Making financial predictions about the commercial real estate (CRE) market can seem like a mysterious art, especially during periods of economic uncertainty. If you are fortunate enough to have a seasoned sponsor or co-investor with deep pockets, money may be no object. Under more typical circumstances, however, you’ll want to gauge your investment options against their relative risks and advantages and do the necessary due diligence to deploy capital resources into the right fund or asset for your situation.
A variety of economic, strategic, sociological, and political factors influence capital flow in the CRE market. These factors can also influence each other in complex ways that in turn affect capital flow positively or negatively.
Why should you care about these various factors? As this article will explain, they can serve as powerful indicators to help you determine how, when, and where to deploy capital in the CRE market.
Interest rates operate as a primary driver of borrowing costs, cash supply, and property values, through an intricate chain of cause and effect. The Federal Reserve’s benchmark interest rate serves as the basis for several financial indices, including the prime rate and mortgage interest rate.
A lower benchmark rate results in lower interest rates for mortgages. This makes the cost of loans lower and more attractive to borrowers, stimulating cash flow. In addition, the CRE market enjoys an increased supply of capital available for deployment into new investments and developments. The demand for CRE assets increases, which consequently drives up property values.
Conversely, when the Fed’s benchmark rate rises, lending rates follow suit. The higher cost of mortgages discourages borrowers from seeking loans, causing a decrease in the overall supply of cash and a slowdown in capital flow. Those who do enter the market will find that lenders require lower loan-to-value (LTV) ratios in an environment of tight capital supply, translating to less cash leverage for borrowers. Investors feel less inclined to pursue CRE targets, which produces a perceived increase in the supply of real assets relative to demand. As a result, property values drop.
Capital Deployment Strategies in Commercial Real Estate Funds
When determining their optimal asset allocation, CRE fund managers pay close attention to interest rates along with a host of other factors. These deployment strategies can offer valuable glimpses into the instincts and thought processes of expert investment managers as they decide where and when to place capital bets on the CRE market.
Deployment Strategies for Private Equity Funds
CRE equity funds draw investors with the promise of income combined with asset appreciation, especially during an extended bull-market run.
It’s no surprise then, that private equity firms during the past several years gravitated towards protective, mature-market strategies as they braced for an eventual end to the longest economic expansion in US history. None, of course, could have predicted the black swan event of the COVID-19 pandemic, which has upended daily lives and the market in the early part of 2020 (more on this later).
Still, equity fund managers have been assuming a defensive posture even before the coronavirus crisis. Here are some of the ways that private equity firms have sought to optimize capital deployment and protect their holdings.
The year 2019 saw a marked increase in the amount of investment “dry powder” composed of cash reserves and highly liquid securities such as Treasury notes.
This development signifies that equity firms are prepared to face economic headwinds but also stand ready to deploy capital into select assets as needed.
Some fund managers have been judiciously hedging against anticipated price swings in the CRE market by diversifying their portfolios into areas like credit, infrastructure, and growth holdings.
Cycle-Resilient Asset Classes
Other firms have balanced their risk profile by shifting deployments to asset holdings whose valuations should prove more resilient to market turbulence. The relative stability of workforce housing, senior residences and medical offices appeals to fund managers looking to weather a downturn.
The big equity firms continue to dominate Class A holdings in gateway cities like San Francisco and New York City. This saturation of investment activity in premium markets opens the door for smaller and mid-sized firms to extend their reach into new mid-market assets in fast-growing secondary and tertiary metros like Denver, Salt Lake City, and Nashville.
Deployment Strategies for Debt Funds and Direct Debt Lenders
In contrast with the equity end of the capital stack, CRE private debt funds offer investors a consistent stream of income during economic times both thick and thin. Here are a few recent trends that have driven capital flow into CRE credit instruments.
Advantages in a Mature Market
As the global economy has cooled amid tariff disputes and trade negotiations, investors have been preparing defensively for a future where asset appreciation rates also slow down. Debt funds and commercial mortgage-backed securities (CMBS) don’t rely on future price appreciation for their attractive yields of current income.
Pensions, insurance companies, and sovereign wealth entities form a sampling of the institutional investors that have gravitated to debt funds as a strategy for offsetting their more volatile equity holdings.
Low Rates, Steady Yields
Low interest rates have continued to make mortgages and other CRE debt instruments attractive to borrowers, ensuring a steady income for fund shareholders. The higher returns of CRE debt funds as compared with traditional fixed-income vehicles have also drawn more investors in search of yield. Finally, these investors can rest on the security of an instrument backed by the solid collateral of real property assets.
