It's Time To Be Defensive In The Capital Markets. That's A Good Thing
For the first time in years, there is fluctuation in real estate capital markets. The panelists at Bisnow's Chicago capital markets event Thursday morning said this is not a sign a downturn is immediate, but they are taking measures to protect themselves from the turbulence.
Baker Development principal Daniel Slack said being defensive is wise, and being aggressive at this stage of the market would be a disservice to investors.
"If you aren't being defensive, you aren't doing your job," Slack said.
Slack said the real estate cycle tends to be 18 months behind the economic cycle and there may be another two to three years of economic growth. The actual length will be affected by the Trump administration's policies moving forward, and the disconnect between the Federal Reserve's moves on interest rate hikes and where 10-year Treasury bonds is startling.
"High interest rates are not a bad thing," Slack said.
USAA Real Estate Managing Director David Reahl said the capital markets have been defensive over the last 18 months. Reahl said 2018 is the year where the industry should see signs of a market correction. USAA is looking at value propositions within the capital stack, and has the ability to provide debt at different points, from life company debt to preferred equity.
Reahl said there are places in the stack USAA can play, but high pricing has the company carefully weighing where it wants to deploy capital.
Reahl said he expects to see economic growth continue through 2018, at least, but a catalyst could stop it and investors need to be mindful of where catalysts are going to happen. He said tariffs on steel and aluminum may be a sign of future turmoil. Still, any economic downturn will not be drastic because of lender caution.
The flow of money into the capital markets is heavily weighted in favor of the debt markets. Pearlmark Managing Principal Doug Lyons said the trend is related to bank regulations limiting proceed levels banks are willing to fund, particularly with construction loans. This opened opportunities for new capital to fill in. That combination, along with where risk returns are on the equity side, led to an increase in capital being raised directly into the space.
Walton Street Capital principal Robert Bloom said the debt side is a great vehicle for investors, from a risk-adjusted perspective. Walton Street can originate a loan, sell off a senior mortgage to a senior lender and is left with a mezzanine piece generating a 10%-11% yield at a 65%-75% loan-to-cost ratio.
The bigger question is how to make money managing a debt fund. Bloom said a portfolio of assets is necessary, and Walton Street is working toward that.
"As an investment vehicle, it's extremely attractive to investors," Bloom said.
GEM Realty Capital Managing Director Derek Lopez said his firm has benefited from debt funds to capitalize its deals, and the competition in the arena has been great. GEM is typically a 65% loan-to-cost borrower, with the ability to go higher if necessary. Some of GEM's peers and competitors are using enhanced borrowing as a financial asset, which helps them be more competitive.
As for constraints on debt loans, Bloom said Walton Street creates loan structures compatible with what the senior banks offer, which limits aggression in the market.
Inland Real Estate Investment CEO Mitchell Sabshon said that is simply good discipline.
"On the margins, you can take a little bit more risk in your three-year transition, first mortgage or mezzanine lending. But whether you're getting your financing by selling off the first piece, issuing an offering to finance the portfolio or getting a warehouse loan from a major bank, you're going to be subject to its underwriting.
"But there is that margin that can result in loans that can leverage up to 11% returns. That's fairly attractive," Sabshon said.