There will be distressed asset opportunities in commercial real estate. Now is the time to get smart. But before we do, let’s rewind and review how smart we’ve already gotten so far.
On March 16, 2020, as someone interested in buying a home, you read How Does Real Estate Perform When Stocks Melt Down. From this article, you learned that real estate tends to significantly outperform when the S&P 500 is down between 10% – 20%. If you bought residential real estate in 2Q2020, you’re likely doing well as demand for residential real estate continues to grow.
On March 18, 2020, you read How To Predict A Stock Market Bottom Like Nostradamus and decided not to freak out. Instead of selling stocks, maybe you even bought stocks. If you did, you’re sitting pretty given the NASDAQ and the S&P 500 rebounded to all-time highs.
If you’re still looking to build more wealth, your attention should now be focused on investing in lagging asset classes. In particular, I’m interested in investing in distressed assets in commercial real estate.
According to Real Capital Analytics, commercial real estate valuations fell by 35% between August 2008 and June 2010. Despite the bull market in stocks and residential real estate so far, history could repeat itself. Therefore, we should be preparing now.
To help us get smarter about distressed asset opportunities, I’ve asked CrowdStreet, a site sponsor and one of the top real estate crowdfunding platforms to answer some questions.
CrowdStreet is focused on finding promising real estate investments in 18-hour cities where valuations are lower, rental yields are higher, and potential growth is stronger due to demographic shifts to smaller cities. The site is free to sign up and explore.
1) Where does CrowdStreet see the most opportunity in CRE over the next 1-2 years?
Best Geographic Opportunity In CRE
Even in the face of economic uncertainty, we remain confident in the long-term potential of 18-hour cities like Austin, Nashville, and Charlotte.
Prior to COVID-19, their job and population growth rates were above national averages. Further, these cities were supported by a diverse employment base.
Compared to metros that have a strong reliance on the service industry, these markets stand a better chance of bouncing back quickly, once the health concerns of COVID-19 are under control.
We also favor these metros because:
- They have a lower cost of living and more affordable housing compared to 24/7 metros like LA and NYC.
- Their job and population growth rates are above national averages, which indicates a market’s economic health and gives us some insight into employers’ confidence in the market. Employment growth can also be used as an indicator of future growth.
- They’re supported by a diverse employment base, often with companies relocating to the area and/or expanding their footprint. This means there is likely a lower unemployment rate.
- They have a growing millennial population since younger workers are relocating in search of well-paying jobs, affordable housing, and a live-work-play balance. As the largest cohort of the workforce, millennial migration greatly impacts the employment growth of an area as they move in.
- They are seeing an influx of institutional capital, such as investments made from pension funds, endowments, or foundations, etc. They represent where the ‘big money’ is moving.
Favorite Asset Classes
Hospitality, retail, and office commercial real estate have been hit hardest during COVID-19. See chart below as of 4/16/2020 with the most pain in 2Q2020 so far.
Let’s review our favorite asset classes today.
Last-mile industrial properties are more valuable today than ever, thanks to the dramatic increase in online shopping we’ve experienced this year. While e-commerce accounted for 11% of all retail sales in 2019, according to a Mastercard study published in June, it doubled to 22% for April and May of this year.
We have witnessed e-commerce steadily gain market share each year over the past decade but the pandemic has greatly accelerated its rate of adoption. Amazon’s stock performance is clearly an indication of e-commerce’s growth.
We believe that heightened demand for last-mile distribution spaces will continue for years to come, especially in growing metro areas, as companies strive to ensure they are well-positioned for the future.
Thanks to the high cost of moving, highly specific, and expensive build-outs often required to bring a new medical office online, we believe medial buildings are attractive.
We suspect that most medical tenants will not break their leases and, instead, will opt to renew when the time comes. Medical was relatively healthy going into the pandemic, and should emerge relatively healthy out of the pandemic.
We like the prospects of ground-up multifamily development projects already in progress in key markets, especially those projects that will deliver late in 2021 or in 2022.
Further entitlements for new developments will likely be greatly muted over the next 12 months. This means fewer competitors when those projects that are already-in-motion hit the market in 1-2 years.
We also like higher Class B to Class A assets in strong locations within vibrant submarkets. These properties, while possibly seeing low-to-no rent growth over the short term, will likely continue to perform well and should see a rebound in rent growth as the economy moves into recovery.
