases (typically retail), and operating expenses increase, then it is much more difficult to raise rents because tenants directly bear the burden of these costs. Tenant's don't merely look at the face value of the base rent, but instead focus on the total occupancy cost (Base Rent + NNN's + additional rent). Under full service leases, like you will find in office buildings, landlord's cover the operating expenses; so any increase is a direct hit to NOI.

The cost of insuring real property has increased significantly in recent years. This is likely to continue due to the number of recent natural disasters and expectations that we will continue to see increased numbers of such events.

Market Risk

Every market is constantly evolving. We hope to buy properties in markets that are improving. In general you want to buy properties that are in the path of growth, meaning there is development taking place nearby (be cautious about direct competition). We also want to see strong and increasing population density, low crime, low unemployment rates, high median household incomes, and strong transportation characteristics (traffic counts, public transportation stops, etc.). This is particularly important for retail real estate. If the market conditions go in the wrong direction, then your investment could be at risk. Be careful about investing in properties if the market is in decline.

Interest Rate Risk

Increasing interest rates can be problematic for owners of real estate. The most obvious impact is when the property has an adjustable rate mortgage; the debt service payments will go up. If you need to refinance the property, and you face higher interest rates, than you could have much larger debt service payments. As interest rates rise, so do mortgage payments. Additionally, since rising interest rates equate to higher discount rates, the net present value of the property will decline. This could result an unacceptable rate of return for investors.

Leverage (Debt) Risk

The more debt on the investment, the more risky it becomes. Yes, debt can juice returns, but it can be a huge risk if the asset faces NOI challenges. Make sure that your property meets the LTV (generally not more than 70%), DSCR (not less than 1.2), and Debt Yield (not less than 10%) tests to make sure you aren't overleveraging the investment. Too much debt can be problematic if occupancy in a property falls, or if tenants stop paying rent (like they did during COVID-19). If revenues fall, then the property may not generate an NOI in excess of it's debt service payments. Then the operator will have to dip into it's cash reserves to make debt payments. It this situation extends for a significant period of time, then there may be no cash to cover the debt service payments, and the lender could take back the property.

In addition to having the risk associated with debt service expense, there is risk that you may not be able to refinance when possible. Let's say for example, you acquire a property with debt that matures in three years. The property will need to be healthy enough to be able to refinance or sell at that time. I've seen several situations where the business plans were disrupted by changes in the market (some of the risks I've outlined here) which made it very challenging to refinance. Due to COVID-19, it may be very challenging for hospitality and retail property owners to refinance their properties at loan maturity in the coming years.

Liquidity (Ability to Sell) Risk

Real estate is a highly illiquid asset class. There are limited buyers and sellers and transactions are very complex and costly. The degree to which the property can sell determines it's liquidity. If a property cannot sell quickly at market price, then the owner faces liquidity risk. Property liquidity varies across product types, markets, submarkets, the property's tenants, capital markets, and other forces.

Physical Property Risk

Despite your efforts to inspect a property during your due diligence, there is no way to understand the physical condition of each and every component in a building. Small physical defects and some deferred maintenance are normal and expected costs investors will incur. Sometimes, however, those defects or deferred maintenance can be substantial and have a significant impact on the owner's ability to execute against their business plan.

Structural Risk

Structural risk relates to the investment's financial structure, not the underlying real estate. The rights and objectives of the individual stakeholders in the deal determines the level of structural risk. In a typical investment, you have the sponsor who finds, acquires, and operates the property. You also have equity investors and a lender. The senior secured loan gives the lender a structural advantage over any subordinated debt and the equity investors. The lender gets paid first, then the subordinated debt (if there is any), and then the equity investors. The equity investors are paid out last; therefore, they have the most risk.

Partnerships can take many forms in commercial real estate investments. These types of business structures also create structural risk. Understanding the incentives and strategic focus of each player in the deal is very important to know going into the investment. I was once involved in a JV agreement with another group. We had agreed to do certain things, and the partner was responsible for other things. The partnership encountered problems because our partner was not proficient in a few areas of responsibility; they were not generating the results we needed. I then took over their responsibilities and we ended up dissolving the agreement. It was a messy situation that could have been avoided if we had fully vetted their competence and ensured that our incentives were all properly aligned.

Asset Management & Property Management Risk

Poor asset management and property management can tank even the best property in the best market. There is always risk that the landlord and the property management team do not operate the property efficiently. The landlord and brokers they hire could do a poor job marketing and leasing the property. Poor management could result in deferred maintenance. Poor management could result in strained relationships with tenants and the local city officials. Property operations teams have a significant influence over the success of the investment, so be sure to invest with a company with the experience and competence to operate the asset such that it achieves it's full potential.

Environmental Risk

There could be any number of environmental risks associated with a property. It's important to obtain the necessary environmental reports and be comfortable with their findings before proceeding with an investment. Always be carful when looking at sites that are, or were, gas stations, factories, laundry or dry cleaning facilities and other uses that could contaminate the soil. Environmental risk can also come from land use and environmental protection concerns as well.

Entitlement Risk

Entitlement involves the potential risk that government agencies with jurisdiction over the property won't issue the necessary permits and approvals required to proceed with the project. This is typically associated with development or redevelopment projects, but can also be an issue for tenants seeking to get the permits and approvals they need for their use and their build out.

