While the U.S. commercial real estate market in aggregate has recovered from the depths of the 2008-09 recession, reaching new all-time highs, the recovery has been uneven across sectors and regions.
Consider the following statistics regarding the current state of the market. Apartment rents are more than 20 percent higher since 2007, while rents in the office, retail and industrial sectors have barely risen at all over the same period. Valuations for apartments and central business district (CBD) office properties are up 53 percent and 43 percent, respectively, while at the same time valuations in retail and suburban office sectors continue to lag 2007 peak prices. Major markets such as New York, San Francisco and Chicago have seen significantly sharper price increases than secondary or mid-tier markets across the country.
Amid this dual-track reality of the current investing environment, first-lien lending backed by transitional properties potentially presents an attractive risk-reward opportunity. Based on a thorough analysis of income generation, occupancy and loan leverage data from the largest commercial real estate sectors, we believe that transitional debt represents a more prudent strategy in today’s market.
We estimate the transitional lending market is now approximately a $50 billion market and growing, up from approximately $20 billion in 2011. Transitional properties are a natural occurrence in the commercial real estate lifecycle, and the label includes properties that are experiencing a temporary interruption in cash flow or are generating income below market potential. Our data shows that the commercial real estate market traditionally has overvalued in-place cash flows and undervalued the long-term income-generating potential of commercial properties. We see significant value in a transitional lending strategy for three primary reasons.
First, the commercial real estate market heavily discounts transitional properties. When valuing properties, we believe the market places too much emphasis on historical performance and in-place tenants, and this misplaced analysis leads to discrepancies in valuation metrics between stabilized and transitional properties. Transitional property buyers typically require an expected unleveraged return of 10-15 percent on the investment in the property, based on Amherst Capital estimates, significantly higher than for stabilized properties. The higher required rate of return results in a steep discount to the value of transitional properties and more than compensates the risk of transitional properties taking longer than expected to stabilize.
Second, transitional properties have strongly outperformed stabilized properties in occupancy gains since 2011. Amherst Capital estimates of CoStar property data found that across the office, retail and industrial sectors, the largest gains in occupancy were seen in properties with lower than 80 percent occupancy. Properties with greater than 90 percent occupancy experienced a decline in occupancy during the same period. Occupancy rates have improved more in low initial occupancy transitional properties compared to stabilized properties. The outperformance of low occupancy properties was also evident during the financial crisis in weaker performing markets, demonstrating that transitional properties remain viable investments across markets. Our analysis has shown the potential for outsized potential value gains for transitional properties as a result of improving occupancies.
Third, we see the risks of the current macro environment pointing to debt, rather than equity investments, as the best approach in the transitional commercial real estate market. We believe that the lengthy run-up in prices since the recession means that equity investments will require perfect execution and are very sensitive to market conditions. In contrast, we believe that low leverage and a capital-committed equity holder can lessen the downside risk on transitional property lending. Demand for low leverage transitional loans is expected to remain strong, according to Amherst Capital’s analysis, and leverage through warehouse financing or the securitization market can further support the earning potential of these investments. With lower risk than the market is pricing in, transitional lending presents an attractive risk-reward profile for investors.
For too long, the commercial real estate market has overvalued in-place rents and undervalued the long-term earning potential of transitional properties. As the transitional market continues to grow, we believe that a strategy focused on debt will enable investors to take advantage of this inherent mispricing of risk and discount to transitional properties occurring in today’s market. Lower leverage and higher spreads associated with transitional loans, combined with favorable occupancy trends in transitional properties, point to a potentially attractive risk-reward opportunity in transitional lending for institutional investors.
Sandeep Bordia serves as a managing director and head of research and analytics at Amherst Capital Management LLC, a real estate investment specialist. The comments provided in this article are a general market overview and do not constitute investment advice from Amherst Capital and are not predictive of any future market performance, view full disclosures here.