We view grocery-anchored shopping centers as among the best investment opportunities within retail right now. According to a study published by the Hartman Group, grocery stores’ share of food spending rose from 50% in February to 63% in March and then 68% in April.
Food consumption purchased at grocery stores is still up in the mid-60% range, a level not seen since the mid-1990s. Even with some expected regression towards the mean whenever we exit the pandemic, we anticipate grocery store sales will remain strong for a number of years.
Self-storage proved resilient during the Great Recession. Given the greater adoption of self-storage over the last decade, we believe it will again prove resilient. So far, public markets agree.
Throughout the pandemic, publicly-traded storage REITs have been among the best performing all asset classes. According to multiple reports from Green Street Advisors, public storage REITs experienced only single-digit percentage drops, roughly in line with industrial and manufactured housing REITs.
In comparison, office, retail, and hospitality REITs all experienced drops of 30-50% over the same time period.
2) How is CrowdStreet positioned to take advantage of any distressed asset pricing / opportunities?
CrowdStreet sits in a unique position in the commercial real estate market. We maintain hundreds of relationships with institutional-quality sponsors who have a broad range of geographic and asset type specializations.
Because of our large network, we’re able to access and review hundreds, or even thousands, of high quality deals every year.
Distressed deals often happen quickly – getting access to these opportunities requires early looks from those in-the-know. You also need agile, reliable capital that can react quickly to these fast-moving deals.
Therefore, we recommend you sign up and get on our e-mail list and automatically get alerted on new deals, distressed or otherwise.
CrowdStreet’s proprietary network and processes, along with a seasoned team of investment professionals, allow our Marketplace to source, review, and share this deal flow with investors.
CrowdStreet is ideally positioned to give both sponsors and investors the speed, rigor, and agility that’s necessary for navigating this type of market.
3) Are there particular sponsors CrowdStreet has worked with who are experienced with distressed assets and have successfully exited?
Ardent. They started in 2009 looking at distressed deals and we are currently looking at their strategic fund.
4) What are the main things a sponsor and investor should look for before investing in a distressed asset?
Here are some key questions sponsors and investors should ask themselves:
- What has to happen for the asset to break even, and then to become profitable? Take a hotel deal for example, with historically low occupancy, these assets are hemorrhaging cash. How much does occupancy have to increase before the hotel stabilizes? What is going to drive this demand – conferences, sports arenas opening up, tourism picking up again etc.? How long will this take?
- How much in reserves will the asset have, and how much runway does it provide for covering expenses and debt service? Do you think 12 months, 24 months worth of reserves? Is this enough time to turn the asset around?
- What is the valuation of the asset and where do you need to get it to hit your pro forma? You’d probably want to see the stabilized asset hit somewhere in the ballpark of a 2018/2019 valuation 5 years. This is how you could back into the going-in basis.
- What does the leverage look like? Does it match your business plan in terms of timing?
- Who’s the sponsor? Distressed deals are risky, you’d want to work with a sponsor who has deep experience in the market and asset class.
- Does the asset and business plan still make sense? Was this a poor performing asset prior to the downturn? Will this become obsolete?
Make Sure You Have Cash On Hand
The current economic slowdown could ultimately lead to many loans becoming ”bad debt” as companies default on their debt. Current levels of distress could lead to a decline in new commercial real estate loan origination.
This means sponsors are more likely to sell their properties in a fire sale to stop the bleeding, rather than restructure their debt since loans may not be readily available.
Over the next 1-2 years, there should be more distressed asset opportunities in the commercial real estate space. Therefore, it’s good to cash up in order to take advantage of potential good deals.
Take a look at the cash buildup at closed-end real estate funds. The one thing that is very different from this financial crisis, besides the much larger government support, is that institutions and people have lots of liquidity. When there is a rebound, I believe the rebound will be much faster than historical rebounds.
I want to thank CrowdStreet for sharing their thoughts on the commercial real estate space right now. I have a feeling things aren’t going to be as bad as the last downturn. There is also going to be a lot of repurposing of space.
Just look at Amazon planning to turn abandoned department stores into fulfillment centers. That’s great for both Amazon and mall operators. Offices will also eventually come back.
I’m not counting out human ingenuity and the desire for profits. Neither should you.