2012 – 2nd Quarter Update
The mantra of the early 90’s was “cash is king”. Without diminishing its royal status, “cash” has been relegated to a slightly lower status and “cash flow” has been coronated.
Almost everywhere, cash flow yields have evaporated. 10-year treasury, municipal and corporate bond yields are paltry compared to ten years ago and they are not without risk ( ie.U.S. debt downgrades, municipal bankruptcies, etc). Total returns are also at risk if prices fall from bubble pricing, especially with U.S. bonds.
Comparatively, real estate (hard assets) have higher yields with varying degrees of risk based on product type. Single tenant triple net leases are perceived to have the lowest risk, depending on the credit worthiness of the tenant and also have the lowest returns. However, these NNN leases are usually flat (no upside) and are priced significantly above replacement costs. Total returns can be severely diminished with increases in exit cap rates and cash flow can vanish altogether if the tenant goes out of business during the lease term or vacates at expiration.
Investment in general office space is perceived as having more risk given the proliferation of the telecommunication business and corporate downsizing. Prices for industrial space have been driven above replacement costs by corporate users and by large institutional developers building speculative space in front of demand. The currently ‘hot” multifamily sector is priced to perfection and appears to be heading towards overbuilding, especially as the economy strengthens and renters become buyers again. There is demand for medical office space, but the high price per square foot and specialized purpose of the space has caused investors concern as it has with similar single purpose facilities uses such as movie theatres.
Conversely, multi-tenant retail is poised for strong opportunistic growth. First, very little new space is being developed or planned and obsolete space is being demolished or re-purposed. With total retail sales now higher than before the recession, strong demand is being created from new retailers or expanding retailers. Higher retail sales combined with lower rents retailers have negotiated over the past several years have pushed retailer’s health ratios ( total base rent plus expense reimbursements divided by total sales) below historic averages. Head winds still exist for obsolete retailers such as K-Mart and Sears, but several non-sustainable or duplicative retailers who were around ten years ago, such have Linens N Things, Borders and Circuit City have now been replaced with more sustainable merchants. Internet sales will continue to decrease retailer’s future square footage needs, especially office suppliers, electronic and book retailers, but has a lesser effect on the majority of the size of most other retailer’s footprints.
Ten years ago, our budgets on prospective acquisitions projected 5-year IRR returns to investors in the 20% range. These returns were based upon 75% leverage and a modest amount of cap rate compression. In reality, realized returns were higher than projections due to greater cap rate compression or shorter hold periods than anticipated. Even though 10-year treasuries were yielding 4 to 5% then, spreads on real estate loans were only 100 to 200 basis points, translating into interest rates on commercial real estate around 6%.
Projected 5-year IRR returns to investors on our recent acquisitions are still at least 20%. However, we are projecting these returns with only 65% leverage. Additionally, while U.S. treasury yields have dropped from an average of 4% ten years ago to 1.6% currently, spreads have widened to 250 to 300 basis points making real interest rates on real estate loans 4% to 5%.
On average spreads between interest rates and cap rates are similar to ten years ago, but alternative investments are much lower. Additionally, cap rates have continued to compress, especially on high profile, trophy properties which traded for above 7.25% two years ago and have recently traded for 6% or less. Based upon a current and future supply and demand imbalance and the low yielding nature of alternative investments, cap rates should remain low for the foreseeable future.
Interest rates are expected to stay low in the short term, but will inevitably increase. While there is some correlation between interest rates and cap rates, they are not directly correlated due to the narrowing of spreads in perceived less risky future macro environments. Even if increasing interest rates do have some delayed affect on cap rates, higher interest rates usually occur because the overall economy is expanding. As the economy expands and retailer’s sales increase, rent growth will occur as health ratios have ample room to increase, which will offset any pressure due to higher interest or cap rates.
Cash was King in the 90’s and significant wealth was created due to the liquidation of all types of real estate assets at significant discounts. To date, this cycle has not seen the same scale of discounted liquidation and it’s not anticipated. Lenders and owners are better capitalized than in the 90s and can afford to hold assets through the troughs or at least owners have some limited infrastructure to add value prior to liquidation. Outside investors are also flush with cash creating competition, propping up prices.
Currently, not all sustainable cash flow is viewed equally by institutional investors as was commonplace ten years ago. However, interest rates on commercial properties are more homogenous, making spreads between cap rates and interest rates on non-institutional assets much greater than ten years ago. Therefore, being able to locate or create sustainable cash flow outside the institutional investor’s current radar screen will provide investors with strong risk adjusted returns. Profits can be maximized by selectively being ahead of the current institutional investment trends and by paying attention to operational fundamentals.
We look forward to discussing our current prospective opportunities, which will capitalize on the above strategy with you soon.
Please feel free to call me with any questions.