Inflation Risk

We've been in a low inflation world for an extended period of time, but there is always risk that increased inflation will occur. This is could be particularly damaging if inflation exceeds the rental increases in leases. For example, if a tenant has a 10 year lease and four 5-year options (meaning they can tie up the space/building for 30 years), and the rental rate increases by 2% every year, the owner of the property could be at great risk if inflation increases to 3% or more. The rental rate will quickly fall below market. If operating expenses increase with inflation, the property owner could be in major trouble.

Construction Risk

Anytime a property undergoes construction, whether that be ground up development or the repositioning or an existing asset, significant construction risk exists. If not managed effectively, projects can be delayed and come in way over budget. You always run the risk that the contractor does a poor job on the actual construction of the improvements, resulting in defects that cost a significant amount of time and money to repair.

Eminent Domain / Right of Way Risk

The government has the right to seize private property without the owner's consent. Of course the government is required to "properly" compensate the owner of the taking; however, that compensation does not rid a property owner of this risk. I've seen road improvement projects where the city adds a lane to a road which reduces the buildable/usable square footage of the property. This can negatively impact current tenants or the potential to redevelop the site. I've also seen the road expansion projects include a median which resulted in drivers being unable to access the property from the opposite side of the road. Always be sure to check with local government bodies to be aware of any potential taking that could impact the property.

Government Legislation/Regulation Risk

Government risk refers to any change in regulations that could negative impact the real estate. This could be changes to the zoning code, building codes, or access to public utilities. This could also be changes to tax rates. In the post-pandemic world, states and city governments are going to have to find ways to make up for lost revenue, which will likely result in increased tax rates. Be concerned not just about property taxes, but all taxes impacting tenants and consumers. You can see how increased tax rates and governmental intervention have caused people to flee states like California and New York--this can't be good for real estate.

Replacement Cost Risk

As lease rates go up in older properties, there comes a time when new construction becomes economically viable. This will cause developers to develop new product, which both increases the supply and creates new-build competition. These new developments could make your property obsolete. You will likely lose your tenants and/or new entrants to pretty new buildings. This will cause your occupancy and revenue to fall.

Functional Obsolescence

Functional obsolescence is defined as "the impairment of functional capacity of a property according to market tastes and standards". In other words, the design of the real estate is no longer attractive to potential users. Functional obsolescence is generally related to the age or look of the property. A few examples that I've come across in my career are office or retail properties with really low ceiling heights. Too little parking for office users can also make a property functionally obsolete. Industrial or warehouse properties with clear heights below 20 feet can be functionally obsolete for most users. Large format restaurant buildings (6,000 SF or more). Office buildings with minimal glass--companies want a lot of glass now. Properties without enough power (amperage) to meet the need's of today's companies. When acquiring properties, be sure that the design and structure is in alignment with current trends.

Economic Obsolescence

Economic obsolescence refers to the loss of value caused by factors external to the asset. This could be changes to the market, changes in traffic patterns, or the construction of public nuisance type projects. For example, a retail property could become economically obsolete if a new interstate exit is built. After the new exit is built, all of the retailers want to relocate to the new developments at that new intersection and your property is no longer of interest to tenants.

Another issue could be related to increasing levels of crime. I've also seen properties face economic obsolescence when the property was annexed by another city which had a negative impact on the schools and increased property taxes.

I've also seen, in many small towns across America, where Walmart will cause the entire retail trade area the relocate from the old downtown area to the area immediately adjacent to the Walmart (typically near the interstate). This could leave many properties in the older area economically obsolete.

Black Swan Events

Pandemics, wars, natural disasters (earthquake, hurricane, tornado, fire, terrorism, etc.). Clearly, we will be more cognizant of these potential issues after living through the COVID-19 pandemic.

Technological Innovation

Can technological innovation disrupt the demand for the property? If so, this could pose a technological risk. For example, as e-commerce becomes more prevalent, the need for physical retail space is in decline.

As you can see, investment real estate comes with a whole host of risks. No investment is completely immune to risks and some face substantially more risks than others. This is why commercial real estate returns are generally much greater than the risk free rate of return. Be sure to consider these risks, and others, when purchasing a real estate investment.

The “cap rate” is probably the most widely used metric in commercial real estate. It’s a metric that I refer to almost every day when describing or evaluating an investment opportunity. In short, a cap rate is the unlevered annualized rate of return of an investment. In other words, a cap rate is the yield one would make on a given investment assuming that it was an all-cash purchase.

Recently I was in a meeting with a bunch of real estate guys and gals. Some were analysts and some were executives with Ivy League MBA's. We discussed and debated the theory behind discount rates and cap rates. It ended up being an interesting conversation about how these two metrics are thought about both academically and in practice. This post is on the role of cap rates in CRE.

The simple equation below indicates how a cap rate is calculated:

Cap Rate = NOI / Purchase Price

or

Purchase Price = NOI / Cap Rate

The cap rate formula is simple and straightforward way to evaluate the pricing of a given asset. You take your net operating income and divide it by the purchase price, and you have the cap rate. The formula can also be used to determine how much you would be willing to pay for an asset. Let’s say you know the going rate for a particular asset is a 7-cap, then you can compare that to the subject cap rate to determine if it is priced relatively high or low.

Quick cap rate example

Let's say a property has an annual NOI of $100,000 and the market cap rate for this type of property is 5%. This means that the value of the property is approximately $2,000,000 ($100,000 divided by 5% = $2,000,000).

