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Optimism Fuels Late-Cycle CRE Investing Strategies

CRE investors believe the eventual downturn will be mild.

The U.S. economy is more than a decade into its current growth cycle. And even as the runway ahead looks a bit shorter, investors are continuing to find plenty of buying opportunities to fit late-cycle strategies.

There is persistent optimism that this late cycle still has room to run. The current year has exceeded expectations in terms of steady, and even increasing, investment sales activity in some sectors. “That right there is the answer from the investment community that there is still a good amount of confidence and a view that this is an extended cycle,” says Lauro Ferroni, director of research, Americas, with real estate services firm JLL.

Investors are taking current conditions into consideration when assessing investment strategies. However, this cycle has some distinctly different characteristics as compared to past cycles. “We think we are in the late cycle, but we also think it is going to be quite a gentle downturn,” says Richard Barkham, Ph.D., chief economist, global, and head of Americas research at real estate services firm CBRE. Investors are being more cautious, but late cycle strategies at this point look very similar to mid-cycle strategies, he says.

Normally, at this late stage of the cycle there are huge amounts of leverage and overbuilding. In fact, real estate is often one of the guilty parties in contributing to a late cycle event that tips the economy into recession. However, new property supply is relatively in balance with demand and there is not as much extreme leverage, partly because there has been so much equity available in the market, says Barkham. As a result, even if there is an economic downturn, commercial real estate is in a relatively good place, he adds.

Secular changes fuel buying

Several secular shifts driven by disruptive technology, demographics and social changes make this a very different end of cycle, industry experts say. The impact of those secular shifts has created a variety of still viable late-cycle strategies.

In past cycles, one could point to examples where investors continued to blindly buy assets even while an avalanche of new supply unfolded around them, notes Barkham. “I don’t think that is true in this case. Most investors see the end of the cycle, but they also see these long-term drivers,” he says. “So they’re willing to take a position in real estate, notwithstanding the fact that interest rates are going up and there are one or two economic wobbles around the world, because they see the demand side of the picture is benefitting from longer term changes.”

Changes in the marketplace, including the growth of e-commerce, the prevalence of the co-working trend and growing demand for “experiential” space across property types, are creating some interesting late-cycle investment alternatives. For example, the rise of co-working has pushed companies to rethink the type of space they want and need to attract workers. Additionally, the growth of e-commerce has presented a challenge for traditional retail, while at the same time driving more demand for industrial and logistics space. Investors that have been cautious of the downside risk in retail are now looking at some late-cycle acquisitions. There are opportunities in retail where prices have over-corrected to the downside. Investors see an opportunity to get in at a lower basis and be able to reinvest to reposition or re-tenant the asset or add value, notes Steve Pumper, an executive managing partner in Transwestern's capital markets and asset strategies group.

“You need to proceed with caution, but I think there are opportunities within the retail sector,” he says.

The focus on retail goes hand-in-hand with the broader industry trend of redevelopment and densification occurring at retail centers where owners are taking advantage of surplus parking or empty big boxes to add restaurant or entertainment venues, as well as bring in mixed-use components ranging from apartments and hotels to office space. These strategies help add value to the assets and also drive more traffic to retail tenants.

That trend of transforming retail could actually pick up in 2019 because of how e-commerce has changed what people want from the retail experience, notes Pumper.

Hunt for yield continues

Investors are mindful of risk at this stage of the cycle. But at the same time, there is still a lot of capital in the market and investors are feeling the pressure to make acquisitions with “dry powder” that is currently at all-time high levels.

Since 2015, investors have been shifting their focus to secondary and tertiary markets in search of higher yields as competition put more pressure on cap rates in primary markets. “Throughout 2018 we have seen a little bit of a reversal of that strategy, especially as it relates to the office sector where more investors are going back to the basics,” says Ferroni. Investors are saying that they want to deploy capital in a more secure, liquid market to better position themselves for an eventual softening in real estate fundamentals, he notes.

Over the past two years, there has been less transaction activity among core assets in gateway markets because that’s where yields have compressed the most. “The opportunities that are getting quite a bit of attention at the moment are where investors can find a core plus or value-add opportunity in a primary market, because it checks multiple boxes for what investors are looking for at the moment,” says Ferroni.

There has been a slight retreat from higher risk opportunistic investments. However, the appetite for value-add remains strong, which could be a sign that people do see a soft landing versus a steep drop, says Barkham. “I think people do know there is risk out there and they are watching it, particularly when the bond yield goes north of 3.3 percent, there are waves of nervousness that go through the marketplace. But intellectually, and on the ground, people are looking at the demand side as being pretty robust,” he says.

In addition, investors do need to be prepared for a rocky ride that might last 24-36 months, adds Barkham. “Our view is that this will be a relatively mild downturn,” he says. Real estate remains a very viable investment. However, investors need to be ready to actively manage their assets, and work with their tenant base to maintain cash flow.

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