In light of economic uncertainty resulting from the impacts of the Coronavirus, this past month we facilitated multiple Zoom brainstorming sessions with our investors. We are fortunate to have highly intelligent and experienced investors in Altus projects; and we were able to benefit from their combined wisdom. These investors are geographically located about as far east (Massachusetts), west (California), north (Wisconsin) and south (Texas) as you can go in the US, and everywhere in between. A couple of the investors on the calls live outside the US for good portions of the year. We had investors ranging in age from their twenties all the way through their eighties. This wealth of experience, array of geographies, and differing life situations created a forum where people shared ideas across investing and risk spectrums.
Some key themes:
- Economic disruption doesn’t change longer term trends (ex. the wave of baby boomers moving into retirement years).
- In the case of the COVID-19 impact, secular trends already in place have just been accelerated
- Multifamily is the safe place to be, now and moving forward.
- Borrowing is going to become more and more difficult moving forward with a wide divergence in asset type (e.g. multifamily will be much easier to finance than retail).
- There will be opportunities both in being more able than others to obtain debt and having structures through which to provide non-bank debt.
- Onshoring, and thus the need for industrial product, is an accelerating trend
- Is “The Last Mile” product something that too many investors are already chasing, or is the demand growing so quickly that developers/investors can’t keep up?
- It is to early in the recessionary period to know where the true value/price dislocations are going to be.
- Interest rates may not go up in the short run, but they are still historically low and should be taken advantage of.
Through these brainstorming sessions, coupled with Altus internal conversations, we were able to gain some clarity on certain high-level investment strategies moving forward over the coming months and years. This doesn’t mean that specific real estate products won’t change, but rather provides a framework through which to view opportunity across different economic environments.
The greatest “AHA” is something that many investors probably already have built into their portfolios, but we never clearly articulated for ourselves. Not all types of opportunities are driven by the same underlying economic forces, and as such need to be understood, underwritten, and structured differently. At Altus we now categorize opportunities into three buckets: Secular, Cyclical, and Opportunistic. We feel fortunate that we are in position to be able to identify and take advantage of opportunities within each of those spheres.
What does this mean exactly? For us, it is important to understand the definition we are using for each.
Secular: These are the long-term trends that exist within an economy. Catching a ride on one of these trends is a great tailwind to investing success. An example of such trends was mentioned above as part of the key themes from our investor brainstorming sessions: on-shoring and last mile distribution. Economic turbulence is not going to derail those trends, and in some cases may cause an acceleration of the trend rate. One such example is cold storage warehousing. Because of pressures around food delivery and the cost of real estate in highly traffic food areas, demand for cold storage space has been growing quickly. The impact of the Coronavirus and the many companies wanting to increase inventory levels in local facilities is steepening the demand curve as Just in Time (JIT) inventory philosophies are more prevalent as companies want more control of their products. This is especially true with hospitals and medications.
Cyclical: Opportunity exists because of temporary dislocations within a certain market. This could be due to financing, overbuilding, or economic cycles. Dislocations (the price versus value relationship being outside historically “normal” bands) occur around existing trend lines in demand for that particular product. An example of cyclical opportunity occurred with single family housing after the 2006 – 2008 housing crash. Houses could be purchases well below replacement cost and immediately rented at rates providing higher than historically average returns. With a growing population, there wasn’t a question of whether the value would go up in the future, it was only a matter of how long it would take to occur. However, cyclical opportunity doesn’t have to be in a product type with longer term (secular) growth. Flat, or even slightly down-trending products can still provide cyclical opportunities when the market dynamics get out of whack.
Opportunistic: Because real estate is not a perfect market (as public markets are purported to be), every once in a while a “great” opportunity lands at one’s feet. Decisive action is required. Profit is almost assured. Broader networks and deeper product understanding increases the likelihood of uncovering one of these opportunities, but even with the most extensive network and the deepest real estate product understanding, such opportunities are still few and far between.
It should be noted that in some cases opportunity may arise that fits two, or even all three of the above categorical definitions. This certainly happened in the early part of 2010s when the trend of rising construction costs (secular) overlapped with cheap home prices due to high foreclosure rates (cyclical), sprinkled with the occasional overlooked or hidden value (opportunistic).