High cap rate or low cap rate . . . Which is better?

A relatively low cap rate equals a relatively high purchase price. Conversely, a relatively high cap rate means the purchase price is relatively low. Therefore, buyers seek after high cap rates, and sellers desire low cap rates (high prices). Cap rates tend to be between 5-10% these days. At the time of this post (July 2019) cap rates are at or near historic lows. Take a look at the below graph to see where cap rates were toward the end of 2018..

What influences Cap Rates

Risk free rate (10-year U.S. Treasury Bond)	Cap rates generally move with the risk free rate. But, changes to the cap rate tend to lag behind changes to the risk free rate
Availability of debt	Greater availability of debt decreases cap rates as more buyers will compete to buy property
Health of real estate market	Strong markets result in downward pressure on cap rates
Property type	Riskier properties trade at higher cap rates
Rent roll (quality of tenants, lease terms, etc.)	Tenant credit plays a large factor, particularly single-tenant assets
Location, trade area, site characteristics

Gordon Growth Model: getting real nerdy

The Gordon Growth Model provides a more accurate and slightly more complex cap rate formula. In my many years in this business, however, I’ve never heard someone refer to the Gordon Growth Model when describing the cap rate. So, on a practical level, you don’t need to know this. However, it does provide some additional color as to how cap rates are determined and what factors influence them. If you’re a finance guy or gal, you’ve probably heard of the Gordon Growth Model. And as you may already know, the model is used to determine the intrinsic value of a stock based on a series of dividends that grow at a constant rate. The formula is:

P = CF / k-g

Where: P = Price, k = discount rate; g = constant growth rate; and CF = cash flow

Real property can be valued using the same methodology. When cap rates are broken down, it’s easy to see that they are determined by a combination of two variables: The discount rate and the growth rate of income. When converting this to real estate terminology we produce the following equation:

Purchase Price = NOI / (Property Discount Rate – NOI Growth Rate)

Cap Rate = Discount Rate – Growth Rate of Income

We can use this formula in the following way. Let's say we have a building with annual NOI of $100,000 and we expect NOI to increase by 2% annually. We can determine the cap rate by taking our discount rate and subtracting 2%. For simplicity, let's assume our discount rate is 10% because that is our required rate of return. The cap rate would be 10% – 2% or 8%. Therefore, the value of the property is $1,250,000 [$100,000 / (10%-2%)].

When to use a Discounted Cash Flow Analysis instead of relying on the Cap Rate

Generally you can think of a cap rate as a back of the envelop metric used to quickly asses the potential yield of a real estate investment. Therefore, sophisticated investors rely on a discounted cash flow analysis to take a deeper dive into the return characteristics of the investment. You will always want to rely on DCF analysis when the property’s income stream is unstable. If the property’s income stream will deviate significantly from one year to the next, you don’t want to make an investment decision based on the cap rate. You’ll need to use DCF. Cap rates are particularly useful when evaluating single tenant net leased properties because they behave like bonds.

Income Multiple vs. Cap Rate

For those of you who have a background analyzing the value of businesses know that businesses trade at a multiple of the company’s earnings. A cap rate is essentially the inverse of an income multiple. To determine the multiple of a particular investment, divide 1 by the cap rate. For example, if a property’s cap rate is 7%, the earnings multiple would be 14.3x (1/7% = 14.3x).

I'm an asset manager for a small real estate private equity company. In this post I'm going to break down what a typical day looks like. You may think that I tried to exaggerate the number of different tasks I'm involved in in a single day, but this really is what a typical day looks like. Of course, if you work for a larger firm with many verticals within each department, then this would not be typical. When I worked for a large publicly traded REIT, my day was much more focused – I performed a lot of the same tasks over and over again. The larger the company the more specialized your work will be. I won't delve into the pros and cons of working for small and large companies on this post, but I do want to make the distinction that the types or responsibilities you'll have as an asset manager can vary widely from one organization to another.

Currently I oversee over 1MM SF of retail and industrial assets in the Western US. OK, here we go.

8:00 AM: I usually get into the office around 8am. However, several times per week I get in between 7-7:30am in order to get things done before the day heats up. I generally spend the first 10 minutes reviewing what I need to accomplish that day, going over my calendar, and setting my goals. I try to identify the two or three highest priorities of each day. After that I usually spend a few minutes responding to emails that came in the night before that need a timely response. They I try to tackle my highest priority objective for the day before the phone starts ringing and meetings begin. This could be anything from reading through a lease, a letter of intent, responding to an attorney, preparing for a meeting, reviewing property-level financials, or running a financial analysis on a transaction.

9:00 AM: Leasing Meeting With Brokers: As an asset manager, I oversee all of our leasing teams (in my portfolio). I hire a third-party brokerage company to handle the leasing for our assets. I have one or two calls with brokers each day. On this day, I have a call with a leasing team that lists three properties for us in one of our key markets. We discuss the one pending lease we have, and the prospective tenants we have. I reviewed a potential deal before the call, so I give them direction in terms of how I want them to respond to the offer. Then we discuss their marketing initiatives and what they are seeing in the market.

9:30 AM: By now I have 20 emails. I go through them, and about 10 of them I need to respond to. One is from an attorney I'm working with on a lease. I review her suggested revisions and respond with my recommendations. Another email comes from a property manager. She would like to do some repairs and cosmetic work at one of our properties before the end of the year. I go into the budget and see if we budgeted for any of these items. There is some room there and I know that 4 of the 10 items on her list would make a big impact considering their cost (good ROI). I approve the 4 items that fit within the budget for the year. I then quickly respond to the rest before my 10 meeting.

