Views from ULI 2012 Fall Meeting (Part 1)

Where are the deals?

If we had to pick our own theme for the 2012 ULI Fall meeting, the apparent one seems to be missed connections.

We’ll divide this out between capital and sponsors; as each are having a hard time finding what they want.  Let’s start with capital.

As has been the case for about a year or so, there is simply not enough real estate being traded right now to meet the capital demand that is out there.  Starved for the types of yields large investment institutions need to meet their return obligations, there has been a massive shift back into commercial real estate.  Many institutions see this as an attractive asset class to grab yield, hedge against inflation and deploy large amounts of capital at once.

Unfortunately, real estate’s renewed popularity is squeezing some of the perceived benefits that attracted money in the first place.  Yields are compressing, and target returns are eroding in order to get “money out the door” and invested.  We see this being true across the board, for both core and distressed deals.

Many newcomers to the space (and there are many) will find it is extremely challenging to actually execute on investments.  Only shops with deep, geographically diverse networks, strong understanding of common sense real estate fundamentals (yes, those actually matter when buying real estate), and most importantly PATIENCE, will find opportunities that make sense.

Core Real Estate Overheated

We stress opportunities that make sense because we believe many of the purchases being made right now may not.  Firms purchasing core deals that are trading below 6% cap rates are playing a dangerous game with investors’ money.  A small increase in the interest rate environment will negate any return on investment as the ability to recover the same price when the asset is sold becomes near impossible.  Why are acquisitions teams taking these risks?  Their compensation structure rewards allocating capital, not seeing the investment through to execution.  We see this as one major moral hazard in the current organizational structures of many institutional shops that was not corrected through this past down turn.

This problem of core product is almost certain to solve itself as investors eventually open up to the idea of exploring the same quality product in secondary markets or, as we view the more logical move, look at slightly lower quality product in strong markets.  Expect rates to compress for this lower quality product as a result.

Distressed Not as Easy as It Looks

The same unreasonable expectations for stabilized assets can be said for distressed deals.  Many investors will continue to be frustrated by the pricing on distressed debt and real estate simply because there are many, many parties chasing it.  These investors came out the gate with hopes of achieving returns in the low to mid 20% range; however they are slowly coming to reality that those targets will be lowered.

While banks may be interested in offloading problem loans and real estate, no bank officer wants to look like the chump who sells an asset only to see the subsequent buyer get massive returns on it for little work.  There is a happy medium that investors must come to where they can still get very healthy returns considering the current interest rate environment and make banks feel as if they weren’t played like idiots. Win-win.

Overall, we believe the investors who look for value-add opportunities off the beaten path will be rewarded.  The greatest rewards will come to those investors who sacrifice some yield on distressed deals in order to increase transaction volume and ultimately build happy relationships with banking institutions.  Banks will eventually see these select buyers as solving their problems as opposed to just profiting off them.

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