As we look at our own business, our investing sweet spot is long term cash flowing properties with lots of interchangeable tenants, that can be purchased below replacement cost. A purchase opportunity fitting all three of those criteria is the holy grail of Altus investing, and would certainly be considered opportunistic. More commonly, we are searching for two of the three. Secular trends may afford opportunity to invest in long term stable cash flow with lots of interchangeable tenants. Cyclical investing is more likely to produce opportunities to be purchased well below replacement cost that can be reasonably expected to have future demand to create said cash flow, hopefully from lots of tenants.
The message we received was pretty clear from our investor brainstorming sessions. Despite the current economic disruption and the coming potential for cyclical opportunities, do not forsake the secular investment guidelines that build wealth consistently over time; and preferably with decent cashflow in the meantime. We have taken that message to heart. With interest rates currently being so favorable, these opportunities are manifesting themselves, as the following two examples describe:
- Using bridge to HUD financing, we are purchasing a fully stabilized multifamily property in Indiana that we are already familiar with. Based on current performance through the COVID-19 shutdown, investors will receive over a 7% yield out of the gate and we will lock in an interest rate somewhere around 2.6% for the coming 35 years. Additionally, the loan amortization alone will create over a 50% return on investment over the coming ten years. (Editor’s note: This investment is already fully funded).
- Through our network, and because of our experience structuring Qualified Opportunity Zone (QOZ) projects, we were introduced to some developers local to a MSA we are quite high on, who have both an existing, newly built, multifamily property and an ongoing multifamily construction project located in an Opportunity Zone. We have reached the outlines of an agreement to purchase both assets, providing Altus the opportunity to invest in preferred multifamily property (secular) in a dynamic market (secular), with the coordinated use of historically low interest rates (cyclical) and growth-oriented tax incentives (QOZs, both secular and cyclical, with a touch of opportunistic, thanks to the government).
We continue to look for similar opportunities, with a primary focus on taking advantage of the low current interest rates across the extended time horizons of growing housing and/or industrial/warehousing demand.
That doesn’t mean we are turning our back on the more cyclical opportunities we expect to come. It’s just that the time for these opportunities isn’t quite here yet, and frankly may not appear at all. The government has never been so involved in the private markets. The Federal Reserve has never been so free with its ability to create money out of a keyboard. We don’t know what the impact of the government’s and Fed’s actions will be on real estate markets. We have some ideas and are actively monitoring several of them while starting to put together the framework. These ideas include (but certainly aren’t limited too):
- A debt fund specifically designed to be a mezzanine lender for transactions smaller than the institutional mezzanine lenders will consider. In the private money world this may simply be called “seconds”. Maybe lenders eschew such loans as to risky, and it has to be acknowledged that these loans are riskier than more traditional, lower leverage firsts. But most lenders aren’t also active as equity investors. We have no desire to go into high leverage situations, but if we can use our creativity and real estate knowledge to take on second loan positions or maintain leverage just high enough to make something work for the borrower (as banks and other private lenders are reducing leverage), we can obtain outsized interest rate returns. If the debt is not able to be serviced, something that will absolutely occur in some cases, we will have just “purchased” a property at a price at which we would have been overjoyed to purchase elsewise. The demand for such a product is huge, and we anticipate that this demand will increase as lenders continue to tighten their lending restrictions. We are actively exploring how we might structure such an offering and welcome any thoughts or ideas that you as a reader might have. An important key to this fund is that it is large enough so that enough loans could be funded/purchased and income continues to flow while the fund upside is realized through the acquisition of properties (Cyclical).
- Everyone feels like retail is dead. Or at least everyone believes that everyone feels like retail is dead, which is probably more impactful on pricing. When there is a real asset that no one wants, it could be a good time to take ownership of said asset at prices that would otherwise be considered rock bottom. Done correctly, there might even be cash flow in such opportunities. Will true opportunity present itself here? It is too early to tell, but it is worth watching (Definitely Cyclical).
- Recessions create distressed debt, at least they have up until now, so we think there is a pretty good chance it will happen again. Commercial Mortgage Backed Securities (CMBS) structures are such that the servicers (those that control the loans) are financially incentivized to have loans go bad. There is already likely to be distress in the marketplace (especially in retail, and possibly office) with servicers being disincentivized to work with borrowers, which will push properties into foreclosure that otherwise didn’t need to be taken that route. Like with the junior debt example above, this opportunity will require committed funds that can move quickly when the opportunity presents itself (opportunistic/cyclical).
In some ways it is a scary time for investing. But it is also an exciting time. We are coming out of several months where our professional worlds (on the investing side, not the asset management side) seemed to freeze. As things slowly come back to life, we are excited about the opportunities.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at email@example.com.