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Guest Contributor: Stress vs Distress: Capitalizing on the Investment Opportunity

Subtitle: By: Sean Burton, chief executive officer, and Jennifer Halvas, managing director of investor relations at Cityview

Reading the headlines, you see market conditions are changing at a breakneck pace.  So how do you know when it is the right time to invest and what opportunities are delivering the best risk-adjusted returns?  It comes down to investing at the right time, in the right assets, with the right partner.  Easier said than done, right? Maybe not.

Current market conditions are presenting buying opportunities that haven’t existed in over a decade.  But knowing what to buy and who to partner with is critical to success.

Investing at the Right Time

In the top performing commercial real estate asset classes (including multifamily, industrial and alternatives), the market is experiencing a tale of two cities. The on-the-ground fundamentals remain strong. There is little widespread asset-level operational distress in these asset classes (unlike office and some retail, which have undergone fundamental shifts). The problem isn’t lack of demand – rent growth and occupancy have been at historically high levels – the problem is the rapid rise of interest rates and the high basis at which many current owners acquired properties over the past few years. As a result, many undercapitalized operators or operators that need to refinance (or replace expiring interest rate caps) are likely to struggle and are going to be motivated to sell or forced to walk away from assets.  This creates an issue for existing owners, but an exciting opportunity for the next wave of buyers.

These market dynamics are going to allow investors to capitalize on market and seller stress and buy quality assets at a deep discount, in many cases 20-30+% below replacement cost. Investing in these performing asset classes could allow investors to see outsized risk-adjusted returns without having to make riskier contrarian bets (like acquiring and carrying the costs of a half-occupied office building with the hope the office market rebounds in the near term).

Investors poised to capitalize during this buying window will likely see compelling returns from stable assets with a history of strong performance, allowing them to take advantage of seller stress without having to purchase “distressed” assets.  The buying window is expected to be relatively short, so investors should start aligning themselves now with quality and experienced operators to ensure they don’t miss out.

Investing in the Right Assets

Commercial real estate continues to be a favored investment and among CRE asset classes, multifamily remains the darling, and for good reason. Multifamily historically has been the best performing and most resilient asset class across cycles. Multifamily acts as an inflation hedge with the ability to adjust asking rents weekly with leases that generally don’t exceed 12 months. As inflation rises, multifamily landlords are able to continually reset rents and keep pace, providing additional downside protection.  Multifamily also provides several attractive tax advantages, including land and property improvement depreciation to offset otherwise taxable property income during the hold period.

Some of the best investment opportunities are likely to come in multifamily in gateway markets, where the current underlying fundamentals remain particularly strong and have less threat from near-term supply.  Multifamily assets in supply constrained markets, like the Western US, are particularly well positioned for continued rent growth without a threat of near-term oversupply that some other markets face (like the Sunbelt).

Investing with the Right Partner 

Investing with the right partner can be as critical as investing in the right asset at the right time.  Investors want a cycle-tested operator with a track record of strong performance across a long-time horizon. Many operators were successful over the past 10 years because of rising values and cap rate compression, not necessarily the value they added to the real estate. That is why it is not enough to have an operator demonstrate their success over the past 10 years. Investors want to look over a longer time horizon that includes prior recessionary and recovery periods.

It is critical to diligence operators to ensure they have the agility to respond to market changes and the ability to take advantage of fast-moving opportunities that will likely present themselves over the next 12-18 months. It is also important for investors to make sure operators are properly aligned with their interests. One way to do that is to focus on simple, transparent structures with sufficient downside protection, like no crystallization of promote, sufficient operator co-investment dollars contributed to the deal/fund, crossed waterfalls, etc.

The Opportunity

Now is a particularly good time for family offices and high net worth investors to look at commercial real estate opportunities and, in particular, multifamily. Not only because of the expected near-term opportunities to buy quality assets at discounted prices, but because there could be less competition for those quality buys. Many institutional investors typically active in multifamily are currently sitting on the sidelines because they are facing internal allocation issues, redemption issues and/or lack of liquidity from other investments in their portfolios. This will likely create an advantage for more nimble investors who can respond to changing market dynamics more quickly.

Savvy investors who partner with managers that have the skill and expertise to source opportunities, apply an appropriate risk-reward analysis and successfully execute on their business plans to add value will likely come out the winners over the next few years.

Sean Burton is CEO and Jennifer Halvas is managing director of investor relations at Cityview. Founded in 2003, Cityview is a vertically integrated real estate investment management and development firm focused on multifamily housing in gateway markets in the Western U.S. Specializing in developing, acquiring, and operating opportunistic and value-add multifamily projects, Cityview has invested in more than 130 projects to date.

The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.

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