10:00 AM: Today we have a meeting with the company leadership. We go over successes from the week prior, goals for the week and I give the executive committee an update on my portfolio. This includes new deals and opportunities, deals that closed last week, and updates on leasing activity, dispositions, construction, and other important issues regarding my portfolio. On this call I find out that our acquisitions guy has found a deal in one of the markets I cover.

10:45 AM: The meeting is over and I’m curious to get more info on this potential acquisition. It is my job to do some of the initial research and provide MLA’s (leasing assumptions) to our financial analyst who will run the Argus model. I read the OM, take a look at the trade area, and do a quick SWOT analysis based on what I know. I write down key issues and questions that need to be answered. Then I call a broker I have a relationship with in that market. I tell him we are going to potentially take a run at this deal and that I’m trying to gather info on it. He’s familiar with the asset and the ownership group, so the call was worthwhile. I then go through the rent roll and make some preliminary assumptions; then I send these to our financial analyst to get a back of the envelope picture of whether we want to pursue this deal.

11:30 AM: Interview a candidate for the accounting department. As an asset manager, I work with just about every internal team on a consistent basis. As a result, we are generally brought in to interview potential candidates for just about every position within the company. I’m part of a panel interviewing this person for the role.

12:30 PM: Lunch. I usually bring leftovers to work. Its fast and generally more healthy than going out. I heat it up and head to the third floor terrace where I can site out side and get some fresh air and sunlight.

1:00 PM: I have 30 new emails. I try to get though these as quickly as I can so that I can get to my work. One jumps out because its an offer on a property I have listed for sale. We pursued a break up strategy on this asset. In other words, we bought a large shopping center, split the property into numerous parcels, and are in the process of selling those individuals buildings/parcels. This offer came in on a retail building that is about 30,000 SF and has about 10 tenants. I read through the offer and mark up the LOI. Then I call the broker listing the asset for me and gather more info about the prospective buyer and how to formulate a counter proposal. I run a quick financial analysis to see where I need to be to make this pencil. Then I run across the hall to talk to my boss about the deal. I propose my counter and talk her through how I arrived at it. She is in agreement. So I send out and LOI to the broker to forward to the prospective buyer.

2:00 PM: Conference call with JV Partner. We entered into a partnership with another operator on one of our deals. Once per week we jump on a call to discuss operations, leasing, construction, and any other issues that need to be discussed regarding the asset. Today, we need to discuss a legal matter so we conference in our outside counsel to discuss the issue. I then gave the team direction as to how to proceed in regards to that legal issue.

3:00 PM: I have an hour before my next meeting. It's budgeting season so I open up one of my property's budget. I need to review the inputs made by our property management team in regards to operating expenses and CapEx for the upcoming year. I see that they are projecting significantly higher costs for 2020 for certain line items and lower costs for other line items. I put together a list of questions I need to ask property management as its my job to manage the budget and keep costs down so that we can meet our FFO targets. I gather my questions and set up a meeting with the property manager.

4:00 PM: Meeting with Construction Management team. Once a week I hold a call with a third-party construction management team. They manage all construction related issues regarding a lifestyle center in my portfolio. We bought this asset because it was priced well below replacement cost and because a ton of value could be created as the former owner didn’t give it the attention it needed. We are completing a multi-million dollar renovation. On top of that, we have six or seven tenants that are in the middle of their respective build outs. We talk about the progress being made on the capital improvements (monument signs, shade structures, splash pad, new lighting, paint, etc.) as well as the status of the tenants build outs and their permits and approvals. There are some hiccups, as always, but we’ve put in place a strategy and made decisions about how we are going to proceed.

4:45 PM: Meeting with Associate: I have an associate on my team and he is responsible for handling a lot of the financial analysis, lease renewals, research, etc. I spend more of my time managing people and deal making and I need him to manage those things that I don’t have time to handle. We meet periodically throughout each day, as I have an open door policy and we are teammates. Today we talk about a few renewals he is working on and how we get these renewals over the goal line. After we strategize about renewals, we talk about a few accounting issues and some research he is performing. We set objectives and goals for tomorrow.

5:00 PM: Usually by 5 PM things are slowing down. There are no more meetings and hopefully no more calls. I try not to leave the office after 6 PM – because I try to get home to have dinner with my wife and see my baby before he goes to sleep. I spend the first part of the hour catching up on emails and chatting with some of the folks in the office.

I’m working on a build-to-suit at on of our properties. One of or tenants, currently located on an endcap, wants a standalone building with a drive-thru. Fortunately, we have more parking than we need and some space in front of one of the anchors. So I spend some time putting together a financial model based on the projected development costs, entitlement costs, and the costs to pay off our anchor tenants in order to do the development (we need a waiver from them since they their leases restrict this kind of development). After that, I run home to see my family.

There it is – a typical day for me as an asset manager. I enjoy the variety of different things I get to work on each day. Although this is a typical day, each day is different. Each day is also unpredictable because unexpected challenges and opportunities present each day.

