Editor’s note: This is the first installment of a two-part series written by Joseph Ori, executive managing director at Paramount Capital Corporation.
The commercial real estate industry is in the boom times once again and below are 10 investment strategies for 2015 and 2016.
1. Sell Class A Garden and Hi-Rise Apartments.
Class A apartments are one of the most overpriced of all asset classes. According to the Mortgage Bankers Association of America, apartment permits, starts and completions have ramped up significantly during the last few years as follows:
This additional supply, especially in the hi-beta markets of Dallas, Houston, Austin, Miami, Tampa, Atlanta, Charlotte, Denver, Phoenix and Las Vegas is beginning to lead to higher vacancies and lower rents. Even some of the high barrier to entry markets in California, like San Jose and Walnut Creek, are seeing a lot of new development.
Class A apartments are trading at cap rates of 3.5 to 5 percent and we don’t think they can get much pricier. The average rental rate increases during the last few years of approximately 4 to 8 percent (depending on the location) will begin to decline to a more normal 2 to 3 percent and values for class A apartments will peak in 2015.
Our suggestion is to sell Class A units and recycle the funds into Class B and C properties in need of renovation and upgrading in second tier locations. These value-add type of properties can be bought at 6.5 to 8.5 percent cap rates and in the right market, can significantly increase in value post renovation.
2. Provide Participating Mezzanine Loans.
Even though there is a lot of capital sloshing around chasing deals, there is a dearth of debt/equity capital for the portion of the capital stack above the first mortgage at about 70 percent and below the owners’ equity investment of 10 percent. This slice of 20 percent of the capital stack is ideal for a participating mezzanine loan. For example, a 95 percent leased office building with a net operating income of $1.3 million and worth $20 million at a cap rate of 6.5 percent, could be structured with a $4 million mezzanine loan as follows.
The internal rate of return on a portfolio of participating mezzanine loans should be 15 to 18 percent, which is higher than a typical commercial real estate fixed income return, due to the higher risk of the transaction and the participation interest. The mezzanine lender is taking some of the equity risk and should be compensated for such. The mezzanine lender will most likely not be able to lien the property and instead have to rely on a guarantee from the owner and a pledge of the owners’ equity interest in the property as security.
3. Provide Private Equity Capital to Commercial Real Estate Developers.
Commercial real estate development is beginning to ramp up and is on the up-slope of the property development cycle curve. Developers of office, retail, industrial and medical properties need equity capital at the property and corporate level. Providers of this capital can take advantage of the vibrant construction cycle, lower cost and higher returns from development versus the acquisition of similar property and friendly lending markets. If the developer is privately owned and has a large regional or national presence, the exit strategy for the capital providers may be a public real estate investment trust, or sale to a real estate investment trust or institutional investor.
4. Sell Portfolios of Single Family Homes.
This is a low margin, volatile business with high costs and unwieldy management. If interest rates begin to rise, home values will fall, cap rates and the cost of capital will increase, which will compress returns. Most of the publicly traded single family real estate investment trusts have underperformed the market as shown in the following table.
5. Provide Investment and Growth Capital to CRE Crowdfunding sites.
Crowdfunding sites that raise debt and equity capital for commercial real estate deals are growing fast and taking an increasing share of the small property funding market. We believe this sector of real estate funding is here to stay and will grow as the democratization of capital becomes more commonplace. There are more than 50 of these sites, however, many of the principals do not have the requisite experience in commercial real estate, finance and the capital markets to be successful. We would recommend only investing in firms that have experienced senior level personnel that have been in the industry for a long time and have a solid track record of completing real estate deals. We also think that this sector of the real estate capital market will consolidate in the next few years and there will be opportunities for capital providers to profit from this consolidation.