February 15, 2016
Interviewed by: Zoe Hughes
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Investing Through The Real Estate Cycle

Harbert Management Corporation is reducing the pace of its multifamily acquisitionsand ramping up its retail deal flowas it responds to the weight of capital targeting U.S. commercial real estate. Senior managing director JonPaul Momsen talks about the firm’s strategy in retail, how Harbertdespite doing fewer multifamily dealsis getting more creative in the sector and taking on assumable debt, and how the firm is underwriting the next recession. 

Harbert Management Corporation is reducing the pace of its multifamily acquisitionsand ramping up its retail deal flowas it responds to the weight of capital targeting U.S. commercial real estate. Senior managing director JonPaul Momsen talks about the firm’s strategy in retail, how Harbertdespite doing fewer multifamily dealsis getting more creative in the sector and taking on assumable debt, and how the firm is underwriting the next recession. 

Less Multifamily, More Retail for Harbert
With Jon-Paul Momsen of Harbert Management Corporation

Zoe Hughes, Privcap: I’m joined here today by Jon-Paul Momsen, Senior Managing Director of Harbert Management Corporation. Thank you so much for joining me today.

Jon-Paul Momsen, Harbert Management Corporation: Thank you for having me, Zoe. It’s great to be here.

Hughes: There’s much debate in the U.S. about the maturity of the real estate cycle and where we are today and how we all need to be preparing for the next downturn, not least by taking risk off the table. Yet there’s also a counterargument that this point in the cycle is actually a good time to be doing value-add and adding a bit of risk. You’re in charge of Harbert’s U.S. strategy. We’re seven years into the recovery; [there’s] not much clarity about where we go, but are you worried about where we’ll be in three or four years?

Momsen: Certainly, that is something we think about when we’re underwriting transactions. In our view, the recovery has been rather lackluster and that’s been good in the sense that it hasn’t built up the imbalances in the system. So, we certainly believe there is a real estate cycle and, at some point, there will be a downturn. But our belief is [that], one, it’s not imminent—it’s not in the next year or two. It’s probably three or four years out, as you say. And, two, it’s probably a shallow downturn. It’s certainly not as bad as 2008 was.

Given the cycle we’re in, we think the returns that are driven by a recovery in pricing are largely over. So, as you mentioned, we believe today really is the optimal value-add part of the cycle where, if you’re creating value in your asset, even if and when there is a downturn, you can still deliver returns that are attractive to your LPs.

Hughes: So, much more an operational part of the cycle?

Momsen: That’s right. You need to be creating cash-flow streams, improving cash-flow streams and improving the quality of the asset and baseline market rental growth may well disappoint. Inflationary, or to the extent we have a downturn, less than inflationary. You need to be ready for that and the investments you’re making need to be robust enough to absorb that.

Hughes: As a GP, particularly, how does that shape your strategy? When you’re looking at property types and where to invest, how are you looking at the next 12 to 24 months?

Momsen: Certainly, it affects how you select markets. There are some markets that are more volatile than others and they do well in a recovery, but they do worse in a downturn. So, certainly, we’re cycling away from those volatile markets—Phoenix, for example. By the same token, we’re also looking at when are tenants rolling in our assets. As we said, we don’t believe there will be a downturn imminently, so we would prefer for there to be early roll in the asset that we can reposition, rather than roll later in the asset’s hold. We’re very cognizant of when the tenants are rolling in our portfolio.

Finally, to us, it informs how you use debt. We want to make sure there’s flexibility in the debt that we can sell earlier to take advantage of this near-term recovery. By the same token, we want enough term in the underlying debt that we can go longer should we need, if there is a downturn we need to ride out.

Hughes: You talk about obviously the leases rolling. Does this also mean that you would look to exit as quickly as possible from any deal?

Momsen: That’s right. I think we would be very active sellers. We want to create the value and we have a business plan to do so. What we’re seeing in today’s environment is because the recovery is there, oftentimes we’re executing our business plan sooner than we anticipated. Rather than holding that asset longer to collect cash flow, we’re going to be active sellers of those assets as soon as possible.

Hughes: Give me a sense as to where you’re investing and where you’re getting excited about property types.

Momsen: If we look back to our portfolio over our last two funds, we’ve been close to 50% multifamily because we’ve found that opportunity to be especially attractive. We continue to think the fundamentals of multifamily are attractive. Our issue is that there’s obviously been a lot of capital that’s come into the multifamily market, so we’re finding the buy to be less attractive today than it was. In our minds, we see the multifamily portion of our portfolio coming down to roughly a quarter of the portfolio.

Hughes: That’s a significant drop.

Momsen: It is, and we would prefer to do more. It really is about whether we can access the deals and underwrite them in the way we would like to. Our view is that fundamentals…and rent growth are going to slow down over the medium term. So, with that view, when we price it that way, we’re just not competitive.

I think the flip side of that is we are rather bullish about the retail sector. In our last fund, we’d been 10% to 15% retail. We see that stepping up to around a quarter of our portfolio as well.

Hughes: What type of retail segment are you really looking at? What ticks the boxes for you?