As an asset manager, you have to be a generalist. You have to be someone who can wear many hats. You have to be comfortable making decisions, managing people, and dealing with a high level of stress. Since you are the CEO of your assets, you have to know them inside out, and give direction to all the people that work on those assets. You have to coordinate all of their efforts in order to maximize NOI. If you want to clock in, enjoy a comfortable and stress free day, then asset management is not for you. To thrive in this kind of work, you have to enjoy working under pressure, being very busy, and solving challenging problems. I hope this helps you better understand the role and life of an asset manager.

Thanks all for your comments.  @Aigo Pyles The data is national. I agree that it is tough to paint commercial real estate, or even a particular sector with one broad brush.  Each asset, trade area, market will perform differently - the purpose of the post is to share general trends and describe some of the macroeconomic forces at work. 

@Elise Bickel Tauber I agree with your thoughts on how to work with restaurant tenants by restructuring leases such that their rent is in whole or in part based on a percentage of sales. I would try to structure them such that there is a floor (maybe NNN's + 50% base rent or something like that). I would also push for deferral instead of abatement. I would agree to abatement only when you get something in return (e.g. extra term, co-tenancy waivers, no-build waivers, etc.)

@David Avery i'm curious to know about the office to residential conversions you are doing. I'm quite familiar with the Phoenix office market so I'd love to hear more.

Thanks, Victor - The stats came from a variety of sources. Most of it comes from what i've heard in conversation from other CRE professionals and from my own thoughts.

@Victor Ong

The CRE Carnage

This exogenous and unexpected shock to the economy has proven to be a devastating blow to some and a gut check to others. Seemingly strong businesses have buckled under the unprecedented economic conditions, a consequence of stay-at-home orders and social distancing. Many businesses, which were slowly nearing the end of their life cycle, have been pushed toward bankruptcy (JC Penny, J Crew, Chesapeake Energy, Brooks brothers, Lord & Taylor, 24 Hour Fitness, Gold’s Gym, Hertz, Aldo, Cirque du Soleil, CMX Cinemas, etc.). In February, the economy was humming along with record low unemployment rates. A few months later, the US had the highest unemployment rate since the Great Depression. Besides grocery stores, shopping centers are nearly empty and many businesses remain closed. Office buildings are no different.

Education, healthcare, and real estate are the three industries likely to be most affected by the pandemic. For decades, these mature industries have resisted change and the adoption of technology and innovation. COVID-19 just rocked the boat. These industries now recognize that they need to change, they need to be more adaptable, and they need to embrace technology. We have been hit hard, but a healthy byproduct will be change. Change for the better. And change that I’m excited to be part of.

There are a lot of questions that we as CRE professionals are asking right now. For example, will local restaurants and retail businesses make it? How many more businesses will fail? How many office employees will work remotely moving forward? Are people going to flee from gateway cities and head for more affordable parts of the country? Will people ditch the apartment/condo and head for a big house in the suburbs? Will we have to practice social distancing and wear masks forever? What's going to happen to business travel and conventions? Will we ever go to ICSC again?

In my opinion, a form of some of these trends will likely stick. For example, more office workers will have the option to work remotely either fulltime, or have the flexibility to work from home a few days a week. The emphasis on safety and sanitation is here to stay; people will continue to be cognizant of these issues and landlords will have to invest more in health and safety products. I think we will see a small shift from the urban core to the suburbs, but I think this is more an acceleration of an existing trend. I think that more people will try to move out of the gateway/overpriced cities like New York, Los Angeles, San Francisco, Seattle, Washington DC, Boston, Philadelphia and head for more affordable states like Texas, Idaho, Florida, The Carolinas, and other sunbelt destinations.

This idea that we will continue to stay locked up indefinitely is faulty. At the end of the day we are social creatures. We thrive on human connection and interaction. Once we develop a vaccine, or highly effective therapeutics, we will go back to being social creatures. Now that I’ve got that out of the way, let’s talk about how all this is impacting the commercial real estate space.

As with any major economic shock, there are winners and losers. In the wake of COVID-19, hospitality and retail are hurting more than other property sectors. Data centers, self storage, industrial and distribution centers on the other hand, are emerging victorious.

COVID-19’s Impact on Tenants

Most important is the impact of the pandemic on our customers, our tenants. Things were humming along as usual, and out of nowhere, many tenants (particularly retailers) found themselves closed and without customers. It’s a challenge no one was prepared for. During every other recession we have seen in our lifetime, businesses struggled but they continued operations and continued to generate revenue. This time, many tenant’s revenues fell to zero in a matter of days. Clearly, brick and mortar retail tenants have been hit the hardest, while many technology companies have seen increased sales (Amazon, Facebook, Zoom, etc.). On the residential side, more renters are now unemployed than at any point in time since the Great Depression. Propped up by generous unemployment checks, the vast majority of renters have paid. It will be interesting to see if they keep paying when the transfer payments go away.

COVID-19’s Impact on Landlords

When tenants feel pain, they make sure their landlords feel pain as well. The majority of retail tenants told their landlords, either through their attorneys or CFO’s, that they cannot pay rent. The notion that tenants have to make their contractual rent payments appears to have gone by the wayside. Some tenants, despite strong balance sheets and the ability to make their rental obligations, have taken an opportunistic approach and demanded rent relief from landlords. They have taken an unprecedented position, one that we’ve never seen before, by simply stating that they would not pay rent. Has a company like Starbucks ever sent a letter to all of the landlords stating that they need help for the next year – I don’t think so. There hasn’t been a single time in recent history where thousands of companies simply decided they were going to effectively breach their lease agreements and avoid paying rent. Very little bothers a landlord more than a tenant, who can by all means make their rent payments, who seeks rent abatement just because they think they have the upper hand.

