Each quarter, we like to share what we’re seeing and reading about in the current real estate market and how that informs the opportunities we make available to the Alpha Investing network. With that said, we are continuing to remain patient in the current environment. We maintain our belief that commercial real estate continues to offer attractive relative risk-adjusted returns in addition to providing investors with diversification from stocks and bonds. However, we also believe now is the time to be more disciplined in underwriting as we seek to mitigate downside risk. We are monitoring current events closely, while also considering the longer-term prospects and fundamentals. We continue to speak with new and existing sponsor partners to evaluate a range of investment opportunities and have remained strict in our underwriting standards. Over the past few quarters, this has led us to pass on a greater number of opportunities that have not met our investment criteria. Year-to-date, we have invested additional capital into an existing commercial real estate debt fund, which contains a diversified portfolio of 15-20+ loans, and will soon close out raising capital for the off-market acquisition of a value-add, 488-unit garden-style apartment community in Phoenix, Arizona. We continue to actively evaluate a wide funnel of opportunities to cherry-pick the handful of investments that fit our approach to responsible investing while still seeking attractive relative risk-adjusted returns.
Patience in the Year Ahead
In March 2019, the Federal Reserve (the “Fed”) kept the target range for its benchmark interest rate, the federal funds rate, unchanged at 2.25%-2.50%. This was the first quarter since the Fed started raising interest rates in the third quarter of 2017 that the Fed has not increased rates. The Fed is also now signaling no more rate increases for the rest of 2019, which is a departure from the year-end 2018 forecast that anticipated two additional rate increases this year.
It was widely forecasted that the U.S. economy would continue to grow in 2019 at a solid, but slower pace compared to 2018 due to tightening financial conditions, slower growth abroad, particularly in Europe and China, and the unresolved policy issues of Brexit and the ongoing trade negotiations. However, the economy is softening more than previously projected in December 2018. The Fed reduced its forecast for 2019 GDP growth to 2.1% from 2.3% in December and increased its unemployment rate forecast to 3.7% from 3.5%. The Fed also announced that it would start shrinking its balance sheet slowly starting in May 2019 and ending the drawdown completely in September 2019. Since the Fed’s March 19-20 meeting, the 10-year Treasury note dropped to a low of 2.388%, the lowest since December 2017.
The Fed has indicated it considers the federal funds rate to now be at the bottom range of neutral, which is a rate that neither stimulates nor restrains the economy. As the market re-adjusts to tightening financial market conditions and a neutral interest rate environment, the Fed will take a patient, data-driven approach to assessing future changes in policy.
The Cap Rate Paradox
The unchanged interest rate and current indication that rates will be flat through the end of 2019 mean that the cost of borrowing should remain steady for the rest of the year, although the Fed may revise its stance as the year plays out. This is in part good news for investors as rising rates would increase the cost of borrowing (i.e., making acquisitions more expensive as they are typically financed with 60%-80% debt). However, the news should also be viewed with caution, as the Fed is pausing interest rate increases because it sees signs of softening in the economy. As it pertains to real estate, a softening economy could lead to lower occupancy and rent growth, which would reduce investor cash flows and yields. In a time when growth is slowing, investing and underwriting discipline that focuses on the metrics and asset fundamentals of each deal becomes increasingly important. This includes evaluating the supportability of acquisition prices and growth assumptions, as well as stress testing the impact of slower growth and rising interest rates.
At the same time underwriting standards should be tightening in light of slowing growth, there is a significant amount of capital continuing to target commercial real estate. This is due in large part to private real estate funds with fixed investment periods that are seeking to deploy their capital within the allotted time frame. According to Preqin, the total amount of dry powder, or investable cash, held by closed-end private real estate funds increased to a record $333 billion in March 2019, up from $135 billion in December 2012, a nearly 2.5-fold increase in just over six years. This abundance of capital has created a competitive deal environment with multiple buyers chasing the same deals, which has compressed cap rates and driven up real estate valuations. Understanding this dynamic, it’s become increasingly important to avoid the “winner’s curse” – being the top bidder for a property. As such, it is now more valuable than ever to work with sponsors who are capable of sourcing off-market deals or opportunities that fall under the radar.
In prior years, the low cap rates have largely been supported by an improving economy with outsized rent and occupancy growth and low interest rates. Today, pricing remains full and cap rates tight, but economic growth is slowing, which means yields will be reduced if cap rates don’t adjust. There is also still the possibility of rising interest rates, which would further reduce yields, although that concern has been more muted after the Fed’s March meeting.
Conventional thinking would expect to see pricing adjust to reflect the fundamentals of a slowing economy, but that generally has not been the case to date. In 2017, when the Fed started steadily raising interest rates after years of a near-zero rate environment, many believed that cap rates would finally start to expand after years of continuous compression since 2010. If cap rates did not ease up, the higher interest expense would eat into investor yields, all else being equal. Not only did cap rates not expand, they largely continued to compress, defying conventional thinking. This can be attributed to several factors: 1) a faster pace of income growth compared to the pace of interest rate increases, which offset the additional interest expense, 2) the amount of capital chasing real estate that has propped up valuations and 3) the relative return of real estate compared to other asset classes has remained attractive.
At a more mature stage in the cycle, returns are expected to be lower. Some fund managers have already reduced return targets to be more in line with the current climate. Typical gross yields on opportunistic funds have dropped from about 20% three years ago to a range between 16-18% today, while value-add yields have dropped 100-200 basis points to average between 13-15% gross, according to Jen Hutter, CEO of the KAP Group, an advisory services firm serving private equity funds.[1] Gross returns are before all fees, expenses and taxes. As we mentioned in our Q4 2018 newsletter, this lower returns environment is impacting all assets, not just commercial real estate, although real estate outperformed most other risk assets in 2018.
[1] Mattson-Teig, Beth. “Private Equity Real Estate Funds Battle Challenges to Deploy Capital.” National Real Estate Investor.
The Alpha Investing Portfolio
To date, Alpha Investing has invested in 35 properties across the United States, as well as a commercial real estate debt fund. The total capitalization of the 35 properties in our portfolio is ~$1.15 billion.
RECENTLY CLOSED TRANSACTION:
Commercial Real Estate Debt Fund
- The investment’s objective is to originate and service a portfolio of loans collateralized by mortgages on underlying commercial real estate properties. Investors in will gain access to a diversified portfolio of these loans.
- The underlying assets will be located solely in the United States of America.
The sponsor is highly experienced in commercial real estate debt, having originated and serviced several billion dollars of real estate loans over hundreds of transactions since 1970, never suffering a loss of principal. - The investment is expected to achieve an average annual return of 11%+ to Alpha investors net of fees.
As we remain patient in our evaluation of equity offerings, we have seen increased interest from out network in our commercial real estate debt fund investment. In prior years, our investment vehicle has been structured to allow for new contributions and redemptions once a year. Redemptions will continue to be permitted on an annual basis, but due to increased demand from our network, we will now be accepting new contributions on a quarterly basis (i.e. January 1st, April 1st, July 1st and October 1st).
It is important to note that while this offering does provide an annual liquidity option, we still view it as a long-term investment. The target average annual return assumes that an investor remains in the fund for a 3+ year time frame. Returns may differ from one quarter to the next and one year to the next due to the timing and ultimate resolution of defaults in the loan portfolio.
As always, we appreciate your interest in Alpha Investing. Please feel free to reach out to us at any time.