Developers, Investors Prepare To Swoop In On Future Cash Cows During Downturn
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Just because signs are pointing to a downturn doesn’t mean every commercial real estate firm is anticipating dire consequences. Many have been waiting years for this moment to seize on opportunities.
Economic indicators point to the U.K. and Germany entering a recession, and many analysts expect the U.S. won’t be far behind. The current cycle has been marked by tighter regulation, investors and developers erring on the side of caution and, in more recent years, real estate circles wondering when an overdue market correction might come.
But the period of economic growth is now the longest in U.S. history, and that has given companies time to plan and raise capital to take advantage of a market correction.
“If we’re going into a recession, there’s not a lot you can do about it,” BentallGreenOak President Sonny Kalsi said. “What you’ve got to do is avoid the self-inflicted wounds.”
Having lots of capital on hand is wise to ride out the recession and keep paying the bills, but it also is useful to take advantage of devalued assets that had higher price tags in a brighter economy.
While the last recession was a widespread lending crisis and all asset classes saw price drops, the next downturn is expected to be more concentrated and shorter given how most in banking and real estate have been preparing for it essentially since the last one ended.
Retail is the asset class showing the gravest signs heading into a downturn, but it can also present the greatest opportunity for investors.
Despite a wave of retail bankruptcies and shift from brick-and-mortar to e-commerce sales, high-quality regional retail centers have generally performed well this cycle, existing assets are selling below replacement costs and interest rates are low, O’Connor Capital Partners President and Chief Operating Officer Joel Bayer said.
“The reason I’m so focused on retail properties is the window of opportunity is relatively short,” Bayer said. “Acquiring assets below their replacement costs at levered, double-digit yields is something we haven’t seen in a very long time, and that situation won’t continue.”
Other downturn opportunities will come down to basic supply and demand. Vocal residents generally leery of excessive development and a tough approvals process make markets like Boston and San Francisco better protected in the event of a market correction.
But office development opportunities in New York City could be scarce after 31M SF of new Manhattan office product has been added to the market from 2009 to 2019 with projects like Hudson Yards and the rebuilt World Trade Center delivering to market.
An additional 19M SF of office product is expected to deliver by the end of 2024, according to Colliers.
Even with market fundamentals nudging investors in certain directions, it still isn’t easy to play the downturn game, especially if you are an investor trying to make a deal at basement values.
“In a downturn, you have to protect your existing portfolio but have the conviction to go into a market, take advantage of dislocation and buy cheaper assets,” Kalsi said. “It’s hard to be courageous in a downturn, but that’s how people make money.”
Don’t Forget The Fundamentals
Opportunities may arise from a downturn, but protecting an existing portfolio is still essential. Aggressive actions like over-leveraging, buying assets with high vacancies and increasing rents can all lead to the self-inflicted wounds Kalsi cautions against during a downturn.
But there are core disciplines that will work in any market, according to New York-based OceanFirst Bank Chairman and CEO Christopher Maher. Focusing on leases and prioritizing extensions over rent increases is key. Locking in a building’s cost structure or taking advantage of today’s lower interest rates to refinance doesn't hurt either.
“Now is a great time to put your house in order so the property is performing at a peak,” Maher said. “We can’t control the economic conditions, but you can control the way you run your business.”
Agility is also a crucial component. When O’Connor Capital Partners bought The Shops at Stonefield in Charlottesville, Virginia, in early 2017, Bayer said the firm assumed it would just put more retail on a remaining development parcel. Market conditions have since driven the company to develop a hotel and apartment building on the site.
“In thinking of the downturn, you should have a long-term strategy when you buy a property but be prepared to change your tactics in the short-term so, if there’s any correction in one of the segments, you’re prepared to do something else,” Bayer said.
Investors interviewed for this story, especially Kalsi, said they are ready to capitalize on any market correction. BentallGreenOak began to slow down its U.S. investments in 2015 because it thought the downturn was coming sooner. While the market has yet to correct, the firm is positioned for a buyer’s market when the day comes.
“The good thing is we are sitting on a bunch of dry powder allocated for the U.S.,” Kalsi said. “I hope that puts us in a good position."