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Some CRE Investors Switch Up Strategies as They Weigh Risk

Investors are increasingly underwriting deals with more conservative assumptions in the late stage of the cycle.

This year, commercial real estate investor Muri Richardson will stay the course with investments into office buildings that need repositioning, while life company Northwestern Mutual is eying investments in retail and cross-border deals in Mexico.

Commercial real estate investors are considering new strategies to deploy capital in 2019 amid a backdrop of concerns over slowing growth, equity market volatility and trade disputes. Others are sticking with what’s worked in the past.

Richardson, of Dallas-based Preferred Real Estate Investments, has followed a value-add investment strategy in the office sector in key Texas markets for the past decade, and says no new strategies are on tap this year.

“Although we’ve seen softening, the (Texas) market is still very healthy,” Richardson says. “We aren’t seeing fundamental change in the demand where we’d say, ‘Let’s do something completely different.’ We are a little more careful about the markets and where we go.”

Executives at Northwestern Mutual, meanwhile, have a contrarian strategy. They see an opportunity to buy retail at a moment when retail assets can be under-valued, so the company would like to make some “select acquisitions across the country” with an investment partner, according to Kevin Westra, regional director for the central region of Northwestern Mutual Real Estate.

“Then we are also looking to buy some office. I know that sounds crazy in this late cycle, but we are contrarian and going against the grain on that,” Westra said recently while at an Urban Land Institute capital markets event in Dallas.

Besides retail and office investments, Northwestern will also consider teaming up with investment partners to look at commercial real estate deals in Mexico, where the competition among institutional investors isn’t so intense, he said.

Commercial real estate had a tough start to the year with investment sales volume down across all sectors in January, according to Real Capital Analytics (RCA), a New York-based research firm. Growth in commercial property prices slowed to 5.8 percent year-over-year in January, with apartments showing the most upside at an 8.8 percent annual pace of growth. The industrial sector also posted steady annual price growth at 7.6 percent. Out of all property types, industrial had the strongest monthly gain at 0.6 percent, according to RCA, compared to 0.3 percent for all sectors combined.

Available capital, but conservative underwriting

Availability of debt and equity should keep commercial and multifamily mortgage originations roughly on par with the volumes seen the last two years, according to the Mortgage Bankers Association’s (MBA) 2019 Commercial/Multifamily Real Estate Finance Forecast, although slowing global and domestic growth may impact overall demand.

“There’s an abundance of capital,” said Richardson, but he also notes that the purse strings holders are becoming more cautious about letting go and that is making it more challenging to get capital to complete transactions. Richardson attributes the caution to the lateness of the real estate cycle.

“What that means is that our equity partners (and) our lenders are all underwriting more conservatively which makes it harder to execute on our side,” he said. “No matter how conservative we underwrite a transaction, our equity partner is usually underwriting it more conservatively.”

Tenant improvement costs are one of the biggest expenses for investors in value-add properties who have witnessed a dramatic rise in the costs of labor and supplies in recent years.

“Returns have compressed themselves,” Richardson said. “Two to three years ago, we were still trying to hit a 20 percent IRR. Today, if we can hit 17, we are really happy and our institutional partners are, too.”

Most popular strategies

Real estate investors surveyed by commercial real estate services firm CBRE plan to be more conservative in their acquisitions this year, but increased caution is counterbalanced by the search for yield, which is drawing more investors into secondary markets, according to the “Americas Investor Intentions Survey,” by CBRE Research.

Value-add remains the most attractive asset strategy (37 percent of surveyed investors), with secondary markets (33 percent) a close second, according to CBRE. The percentage of investors pursuing a secondary asset strategy has increased now for five consecutive years, according to the firm.

Orlando was the biggest secondary market winner in terms of rising investor interest in the city. Denver, Phoenix, Nashville, Tenn., Minneapolis/St. Paul and Las Vegas are also popular. When it comes to primary markets, investors prefer Los Angeles and Southern California, Dallas-Fort Worth and Washington, D.C.

Although risk aversion is on the rise, core assets are less favored, which could be due to high asset prices and scarcity, the CBRE report notes. But while many investors remain optimistic, Jonathan Geanakos, president of the Americas capital markets group with real estate services firm JLL, notes that caution is creeping in.

Investment sales activity in the U.S. is expected to moderate by 10 percent as investors become more selective and develop new strategies to deploy capital, against a backdrop of slower growth, says Geanakos. “Fundamentals are still strong and there are pockets of growth, but that growth is not consistent across all sectors, and we’re starting to see some defensive positioning creep in,” he notes.

Editor’s Note: NREI contributing writer Kerry Curry occasionally writes for the Urban Land Magazine, a ULI publication, where she covers activities of ULI’s North Texas chapter based in Dallas.

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