The past few years have seen a shift towards open-end debt funds, as late-cycle investors recognize the value of instruments that offer greater flexibility and opportunities for diversification.
Demographic Influences on Commercial Real Estate
Real assets are built to be used and occupied by people. So when certain segments of the population go through significant life changes, you can expect to see shifts in demand for CRE asset classes, along with corresponding shifts in the direction of capital flow.
In the US, investors and capital providers should pay close attention to two trending demographics: baby boomers and millennials.
Boomers in Retirement
With a population of 73 million, all baby boomers will reach age 65 by the year 2030, opening up a vast future market for senior housing and assisted living facilities. Exciting new opportunities await investors and developers with the capital and creativity to reimagine retirement communities for a generation shaped by television, Motown, rock & roll, and yoga.
Millennials in Their Peak Years
At 90 million strong, millennials represent a rising demographic of young adults entering their prime working and spending years. Coming of age in a world of digital connectivity and the sharing economy, this generation is redefining the CRE market across multiple asset classes.
Many millennials continue to carry tuition debt and are electing to delay marriage and starting a family. As a result, apartment complexes that offer the best of urban amenities (proximity to retail stores, restaurants, and transit) and suburban convenience (spacious living quarters and parking garages) promise to draw renters from this generation for years to come.
CRE developers are learning to cater to the job preferences and culture of millennials, who favor flexible office space environments tailored for co-working, with dedicated zones in the parking lot for rideshare pickups and drop-offs.
Industrial and Retail
As a generation of consumers who expect to move seamlessly between the modes of digital browsing, online fulfillment, and brick-and-mortar service, millennials increasingly influence how warehouses and retail buildings are constructed to support Omni channel shopping experiences.
Government Policies That Impact Commercial Real Estate
Even in a free market, the government can intervene on occasion or on a regular basis to help stimulate capital flow in the real estate sector. The US government, for example, spends an estimated $450 billion annually on real estate programs.
Here are a few of the US policies and programs that impact the CRE sector.
Small Business Administration (SBA) Loans
SBA loans constitute the largest government-sponsored lending program for CRE development. Eligible small businesses can qualify to borrow up to $5.5 million for real estate expenses below market rate.
Commercial Real Estate Depreciation Program
This is a federal tax expenditure program that allows CRE owners to claim the decreased value of their building assets as an annual deduction. With the tax savings, owners can deploy more capital to projects such as building renovations or new acquisitions.
Government Response to COVID-19
The sweeping shelter-in-place mandates issued by numerous US states and municipalities have disrupted businesses, livelihoods, and markets in unprecedented ways. A recent report by a panel of industry analysts examines the economic ripple effects that these mandates will likely have on the CRE sector:
- The tourism industry has borne the immediate brunt of the economic fallout, and hospitality businesses will be forced to reconsider their financial obligations with respect to operational interruption, liability insurance, and cancellation costs.
- Non-essential retailers may face extended store closures, and many businesses with tight cash flow could close down permanently. CRE capital lenders can anticipate an increase n the review and renegotiation of debt agreements.
- With many companies adopting work-from-home policies to slow the spread of the virus, office owners could shift their capital resources away from physical facilities in favor of networking and cloud-computing infrastructure, as the knowledge industry grows more reliant on the capabilities of a remote workforce.
In response to these and other bleak macroeconomic forecasts, the Federal Reserve has slashed its benchmark rate by a full percentage point and pledged to buy back $200 million in mortgage-backed securities. However, some believe that the Fed’s planned buyback of corporate bonds (to be managed by BlackRock through a contract agreement) could have the effect of sidelining REITs anchored in mall and hotel holdings.
All eyes are also on the bipartisan $2 trillion stimulus bill signed into law by the president. In a best-case scenario, the stimulus package will keep businesses and American taxpayers going long enough to see the light of economic recovery after the worst of the national outbreak has passed.
Given the rapidly evolving situation around COVID-19 and its economic fallout, few things seem certain at this time. But with a watchful eye on the market and a solid understanding of CRE cash flow, you’ll be in a position to protect your investments and optimize your capital deployment when the next opportunity arises.
Regardless of your starting point, Black Collie Capital can help you. We work with a wide variety of real estate markets, giving you diversified options that build on your strengths and connections while offering new opportunities as well. Black Collie Capital is a private Real Estate Finance company that specializes in debt and equity placement across all asset classes nationwide. To learn how we can arrange financing and creative capital solutions for your commercial real estate needs contact us here!