I’ve seen a new era in the landlord-tenant relationship. Unfortunately for landlords, tenants have appeared to gain ground and obtain a larger sense of control. Despite what the contract says, tenants have been able to bully their landlords into providing them with rent deferment, and in many cases, rent abatement. Tenants are currently in the drivers seat because they think that landlords are not in a position to boot them out. Most landlords would prefer to let a tenant limp along than be left with an empty space. Eventually these conditions will change and landlords will be able to exert more leverage, but until that time, tenants will continue to demand concessions whether they really need them or not.

The Pandemic’s Impact on Property Values

Property values dropped precipitously in April and May. The all-property price index is down 11% from pre-COVID levels. An 11% drop in CRE values in just a few weeks is astounding. I'll break down each asset class below, starting with the largest drop in values since the onset of the pandemic:

• Hospitality: -25%
• Mall: -20%
• Retail: -15%
• Student Housing: -14%
• Apartments: -10%
• Net Lease: -8%
• Office: -7%
• Health Care: -7%
• Self-Storage: -5%
• Industrial: -5%

The above numbers are not surprising. Travel came to a halt and likely won't recover for several more years. Malls have been mostly closed for months. Restaurants, apparel, gyms, theaters, and other retailers have been forces to close or reduce operations. College students may not go back to campus in the fall and many apartment renters who are employed in the service sector and retail sectors are now unemployed. Office workers have ditched the cube for their living rooms. Routine, elective, and many semi-urgent medical procedures have been put on pause. Clearly these changes in the economy are reflected in CRE property values. I'll dive into each of the main food groups below.

Hospitality

The pandemic has hit the hospitality sector harder than any other. The pandemic caused business travel and tourism to come to a screeching halt. Remit Consulting suggest that occupancy fell from 70% in early March to a low of 15% in early April. This immediate and profound drop is devastating for most operators. Fortunately, after bottoming out in April, occupancy has since increased to over 40%. Unfortunately, 40% occupancy is not enough to get out of the red as the breakeven point requires significantly better occupancy. This is why you’ve seen so many hotels completely shut down for the time being.

This is the most challenging asset to price today because there is so much uncertainty. Several prominent CRE research firms indicated that they believe prices have fallen about 25% this year. Drive-to resorts are doing much better than fly-to resorts. A few of the drive-to destinations that are performing relatively well are Florida, Hilton Head, and Sedona. Hotels that rely more heavily on business travel are going to struggle much more than drive-to destinations. Business travel likely won't return until next spring, and possibly later if there is no vaccine.

The experts have projected that demand for hotels will return to 2019 levels in 2023. One resource indicated that up to 20,000 hotel units in New York will permanently close. With such a protracted drop in demand, many operators will be forced to call it quits. I believe we will see a very meaningful number of hotels shut down for good.

I would only buy hotel properties that have a clear traffic driver and strong supply-demand characteristics. Hotels next to conference centers with a ton of nearby competition are destined to struggle, if not fail. Conferences will likely be permanently impacted by COVID-19 and the golden age of business travel has clearly passed. Businesses have found that spending all that time and money on travel did not have a profound impact on sales; therefore, companies will likely cut back on their travel budgets indefinitely.

On the other hand, a hotel with limited competition in a growing area and next to an expanding hospital or other driver may make sense.

An opportunity to keep an eye on, or consider if you have the skill set, is the conversion of hospitality product into affordable housing or multifamily. We will likely see a lot of distressed properties (B and C quality) coming to market at well below replacement cost pricing. Real estate entrepreneurs with entitlement and redevelopment expertise may be able to swoop in and buy these heavily discounted assets. They will then be able to reposition the property for the needs of the community, which will likely be multifamily or affordable housing.

Retail

Retail has been temporarily crushed by COVID-19. Much of what I stated above, about tenants refusing to pay rent, was in reference to the retail sector. Collections for shopping centers was around 50% in April but has steadily increased as businesses have reopened. Shopping center collections increased from 61% in June to almost 70% in July–still terrible and unsustainable figures. PPP funds helped, as recipients of those loans must use a portion of the loan proceeds toward rent. With COVID-19 cases on the rise, restrictions have been reinstated in many parts of the country. This has forced some businesses to shut down a second time. If these conditions continue, we will see many more “For Lease” signs in spaces recently occupied by restaurants, nail salons, theaters, gyms, dry cleaners, or apparel stores. Retail spending dropped precipitously in March and has stayed well below average since. Retailers only have so much time before they run out of liquidity and can no longer pay their debtors.

Retail will continue to face significant headwinds. As I’ve pointed out in other articles, the US is over-retailed. We have built way too many strip centers, power centers, and regional malls. Much of it needs to go away. McKinsey estimates that a third of the 1,100 malls in the U.S. could end up being demolished. Some of it can be repurposed as it is well located, but much of it needs to be scraped. Class-A properties in well-located areas with strong demographics and quality e-commerce resistant tenants will once again thrive in the post-pandemic world. Properties in rural, poorly located areas, can safely assume their best days are behind them.