Momsen: Certainly, we’d love to do grocery anchored—we cannot from a yield perspective largely do that. What we’re really looking at is more the fundamentals that have happened due to the densification of buying power that has been driven by all of the residential development we’ve seen in the inner, premier, suburban locations and inner-core urban markets. We’re going to be focused there, from a submarkets perspective.

Hughes: Obviously, retail is going through quite a transformation, with the internet and things. How does that impact some of the strip centers and the power centers you’re talking about?

Momsen: I think it is transformational what is going on and it needs to be recognized. That’s where the growth in retail really has been driven. By the same token, what we’ve seen is [that], over the last 10 years as this has become such a reality, a lot of retailers have learned how to adjust and use the online channel to complement their brick-and-mortar spaces.

Hughes: Very much that Omni channel.

Momsen: That’s right, and what that means is their format has changed. Best Buy is going from a 60,000-foot box to a 30,000-foot box. So, if you’re sitting with a retail center with a Best Buy in 60,000 feet and they’re rolling in three years, I think you need to be concerned. By the same token, we own a power center today that had a 30,000 vacancy and we took that Best Buy from the 60,000-foot box into our box. So, being very cognizant of how those formats are changing, but also recognizing—

Hughes: —Compressed formats, yeah.

Momsen: That’s right. But also recognizing that brick and mortar is here to stay. Especially in those walkable, premier suburban and urban locations. People still want to go to the store, peruse and buy there as much as they compliment that with their online sales. So, we don’t think it’s ultimately going to kill brick-and-mortar sales. We just think you need to understand the dynamics.

Hughes: Obviously, you’ve been a big investor in the multifamily side and you’re not pulling out completely. Are there other sectors of multifamily where you say, “This is a good time to be investing?”

Momsen: We’ve looked at the numbers and if you look—because nobody’s building B apartments—the actual share of the stock that is B today is shrinking dramatically as all this new A development is being delivered. The actual stock of affordable multifamily is shrinking today, while the demand for that continues to grow. So, we do see an opportunity there.

Hughes: Are you not seeing, though, the competition for deals? Because the capital is flowing. It is trickling down those classes and looking for the better opportunities.

Momsen: There is plenty of value-add capital in the multifamily space, for sure. So, what we’re trying to do is find opportunities where the capital isn’t. One of the seams we found that is quite attractive to us is buying deals that have in-place, assumable debt. That’s attractive because, I would tell you, 75% to 80% of the multifamily capital today is driven by current cash-on-cash yield. We’re absolute return buyers; we’re not current cash-on-cash yield buyers.

That assumable debt—number one, interest rates have stayed low, so oftentimes the interest rate is higher than you can get today. But, number two, and probably more importantly, the interest-only period has burned off usually when they’re selling, so the payment constant on the debt is that much higher, driving down the cash-on-cash yield. Those are attractive to us because it creates two value steams, if you want.

The first is, we get value from repositioning the real estate, which we’re good at. The second is, we get value from burning down that bad debt. And, as the term on that debt is reduced, the fees and costs are reduced. But also, to the extent we are in a rising interest rate environment, which we believe we will be again, that also will reduce the fees and costs when you come to sell it. We believe that creates extra value to the investment.

Hughes: Is there such a thing as an off-market deal today?

Momsen:    Certainly, that’s a question we get a lot. My belief is that yes, but they take different forms. So, there are some deals where, for example, we closed a deal in the recent weeks where we had closed a deal with the seller before.

The other aspect we see today is that the brokerage community, I think, for the last number of years has been out-indicated by the market. In essence, they’ve given opinions of value and the market has outperformed. So, in order to win business, I think they’re starting to indicate higher values and they’re now actually out-indicating the market, which is leading to a number of failed processes that we’re happy to participate in the process.

Then, the final way that we consider it off-market is a deal that is fully marketed, but I have something that everyone else doesn’t. Whether that’s a tenant-in-tow or knowledge of the asset that others don’t, etc., we consider that an advantageous way to buy from an off-market perspective.

Hughes: When investors speak to me, one of the things they’re very concerned about is obviously the lack of clarity in the cycle. This has been a very unusual cycle. It’s a much slower recovery and they don’t have the vision over the next few years. One thing they want is optionality. They want liquidity, but obviously not to keep things in cash. How do you as a GP create that optionality when you’re actually investing and looking to that down cycle?

Momsen: Yeah. For us, it’s all about portfolio construction. Part of this we touched on before, where we will be active sellers on the front-end of the cycle and be giving liquidity back to our investors. Not all of them want the cash back, but we believe that’s prudent. By the same token, we believe that you need to underwrite such that if there is a downturn, as we said, the returns are still robust enough to last through the downturn.

We’re making sure that, in all of our investment committee presentations, we’re underwriting a recessionary scenario. Usually, that is in Year 3, which is our view of about when this happens. That rent growth would go negative and, again, it’s submarket by submarket as we look at what those markets have done historically. But a year of negative rent growth, and then a year of zero rent growth—basically flat rent. And on either side of that, just inflationary rent growth. If we look at that scenario, we’re looking to make sure the investment still delivers double-digit returns to us—10% to 13%. [That’s] certainly below our target returns, but robust enough not to disadvantage the rest of the portfolio significantly to make the fund not deliver on its returns. Finally, we believe that, on the backend of that downturn, there will be buying opportunities that will be very attractive.

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