At this juncture, we continue to believe that commercial real estate offers attractive relative risk-adjusted returns in addition to providing investors with diversification from stocks and bonds. However, we are also cognizant of increasingly divergent views and mixed signals as it relates to the trajectory of the economy. As such, we are maintaining our focus on disciplined underwriting and continue to seek opportunities that we believe mitigate downside risk. In an uncertain market, it is increasingly important to align ourselves with high-caliber sponsors with proven track records, strong debt and equity relationships, and experienced principals whom we believe have the ability to succeed in any stage of a market cycle.
During the second quarter, we evaluated several transactions with existing sponsor partners and chose to move forward with two multifamily opportunities and one senior living opportunity. We shared these offerings with our network in June and early July, and they are all expected to close between late July and mid-August. They represented our 2nd, 6th and 12th transaction with the respective sponsor partners. We also made our fifth investment into a commercial real estate debt fund, which is run by one of our most established sponsor partners. While we seek to reinforce these existing sponsor relationships, we will also continue to remain active in evaluating new potential sponsor partners and will selectively introduce new sponsors to our network if they pass our rigorous sponsor underwriting process.
Bottom of the Ninth or New Normal?
As of July 2019, the current US economic expansion is officially the longest in the nation’s history, surpassing the previous record of 120 months of consecutive growth. Some have compared the economy’s current position to late innings of a baseball game, implying that we are nearing the end of the cycle. Economists with opposing views say economic expansions do not die of old age, pointing to Australia, which is now in its 28th straight year of economic expansion. Only time will tell if we are indeed near the end of this expansion cycle or still have further room to run. Through the first half of 2019, solid fundamentals have continued to support steady growth, but persisting uncertainties including trade tensions and slowing global growth threaten to dampen the outlook.
US GDP grew at an annual rate of 3.1% in the first quarter of 2019, driven by net inventory and net exports, which are not expected to be sustained for the rest of the year. GDP growth forecast for 2019 remains in the 2.0-2.2% range. Despite coming off a strong first quarter, fluctuations and mixed indications in recent economic data are giving market participants pause. Unemployment remains at a 50-year low, hovering around 3.6%, but job creation numbers have swung wildly from month to month. Nonfarm employment added a robust 224,000 jobs in June, following a weak May that added only 75,000 jobs. The 10-year Treasury yield rocketed back above 2% following the June jobs report, after falling to its lowest level since November 2016 following weaker than expected confidence data. The level of consumption and business investment is also mixed. Consumer spending increased in the second quarter, supported by low unemployment and increasing wages, while business fixed investment appears to have slowed. US manufacturing activity also fell to its lowest level since October 2016, driven by uncertainty over supply chains and costs, and a weakening demand for US-made goods caused in part by the strength of the dollar.
The Federal Reserve (the “Fed”) is now projecting a more accommodative stance, citing low inflation, as well as growing risks to the economy from escalating trade tensions. The market currently expects there to be at least one rate cut to the Fed funds target rate in 2019 of 25 or potentially even 50 basis points, likely as early as the July meeting. This would be the first rate cut in over a decade since the start of this economic expansion cycle. The Fed’s benchmark rate is currently 2.25–2.50%, which is still very low by historical standards.
Opportunity for Commercial Real Estate
A rate cut would indicate the Fed sees signs the economy is softening. By cutting its benchmark interest rate and reducing financing costs, the Fed can encourage borrowing and investing to stimulate the economy. For commercial real estate, lower interest rates decrease interest expense, which increase investor yields, all else being equal. While lower interest rates are positive for real estate, the backdrop of a softening economy could lead to lower market rent growth, compared to a stronger economy, and damper revenue and net operating income (“NOI”) growth. If the slowdown in NOI growth is greater than the reduction in interest expense, investor yields would decrease, despite lower borrowing costs. While projections of future rent growth in many markets have already moderated compared to prior years, overall, rent growth projections remain positive and sustained. This is because the labor market continues to show its strength and commercial real estate supply has largely remained in check.
Multifamily has seen the most development in recent years, but new supply is expected to slow significantly starting in 2020. Lifestyle shifts such as delayed marriage, changing preferences for urban live-work-play environments and the continued financial challenges of homeownership, including high home prices and rising levels of student debt, have allowed demand to largely keep up with recent supply. The high-level of multifamily development alone also does not tell the full story. New supply has largely been Class A product, concentrated in major metros. Developers can only build Class A product because rising land, labor and material costs have made it unprofitable to build lower-end, more affordable housing. Because of the high rents needed to make construction feasible, development has been concentrated in major urban markets that have a larger number of high-paying jobs.