I would also stick to grocery-anchored centers, not just because they’ve performed well during the pandemic, but because they are poised to continue performing well. Grocery will continue to be e-commerce resistant because of the prohibitive economics of grocery delivery. In short, nobody can make online delivery in the grocery space pencil. It’s great for the consumer, but it won’t take hold because the provider will always lose a significant amount of money on each transaction.

As a result, capital has stopped flowing to retail. CMBS has dried up. All deals that would have closed after March have been put on pause. Uncertainty around rent rolls and caution among lenders are the primary drivers of the pause on transactions. With so many tenants paying partial or no rent, how do you determine a property's true NOI? With so many tenants running out of cash and/or being artificially propped up with government stimulus monies, how do we know who's here to say and who's not? For those reasons, transactions are at a standstill. Transaction volume won't recover until after we have a vaccine and things begin to normalize. Cap rates will likely expand because most institutional investors will want to reduce their exposure to this sector.

The Darwinian nature of retail has presented itself once again. Retail trends that were present pre-COVID will only accelerate. Many tenants will fail and we will see another big wave of retail bankruptcies. Retail has always seemed to evolve and remain healthy. In the past, when one retailer failed, it seemed that new retailers with more relevant business models took their place. In many sectors, I don’t see that happening this time. This disruption is different because it is effectively accelerating trends that would have taken years to play out. I don’t see retail recovering like it has after past disruptions. I don’t see new entrants backfilling all of the spaces left behind by those who succumb to the COVID-19 economy. This time, much of the vacancy will not be absorbed, except in A-quality locations. I think we’ve hit a tipping point and I don’t see retail fully recovering. The overbuilding of retail over the last 50 years has ended its run.

Regional malls with dark anchors will need to be repurposed; big boxes will need to be converted into last-mile distribution centers, entertainment uses, or redeveloped into housing. Derelict shopping centers must be torn down to make way for multifamily and townhome developments. In-line retail space needs to be retrofitted into urgent care centers, radiology centers, or dialysis clinics. Well-located retail, on heavily trafficked thoroughfares, need to be repositioned such that they can accommodate drive-thru operators.

On a positive note, there will be great opportunities in retail. When capital leaves, prices go down. Capital is leaving and prices will go down. There will likely be many distressed retail assets in 2021-2022. Some will be very cheap, but don’t just buy retail because it is cheap. Only buy good real estate. Location, location, location will be more and more important to tenants. National tenants don’t care how cheap the rent is; they care about being in the best location in a given market and trade area. If a property is not in a prime location, I would stay away from it unless it can be repurposed. Don’t be fooled into buying low-quality properties because they are cheap. With additional vacancy hitting the market, tenants will be able to locate where they want; if you aren’t where they want to be located, then you’ll struggle.

Student Housing

This product type will face major short-term challenges and likely long-term difficulties as well. COVID-19 has upended our higher education system in many ways. Most challenging for the student housing sector, is that many students will be doing their coursework online this fall. Most universities are allowing a portion of the student body to attend in-person classes, but it appears that the vast majority of students will be taking their courses online, likely from their childhood bedroom to save on cost. A return to normal won’t occur until after a vaccine, and even then it likely will not return to pre-pandemic levels.

The trend toward online and lower-priced options has, and will continue to accelerate due to the pandemic. The Kahn academy, Udemy, Coursera and online courses from traditional universities will steal more market share and lead to lower on-campus enrollment numbers. Several liberal arts colleges have already filed for bankruptcy or announced that they will be closing their doors. This shift will cause demand for off-campus housing to drop. I would be very cautious about making investments in student housing. It is too early to tell how this sector will perform, even after a vaccine is produced. I would be very careful about housing near any second-tier university with declining enrollment. The student housing radius surrounding the campus is likely to shrink; therefore, I would be extremely cautious about Class A product that is not walkable.

Office

We benefit from interaction, sharing ideas, bumping into one another, and meeting in person. I think we’ve all come to dislike Zoom meetings and would prefer to meet with colleagues in person. However, most office workers have come to realize that they are productive and happy working from home. I don’t see a shift to full-time remote working for the vast majority of us. I believe that we would all prefer a hybrid approach: working 2-4 days per week from the office and one or more days from home. Having worked from home for several months I have come to realize two things: 1) I can’t imagine never going into an office; and 2) I can’t imaging spending 10 hours a day, five days a week, in the office/car. I don’t want to be away from my family that much, and I don’t think it is necessary. I think a hybrid approach will likely become the new norm.

Office will likely struggle for the foreseeable future, particularly in areas that are over supplied. The effects will not be immediate, but as leases rollover over the next several years, we may see a dip in overall demand for office space. Prior to COVID-19 we saw an increase in demand for suburban office, I think this will continue as sprawl will likely accelerate and people will want to work closer to home.

Office is interesting because we will likely see two opposing trends. We will see a significant increase in remote work. At the same time, social distancing measures will be taken to reduce the potential spread of illnesses in offices. Shoulder-to-shoulder arrangements and dense cube farms will have to be dismantled and replaced with larger cubes or more private offices. This 10-year trend toward more office density (fewer square feet per user) will start to head in the opposite direction (more square feet per office worker). The net effect of these two trends remains to be seen; however, I think that the net effect will result in a decrease in demand for office space.

Multifamily

Thus far into the pandemic, equity capital has been most interested in apartments, industrial, and life science. Apartment values have declined by approximately 5-10%. I don’t expect much distress in this asset class. Since there remains a lot of capital chasing US commercial real estate, multifamily will not see major declines in value because it is still a very sought after asset class. From what I’ve seen thus far, industrial and distribution top the list of preferred property types followed by multifamily.

