June 2, 2022

With 'Pressure Coming From All Sides,' Investors Shift Strategy, Take Lower Returns To Keep Deal Flow

Bianca Barragan

It is unusually difficult to do just about anything in commercial real estate right now.

Rising interest rates are making the cost of borrowing to build or buy more expensive. Construction prices are ever-rising and supply chain pain has made materials hard to get. Competition in hot asset classes is pushing sales prices up.

“There's no doubt that there's pressure coming from all sides,” Standard Communities principal and co-founder Scott Alter said.

But builders gotta build and buyers gotta buy, and sources that spoke with Bisnow indicated that they are largely still doing both, just with tweaks to their strategy, methods or underwriting — and, sometimes, a hit on profit.

Competition is fierce among those building and buying in the industrial, multifamily and healthcare space, and in some cases, investors in those asset classes are pivoting their approaches.

Meridian Chief Development Officer Mike Conn said he sees a lot of money chasing healthcare real estate because buyers see it as recession-resistant. Those buyers are “paying core-plus prices for value-add healthcare real estate,” Conn said, driving up prices.

The average price per SF for medical office buildings rose to $389 per SF in the last quarter of 2021, the highest that metric had been in the last five years, a year-end report from Newmark found.

“That value-add is where we would normally buy, but people are willing to pay, in our opinion, more than it's worth, so we're not participating in that right now,” Conn said.

Instead, Meridian has focused on projects that are “going up the risk spectrum,” like repurposing buildings not made for healthcare uses, and continuing to do a lot of ground-up construction.

“Sometimes you can save money by doing repurposing, but what you really save is schedule, and schedule, you know, equates to cost savings,” Conn said.

But renovations still mean construction, and thus still a pricey undertaking. Conn said Meridian bought a vacant 60K SF building earlier this year in Northern California for about $13M and plans to spend $25M to renovate it.

“I mean, that's backwards,” Conn said. “Normally, you wouldn't put that much capital into a building, but it's in a really good market with low vacancy. We have the building almost fully committed with tenants already and we've barely even started construction.”

RREAF Holdings, which primarily invests in multifamily but also has hotels and does ground-up development in multiple asset classes, is still buying existing buildings, although it, too, is seeing an incredible amount of capital chasing deals. Its way around that is never to pursue a property that’s being “fully marketed,” RREAF Holdings President and Chief Investment Officer Doug McKnight said.

“If it's out there for the world to see, there's going to be some capital that's going to chase it too hard,” McKnight said. “They're going to overpay.”

Instead, RREAF is leaning on its network of brokers and working directly with longtime owners to source off-market deals, whether it’s a portfolio or a single asset.

“Over the last year, we have sort of felt that we may be net sellers,” McKnight said, noting that in approximately the last 15 months, RREAF has sold about $500M worth of assets. “But actually, we're ending up being net buyers because we are also very strategically looking for and successfully sourcing off-market assets, single assets, portfolios of assets.”

With so many headwinds bearing down, developers have often tried to find some give with land prices, but with mixed results.

High construction costs reset land pricing a little bit, Standard Communities’ Alter said. His company works in the multifamily space, largely with income-restricted affordable properties but also with market-rate properties.

“It is putting downward pressure on the sellers we’ve worked with,” Alter said.

But D2 Capital Advisors Vice President Jack Cortese said he’s seeing investors trying to use the very real rise in construction materials and costs as “a sort of bargaining chip” when they’re looking to acquire development sites. In instances where that tactic was employed with property his company owned, “it didn’t work.”

D2’s development business mainly focuses on preparing sites for industrial development, taking them through remediation if needed and securing entitlements — everything needed to put shovels in the ground. It recently sold a site in South New Jersey that it was planning to develop itself. The number of offers it received for the site and the dramatic appreciation of the value of the site made it clear that selling was a better option, Cortese said.

Increased costs, inflation and other factors are having impacts on the profit some developers and investors are seeing.

“There definitely has been a compression of returns, there's no question about it,” Alter said.

Yields were at a record high at the end of last year. A report for the fourth quarter of 2021 from the National Council of Real Estate Investment Fiduciaries found a total quarterly return of 6.15% for the properties in its property index, the highest the NPI has seen since it began tracking in Q1 1978. However, that was prior to this year's interest rate hikes.

Even though profit margins have come down on properties that are built ground-up and those acquired for renovation, Alter said both market-rate and affordable properties are seeing some rent inflation, and that’s helped blunt some of the impact.

“It's offset a lot of it — not all of it,” Alter said.

With the cost of construction going up, developers are taking less profit on each deal in an effort to try to keep the cost the same for the tenant, Conn said.

“We're absorbing as much of that as we can, but at some point, we won't be able to absorb that anymore,” he said.

As often as it can, Meridian gets the general contractors and design teams to share some of the risk associated with the fluctuating costs of construction. Bringing those teams in early and making sure everyone is talking to each other can maximize efficiency and keep costs in check.

“You don't want your architect picking out an air conditioning unit that has a 40-week lead time, when the contractor said, ‘Hey, I’ve got the same one over here, it's only an eight-week lead time,’” he said.

Under this model, “everybody shares a little bit in the pain, if you have a cost overrun or a schedule overrun, and everyone shares in the reward if there's a savings,” Conn said.

But not everyone is taking a hit.

“Our returns have not gone down,” McKnight said.

He noted that RREAF hit or exceeded its original pro formas on all of its exits in the last 15 months. Most of those were sales of existing assets that it had purchased but some were ground-up projects.

“We believe, and we feel very strongly about it, that we're going to be able to continue to maintain our margins and continue to maintain our returns,” McKnight said.