This concentration in product type presents an opportunity in multifamily to target the unmet needs of renters who cannot afford new Class A development rents. While the metrics are challenging to build affordably priced housing, there are opportunities to acquire existing Class B and C multifamily and execute a value-add capital expenditure program to improve what are often older and dated products. This also improves the renter experience, as part of changing renter preferences are the desirability of amenity spaces, modern finishes and in-unit washer/dryers, among others. There is a population of renters who are willing to pay a premium for this improved product that remains within their affordability threshold. The rent premium for the upgraded product is not dependent on market rent growth and presents an opportunity to capture outsized rent increases, even in a slower growth environment. Targeting secondary cities that are experiencing job and population growth provides strong fundamentals of demand and employment. If the employment market does soften, the improved Class B/C multifamily is better insulated against the downturn as its rents are affordable to a larger population and it can gain market share from renters who may no longer be able to afford Class A rents.
A couple of Alpha Investing’s recent investments are core-plus and value-add multifamily in secondary markets experiencing strong employment and population growth. Financing on these transactions is benefitting from the 10-year Treasury’s steady decline in the first half of 2019, which has caused borrowing costs to follow suit. Market consensus is all but certain interest rates will remain low for the rest of 2019. While lower interest rates should provide some relief from tightening spreads to acquisition cap rates (discussed in our Q1 2019 newsletter), it may cause some buyers to become more aggressive in underwriting, driving cap rates down further and bringing spreads back down to razor-thin margins. Some buyer’s willingness to stretch for the winning bid may crowd out disciplined investors, like Alpha Investing. Yields aside, it is important to take a step back and evaluate the bigger investment picture. If the Fed does cut its benchmark interest rate, it signals concerns about the continued strength of the economy. A slowing economy could mean slower job creation or, in a more pessimistic case, job cuts, which would impact companies’ and consumers needs and abilities to pay for real estate. At Alpha Investing, we firmly believe in disciplined evaluation of market and asset fundamentals. At a time when there are more divergent views on the trajectory of the economy, it is important to focus on markets with strong employment and population growth. Furthermore, within those markets, we like assets with targeted business plans to increase NOI that is not reliant on market growth. That way, a component of growth can be actively managed. While we recognize investor returns can be enhanced through financing, we believe the metrics of the investment should be compelling independent of financing. We will continue to monitor the economy and its impacts on commercial real estate. At present, we believe the fundamentals for real estate remain positive and are actively evaluating investment opportunities.
The Alpha Investing Portfolio
To date, Alpha Investing has invested in 36 properties across the United States, as well as a commercial real estate debt fund. The total capitalization of the 36 properties in our portfolio is ~$1.2 billion. We are expecting closings on three additional properties in the coming weeks.
RECENTLY FUNDED TRANSACTION:
Senior Living Acquisition
- Off-market acquisition leveraging situational distress, which resulted in favorable acquisition price of $8.5 million, a significant discount to the property’s current debt balance of ~$11 million.
- Historically cash flowing property that has been underperforming since a regulatory “stop placement” was mandated on the property in 2017. Business plan to revert financial operations to historical levels.
- Favorable senior demographic profile within four-mile radius of the property with 17.7% of the population (19,947 residents) over the age of 65 and 7.4% of the population (8,372 residents) over the age of 75.
- Healthy adult-child demographic profile (often key decision maker) within four-mile radius of the property with 24.9% of the population (28,090 residents) between the ages of 45-64 with a median income of $64,079.
This transaction is fully funded and expected to close by the end of July. It represented our 12th transaction with our sponsor partner. At Alpha, we primarily invest in stabilized assets that we believe have both upside potential and downside protection. We do not seek to overexpose ourselves to risk in an effort to chase yield. However, this senior living acquisition is a reflection of our selective opportunism. We evaluated the transaction in late 2018 at a proposed purchase price of $11.2 million. We subsequently introduced our established senior living operator/partner to the opportunity, who was ultimately able to co-sponsor the transaction and negotiate a much more favorable purchase price of $8.5 million due to situational distress. Although the asset is not stabilized at acquisition, we believe the return potential of the investment is very strong relative to the risk, primarily due to the experience of our sponsor partner, our evaluation of historical financial levels of performance, and the favorable purchase price.
As always, we appreciate your interest in Alpha Investing. Please feel free to reach out to us at any time.