As the United States economy recovers from the pandemic and the Federal Reserve moves into a tightening phase, uncertainty abounds as commercial real estate investors work to forecast the effects of high inflation, rising interest rates, social and demographic shifts, and geopolitical shocks on their future returns.
We cannot know what the future holds—markets are always uncertain. If they weren’t, there would be no way for investors to earn more than the risk-free rate. Uncertainty is what creates opportunity.
No matter the asset class, returns will be influenced and impacted by a multitude of factors. Some are within an investor’s control, while many are not. Commercial real estate is no different. Those with a sound investment strategy, an understanding of what factors will most likely drive returns, and insight into where to focus their attention will be primed to take advantage.
INTEREST RATES. Like farmers watching the weather, interest rates are perhaps the most-watched data for many real estate investors. Yet rate movement is completely out of their hands. And just as some rain is good for crops while too much is a problem, the effects of interest rate changes on real estate can be a matter of degrees. Falling rates lead to lower borrowing costs (creating greater demand), but real estate can also outperform in rising rate environments given inflationary pressures.1 Like a farmer watching the clouds, property owners can prepare for changes in rates but certainly can’t stop them.
TENANT DECISIONS. Property owners can propose attractive lease terms and negotiate in good faith, but a change at the board level, loss of funding, or shift in business goals on the tenant’s side might scuttle an agreement even late in the process. Alternatively, the tenant who wanted to leave a month ago might win a new contract and now wants to expand into the space next door.
COMPETING SUPPLY IN A MARKET OR SUBMARKET. You may control what happens on parcels you own, but you cannot control what your neighbor does with theirs.
PROPERTIES AVAILABLE FOR PURCHASE. You might want to own an apartment building in a very specific part of your favorite city. Unlike stocks and bonds, however, the timing of a transaction depends both on when you want to buy and when the seller wants to sell. If only half of that equation exists, no transaction will occur.
ASSET PRICING. Congratulations, the apartment building in your favorite part of town has finally hit the market! But are the pricing and returns acceptable to you?
GOVERNMENT APPROVALS AND SUPPLY CHAIN DELAYS. Ask any developer about their experiences with local officials and suppliers and you will understand why new buildings can take so long to complete.
With so many important factors out of one’s hands, what can an investor do to increase their likelihood of success? Our advice centers on three items: focus on the elements that can be controlled, prime your portfolio to benefit from positive surprises, and think proactively about how you will respond when unforeseen issues invariably come up.
INVESTMENT STRATEGY. Your investment strategy reflects your willingness to accept uncertainty in the items you cannot control. A core, stabilized, income-driven strategy with a generational investment horizon will be less susceptible over time to periodic variations in outside factors. A successful value-add (buy-fix-sell) or opportunistic development strategy can generate high returns, but will be reliant on market timing, avoiding construction delays, leasing momentum, and a favorable selling environment upon completion.
PROPERTY TYPE. Returns for apartments, offices, warehouses, and retail assets are driven by different factors. Investors can take a diversified approach or focus on the sector that best meets their objectives.
LEVERAGE STRATEGY. Are rates low today? Borrow as much as is appropriate and lock the rate for as long as possible. Are rates high today? Use more equity and plan to refinance when loans are more attractive.
ASSET SELECTION. Worried about too much new supply driving down rents? Stay away from markets or submarkets where it is easy to build. Prefer to avoid uncertainty surrounding capital improvements? Buy newer assets. Concerned with political or tax uncertainty? Focus on locations with pro-business mandates. Is an asset class out of favor and primed for a rebound? Select properties with the highest probability of benefitting from the bounce.
INVESTMENT PACING AND TIME DIVERSIFICATION. When investment conditions are most favorable—fundamentals are attractive, pricing is fair, and competition is low—buy more. When prices are high and competition is fierce, be selective or even be a net seller. Like dollar cost-averaging in the stock market, some purchases and dispositions will turn out to be better-timed than others, but only in hindsight.
PRICE DISCIPLINE, RETURN EXPECTATIONS, AND UNDERWRITING ASSUMPTIONS. Most commercial real estate is sold in an auction process, and it’s easy to get carried away in a rising market. Keep your cool while others are losing theirs. If it’s a must-have asset, be sure to set realistic return expectations. On the other hand, be willing to buy when market sentiment is overly pessimistic.
BUY / HOLD / SELL DECISIONS. No one can force you to buy, and unless you are over-leveraged you should never be forced to sell.
ADVISOR SELECTION. You control the company you keep. Hire and rely on fiduciary advisors who understand your goals, property management and leasing teams who take an ownership mindset, and trusted development partners or contractors whose incentives are aligned with yours.
All commercial real estate owners spend time thinking through the factors that could make or break an investment. It could be the new tenant who absolutely must rent your building immediately at any price or the site next door that becomes Amazon’s HQ3 and doubles your value overnight.
It could be the company board that pulls back an important lease at the last second, the city decision that goes against your development, or the global pandemic that doesn’t care what your business plan looks like.
Instead of worrying or fantasizing about things that can’t be controlled, surround yourself with trusted advisors, optimize your investment process to meet your goals, set yourself up to benefit from positive surprises, and minimize the impact of negative changes.
Most importantly, expect the unexpected along the way.
This material is solely for informational purposes and shall not constitute a recommendation or offer to sell or a solicitation to buy securities. The opinions expressed herein represent the current, good faith views of the author at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented herein has been developed internally and/or obtained from sources believed to be reliable; however, neither the author nor Manchester Capital Management guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this article are subject to change continually and without notice of any kind and may no longer be true after any date indicated. Any forward-looking predictions or statements speak only as of the date they are made, and the author and Manchester Capital assume no duty to and do not undertake to update forward-looking predictions or statements. Forward-looking predictions or statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward- looking predictions or statements. As with any investment, there is the risk of loss.
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