February 10, 2014
Interviewed by: Privcap
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GreenOak: Navigating The Gateway Markets

NYC, LA, Boston & San Fran. Investors can still reap rewards from what are now considered the riskier gateway markets, and Sonny Kalsi of GreenOak describes the “core four strategy” to pinpoint value in these saturated, major cities.

NYC, LA, Boston & San Fran. Investors can still reap rewards from what are now considered the riskier gateway markets, and Sonny Kalsi of GreenOak describes the “core four strategy” to pinpoint value in these saturated, major cities.

GreenOak’s Core Four Strategy: Navigating the Gateway Markets

With Sonny Kalsi of GreenOak Real Estate

Zoe Hughes, PrivcapRE:

I’m joined here today by Sonny Kalsi of GreenOak Real Estate, welcome and thank you for joining me.

Sonny Kalsi, GreenOak Real Estate:

Thank you Zoe.

Hughes: In the wake of the crisis we’ve seen major capital inflows going into the gateway markets globally to the point where some core investments are really now considered perhaps even more riskier than value add and opportunistic, with cap rate expansion on the horizon growth slow actually at best, is there actually any value in gateway cities today?

Kalsi: Yes but it’s harder to find. So, strategically, the way we thought about investing is then, what we call core four investing, so investing in four core markets, New York, Boston, LA, San Francisco. And we started this strategy about two and a half years ago and it’s definitely harder now than it was then, there’s a lot of capital, more people coming into the market everyday, it feels like someone is raising a new core fund or a new Chinese investor or somebody else that’s showing up. But one thing that I have found is that a lot of that capital is still very focused on higher quality, stabilized assets, stuff that requires less work and so my view is as long as you’re still willing to do the hard work there’s still money that can be made.

Hughes: Cause obviously what we’ve seen from the investors is really going for the ultra-core, but some of the cap rates, some of the deal, the pricing has been exceptionally low also, the price has been very high, so we’ve seen that kind of move to secondary markets, do you not think this is the time to perhaps look for, kind of take on a little bit more risk, look for high yields outside of the core markets?

Kalsi: My issue simplistically is we have about 25 years of investment data to look back on and we’ve done a lot of parsing and analysis on it, and I’m not sure I’ve ever really made money as an investor in a secondary market anywhere. Secondary city even China, I would challenge most Americans to name a secondary city in the UK, much less the U.S. we just haven’t made money in them historically and I think what we have found is that we’re better off staying focus on the big gateway cities and liquidity and when that opportunity doesn’t make sense anymore, you pull back, you just don’t invest so much right, and that’s probably a little bit of a leading indicator cycle wise that maybe we’re coming towards the end of the cycle. The issue of the secondary market very simply is I think they’re classic value trap markets, meaning that they look cheap on paper, they can very early a relatively better spread, you can go in, you can enjoy that yield but there’s two issues. Keeping that yield, there’s not as deep tenant markets right, number one, number two much lower barriers to entry, right so when rent starts going up a little bit, people start building new assets, which really puts a cap on rents, but then the biggest issue is liquidity on sale. I mean honestly people don’t want to be in those markets long term right, they’re trading markets even for institutions and for sure, the wealthy Chinese guys that are showing up to buy three flats in an office building in the U.S. are doing it in New York and San Francisco, they’re not doing it, my partner and I always pick on Cincinnati and Nashville because those are our two relative home towns right, so I won’t pick on somewhere I’m not from, but they don’t want to do it in Nashville or Cincinnati.

Hughes: So as you kind of look back to kind of the core markets, the New York’s the London’s and how do you actually create NOI growth, that’s the major concern, that with interest rates going up, there will not be enough growth to offset?

