February 20, 2023

Will 2023 Be the Year Investors Have to Change Their Expectations?

Nellie Day

Many commercial real estate investors have been riding high since the Great Recession, but some say current market fundamentals may upend all that.

High cap rates and low debt are the things investors dream of. They’ve also been the reality, in many cases, over the past 10 or so years as the economy, optimism and values continued to climb. Well, they don’t call them real estate cycles for nothing. What goes up tends to go down — and that also applies to the economy, optimism and values.

Suddenly, the spread between buyers and sellers widened. Buyers wanted to take advantage of price reductions brought on by inflation, high interest rates and other factors, while sellers were citing comps that were three-plus months old.

This has left us with a delta, along with a few questions. Are sellers in the wrong? Are buyers? Does the industry need a hard reset? Lastly, are there still opportunities for solid returns?

WREB turned to some of the West’s most prominent investors to find out.

On navigating lingering fear in the current market…

Don’t let either fear or greed guide your decisions, but be prudent and smart in how you acquire projects. Sometimes the best deals you do are the ones you don’t do. Don’t force anything in a market like this.

— John Drachman, Co-founder, Waterford Property Company in Newport Beach, Calif.

On making smart long-term decisions…

Investors can make smart long-term decisions by acquiring well-located assets below replacement costs with positive leverage. This takes patience and diligence. For the most part, we are not seeing positive leverage in the market as in-place cap rates are in the 4 percent to 5 percent range for most assets, while the cost of debt is between 5 percent and 6 percent. This has caused investors to be sidelined until buying opportunities present themselves.

— Dan Blackwell, Executive Vice President, CBRE in Newport Beach, Calif.

On technology’s impact on commercial real estate investing…

In the past 20 years, technology assisting in the operations of real estate — and professionally managed alternatives — has improved dramatically such that prior risks stemming from poor transparency, unpredictability or unprofessional operators have largely been mitigated. That said, with lower perceived risks comes lower expected returns. If you look back 20 to 30 years, before the technology boom that’s sort of leveled the playing field, expected yields on these investments were significantly higher. But institutional investors have repeatedly traded yield for reduced risk.

— Edward Ring, Founder and CEO, New Standard Equities in Encino, Calif.

On investor expectations…

Sellers are coming to the realization that prices today are not the same as early 2022 and those with pressure from the D’s — debt, divorce or death — are meeting the market. Those investors that want outsized returns will have to move up the risk spectrum, acquiring value-add or opportunistic buys. Investors with strong balance sheets and access to debt should find ample opportunities that will prove smart in the longterm.

— John Pollock, Chief Executive Officer, Meridian in Walnut Creek, Calif.

On real estate fundamentals…

Investors navigating the market should dig into the true fundamentals across each submarket that piques their interest. I’m a true believer in making investment decisions based on fundamentals, rather than “technicals.” For instance, a fundamental is a thorough assessment of supply and demand for the specific product, while a technical is perhaps that the interest rate on the loan is 100 basis points below the cap rate, and therefore a positive arbitrage exists between the cash flow and the cost of debt. If one is simply looking at technicals, grave errors could easily be made, resulting in a loss of principal.

— Edward Ring

On alternative investments…

Investors are embracing alternative real estate assets due to the impact of technology on real estate. Traditional large investments in Class A urban office projects or malls have been impacted by technology. Asset classes like lab space, self-storage or data centers appear more attractive as technology has not had as much of a negative impact. In fact, it’s probably had a positive impact. As data on alternative asset classes has become more available, institutional investors recognize they have to broaden their investment horizons to get the yields they need.

— John Drachman

On healthcare real estate investing…

The resilience of healthcare became evident during the Great Financial Recession and is proving true today. The fundamentals of healthcare remain strong, with an aging U.S. population and their utilization of healthcare as demand continues to outstrip the availability of providers and the real estate where they deliver care. The good news for healthcare real estate owners is that most of these healthcare services are done in an outpatient setting, and hospital systems continue to push more services out of their high-acuity hospitals where procedures are expensive.

— John Pollock

On lessons to take from the Great Recession…

Many investors learned the negative side to leverage during the global financial crisis. We also saw shorter hold periods become more common during that time. However, during the global financial crisis, there was not much distress in the multifamily sector in Southern California as there was not much over-leveraging. At that time, we experienced rental rates flatten to drop slightly while cap rates increased. This caused transaction volume to drop substantially. Currently, the market is experiencing similar low levels of transaction volume. The majority of recent transactions in Southern California had moderate loan to values, so I don’t expect distress in the market. I believe the best lesson learned from the global financial crisis and in today’s market is don’t get over-leveraged.

— Dan Blackwell