Certain multifamily properties will likely face headwinds. I have concerns about properties that were bought when things became very frothy at the peak of the market. Overleveraged properties may be in trouble if delinquencies rise, vacancy increases, and rents fall. Properties with near-term debt maturities could face challenges as NOI could be below underwriting. I've spoken to a few operators who are able to find financing in today's environment; however, access to capital is still a question mark moving forward.

We will likely see the acceleration of millennials moving into single family detached homes in the suburbs. We will likely see a slowdown of baby boomers downsizing and relocating to more urban areas. The shift in these two trends will likely have a small impact on demand. Overall, the supply-demand fundamentals in most markets are still favorable. I would also suggest that developers consider larger floor plans that have some sort of office component, since more people will be working from home.

Industrial

Despite a slight drop in values due to the pandemic, industrial real estate remains healthy. The pandemic will only accelerate industrial’s desirability as retail, hospitality, and office face long-term challenges. The pandemic has changed the way we shop; more money is being spent online than before COVID which results in higher demand for the industrial/warehouse sector. I’ve already heard a number of institutional investors suggest that they want to de-risk and allocate more capital to industrial and warehouse. I anticipate strong demand for industrial, low cap rates, and a strong development pipeline; both infill, as last-delivery becomes increasingly important, and in traditional industrial hubs.

Also, given the shock to supply chains during COVID (think toilet paper), companies may decide to diversify their supply sources or build up the “buffer stock” to quickly meet demand surges. That would increase demand for industrial/warehouse space. In short, I feel that industrial will quickly recover from this hiccup and emerge as the darling of the commercial real estate sector.

Despite all of my rosy remarks above, I do have a few concerns about industrial. Anytime there is a recession or downturn, imports and exports decline. A decline in imports and exports results in a decrease in demand for industrial and warehouse space near ports and airports. This is the one area of the industrial market that could face short-term challenges.

A Quick Word on Debt

Fortunately banks and other lenders are better prepared for this crisis than they were during the great recession. The shutdown has made it difficult for tenants to pay their rent; which results in landlord’s being unable to make their debt service payments. Forbearance requests and elevated risk of mortgage defaults is the hot topic of the day. It remains to be seen how much forbearance will be necessary and if lenders will decide to take back the keys–at this point lenders have no interest in taking back the keys so they have largely been flexible as it relates to forbearance.

A Few Things to Consider when Underwriting New Deals

There are two obvious challenges that those of us on the investment and asset management side of the business will face in the coming years. Because city and state budgets got upended by the virus, they will have to make up for the decrease in revenue, and increase in expenses. Unlike the federal government, state and local government’s have some incentive to be at or near a balanced budget. This will surely come in the form of higher property taxes. Therefore, as you underwrite potential acquisitions, I suggest inflating property taxes because they will surely go up. Insurance costs will likely go up as well. The cost of property and other forms of insurance have been rising steadily for many years. The COVID-19 pandemic will only add to that trend. Therefore, just like with taxes, I suggest you plan for increased insurance premiums as you are underwriting new deals.

Be Grateful for the Masters Degree

There is no doubt that this has been a difficult time for most of us in the CRE space. Many CRE employees have lost their jobs or been furloughed. Many investors are worried about losing their properties or not having the liquidity to make it out of the crisis. Many real estate directors on the tenant side have lost their jobs or taken a pay cut. Folks on the professional services side, like brokers, architects, and other consultants are struggling to find business and do deals. It's a tough time to say the least.

However, I would encourage you to consider this experience a masters degree in real estate. I won’t call it a free masters degree, because it has come at a cost, but what we’ve learned through this crisis is invaluable. I would argue that what we’ve experienced, and what those of us in the thick of it have learned, is not something a textbook or course could ever replicate. Nobody was predicating a crisis like this. Nobody had a game plan, and no textbook or course prepared us for the challenges we are overcoming. The things we have learned over the last several months will benefit us for the rest of our careers. I encourage you to write down what you’ve learned so that you can use it as a reference next time.

Investment Opportunities

The pandemic and the resulting economic collapse will lead to huge opportunities in the commercial real estate space. Keep in mind the following:

It’s hard to say where those opportunities are, since we are midway through this crisis (I think, but who knows). Forbearance by lenders has kept many properties from going back to the bank. However, this may change after the election and into 2021. We will likely see a wave of defaults and distressed assets hit the market. All I know is that there will be opportunities to pick up properties at very good prices.

When considering an investment strategy, go where capital isn’t yet, so you can sell to them. In other words, figure out where you think capital will be allocated in a few years, and buy those assets today. When the demand for those assets increases, so will the value.

Final Thoughts

As I mentioned at the beginning of this article, commercial real estate is one of three major industries that will be significantly impacted by COVID-19 (healthcare and education are the others). Change and disruption mean opportunity for those that embrace it and seek to innovate. For those of us who are experienced, yet still relatively young, we have been handed an opportunity to grow and advance. I anticipate many senior positions will be filled by young, yet seasoned (30 somethings), CRE professionals who will bring new strategies and ideas to the table. My advice is to continue to educate yourself, to think strategically, to come up with new ideas and consider new approaches to solving problems (even if they may be crazy). These qualities will drive you to success and prepare you to be a leader in this ever-changing industry.