Kalsi: Right, yeah. Well so I would look at it I guess a couple ways. The only way to create the NOI growth is really, you have to find something that is underperforming right, if you’re taking a bet on rents, I think that’s really hard to do. If I had to take a half step back, investing can be really simple, it could be about value or growth right, if you just really reduce it to its basic concepts I think at this point in the world it’s really hard to bet on growth anywhere right, there’s a lot of headwinds all around us, given what’s going on in D.C. right now, given what’s going on honestly in Asia, there’s a lot of headwinds, so you have to be very value oriented. The only way you find value in gateway cities is you have to find something that’s broken right, so it’s underlet for a reason, it’s got a bad capital structure for a reason, the landlord doesn’t have money, isn’t willing to invest in tenant improvements and you find those opportunities, that’s how my view is, you generate the NOI growth because you generate it off a low base, you’re not taking a bet for rents to go up. But that being said, when rent do, if they go up, they always go up first in gateway cities and they always go up at a higher rate in gateway cities because simplistically gateway cities have such a huge barrier to new supply, that it’s impossible to build. It’s impossible to build in New York and San Francisco, everything is built up, there’s no vacant lands anywhere so if you want to build something, you got to buy something, tear it down, get it re-entitled, build it, get the financing to build it, so that’s how we got to think about it.

Hughes: So what is the kind of depth of the market for these opportunities, you’re talking about the barriers to entry but there is a lot of capital coming into these markets, surely there can’t be that many deals out there, that need that reposition and that value add opportunistic strategy?

Kalsi: You know, you mentioned you work in London, that’s too big, two cities and 80 percent of what we’ve done in New York, London and Tokyo, so use those three cities, huge massive cities, Tokyo’s 800 million square feet, New York is 500 million square feet, London’s 300 million square feet, there three of the four largest office markets in the world. We have thousands of buildings and what I always tell people if you’re driving in from JFK and you’re coming across the bridge and you look at the city and you see all these beautiful towers on the horizon, we’re not buying any of those right, you got to look down on the canyons and valleys and all these other assets, that’s where the opportunity is. In our business we’ve been able to invest 75 percent of what we’ve done off market right, 75 percent of the deals have been off market, but about 75 percent of what we’ve done have been buying from families, that is still, in these cities, you still have a lot of long term generational ownership, and you’re getting on the third and fourth generation where it’s one thing when it’s brothers and sisters that are owning the assets that dad put together, it’s another thing when there’s cousins and second cousins and third cousins, it’s a big opportunity there and I continue to believe that that’ll continue be a good opportunity, the other thing which I think and you referenced interest rates are starting to go up, I think that’s going to create opportunity.

Hughes: In what way?

Kalsi: A lot of people, whatever term you want to use, kicking the can down the road or delay and pray, they’re both such great ones that came out of this last cycle. I think that when rates go up it’s really, anyone that’s been able to get by in an artificially low interest rate environment they’re not going to be able to do it anymore. And if you think about it, if their asset’s been suffering from an NOI standpoint, they’ve been able to get by with low debt service coverage, if they’re not in a position to improve their own NOI for all the reasons I mentioned before, when rates start going up they’re going to come under pressure and I do think a lot of the financial institutions are in much better shape today than they were in ’08 or ’09, they’re in a much better position to take the loss and move on, and we’re seeing more and more of that actually, the amount of distress deal flow we’ve seen in the last 12 months, it’s been higher than what we saw in the 24 months before that and I think it’s because of this.

Hughes: What’s your expectations in terms of that distress deal flow as you kind of look forward to the next 24 months?

Kalsi: I think it’s going to increase, I really do. I think if you look at all this financing that got done from ’05 to ’07 about half of it’s been dealt with, half of it hasn’t been dealt with and the half that hasn’t been dealt with, the good news for them, the lender/borrowers is that values are up, the bad news is NOI hasn’t gone up a whole lot right, I mean values are up not because rent’s gone up a lot, it’s because cap rates will come down because of this artificially low interest rate environment we’ve been in. I think as interest rates go up, it’s going to seem a bit paradoxical to people but actually I think it’s going to put more pressure on these guys right. So look, I’m not, I tell my investors hey, look, we’re a distress fund, we had a lot of stuff through distress, I think it’s going to put pressure on people at the end of the day, the last two investments we’ve made in the U.S. were both deals where the borrower sold the asset, the lender got paid off in full and one case the borrower got nothing, and the other case the borrower got a little bit, they would have lost money, the lender would have lost money, sold it two or three years ago but the borrowers are at least getting to a point now where they got through it, they don’t have a taint on their record, they can repay their lender, there’s more of this that’s going to come out to market right and it all comes down to your ability to increase NOI.

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