June 17, 2014
Interviewed by: Privcap
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Exit Strategies: Pricing, Rental Growth and Competition

Pricing has risen quickly in many core and secondary markets in the U. S., forcing some buyers to underwrite aggressive rental growth to win deals. Experts from W. P. Carey, AXA Real Estate and Real Capital Analytics discuss.

Pricing has risen quickly in many core and secondary markets in the U. S., forcing some buyers to underwrite aggressive rental growth to win deals. Experts from W. P. Carey, AXA Real Estate and Real Capital Analytics discuss.

Pricing and Rent Growth Assumptions: A Tale of Aggression

Understanding Real Estate Exit Strategies

Zoe Hughes, PrivcapRE:

I’m joined here by Olivier Thoral of AXA Real Estate, Dan Fasulo at Real Capital Analytics, and Gino Sabatini at W.P. Carey. Gentlemen, thank you so much for joining me today.

We’re looking at exit strategies, particularly in the U.S. market. We’re definitely seeing a market that is almost thought to rebound and has recovered, yet a lot of investors are clamoring for yield and for deals. Gino, I want to open up the questions to you. What are you seeing on the ground in terms of opportunities and competition in terms of pricing?

Gino Sabatini, W.P. Carey:

The U.S. is very competitive, there’s no doubt about it. There’s a flood of capital both on the retail and the institutional side and people are searching for yield. It’s a low-yield environment and people need cash to live on. You can’t spend IRR on a daily basis. In a search for that yield, they’re bidding up the prices of assets, pushing cap rates down.

What’s surprising is that certain markets that historically have commanded a premium—a secondary market in Iowa for instance—now trade at a very similar cap rate or yield to a primary market. Especially on the shorter terms, we’ve decided to focus on some of the more primary markets because there’s probably less risk associated with those assets for similar yield.

Hughes: Olivier, you’re building asset portfolio obviously in the U.S. What are you seeing on the ground?

Olivier Thoral, AXA Real Estate:

As you know, AXA has been a very large asset manager in Europe for nearly 15 years and we started in the U.S. over four years ago. We don’t have a huge portfolio of real estate in the U.S. today, so we are growing that portfolio carefully, smartly, taking into account our client objectives. They want to get exposure and it’s a long-term exposure for most of them, rather than just an opportunistic play.

Also, we need also to take into account the state of the market. As we said before, this is a very competitive market. Core prime properties are probably overpriced, so we are looking for ways to grow the value over time. One strategy we are implementing is on the office investment, to look for leasing rates for repositioning risk whereby even if you are in a prime location, there is a bit less competition and you also can achieve a growth of the NOI, which over time will give protection against rising interest rates.

Hughes: Dan, talk us through some of the headline figures you’ve seen in terms of the U.S. market and capital trends. What was transaction volume growth when you look back at 2013?

Dan Fasulo, Real Capital Analytics:

We did about $350 billion with transactions last year. That’s all the property sectors. It’s up about 20% year over year, with some differences based on which sector you were in, but everything’s moving in the right direction.

There has been a massive shift or massive flows from core primary to secondary markets and secondary property types and it started in 2011. Last year, it really sped up.  The market capital’s not really discriminating market by market anymore. Wherever there’s some nice yield to be achieved, there’s capital there today.

It’s not just the equity side. It’s the debt side as well, which is the missing ingredient to make all these secondary markets move again.

Hughes: Olivier, are you actually expanding your search in terms of where you’re searching for deals given what’s happening with the ultra-core markets and pricing there?

Thoral: We are targeting more or less the 10 largest U.S. markets. We have a focus on the gateway cities, which are resource constraints because that’s a protection of long-term values.

Also, we are looking at a build-to-suit industrial strategy, again, because we believe it’s a way to get invested in certain income-producing properties with the right selection of the partners in terms of delivering the construction and the location.

So, we’re a bit contrary to W.P. Carey. We are not just focused on income or primarily focused in income. We also are looking at capital values, not just as an exit but also throughout the life of the property because an important part of our capital is it might liquidate the objectives sooner rather than later, so we need to be able to have sustained capital values throughout the life of an investment.

Sabatini: That makes a ton of sense and that’s what creates opportunities for buyers and sellers. We have different objectives for our capital. He may need to get out of a property because his hold period is shorter and his investor demand is different. On the other hand, we have investors who are looking for a longer hold period.

Hughes: With that focus on the more core primary markets, what are your expectations in terms of vacancy and rent growth? What are the underlying drivers of that NOI growth?

Thoral: We want be convinced that there is a real ability to grow income. We may look at the property that’s under-managed and, therefore, has much higher vacancy rate than the average on the market or that is significantly under-leased. But, we are looking for vacancy and working on active asset management to lease up that property rather than betting on rental growth because we all know it’s cyclical.

Hughes: Are people really underwriting the rental growth as they look forward for the prime markets?

Fasulo: What choice do you have? In a place like Manhattan, if you’re not underwriting growth, you’re not winning the deal. We’re already back to that in your top five or 10 markets. Across the board, when it comes to property sectors, it’s a decent bet in certain supply-constrained environments where vacancy levels have gotten back to that historical point where rents start to spike. We’re close in a couple of markets.

Nationwide, that’s when I get nervous, when you’re underwriting 3% to 5% growth in Chicago or Houston.

Sabatini: We really don’t factor in rental growth in our backend residual value assumption. We factor in the rents that are built into the lease and that’s it. We lose a ton of deals. I couldn’t tell you how many we see every week, probably 100, and we do maybe 35 a year.

As Dan said, the only way to win, especially core MSA deals, is to assume a larger backend residual. You can do that either through aggressive rent-growth assumptions or through a big sale price down the road. It comes out to the same bet that you need to make.

Hughes: With interest rates expected to increase, are we going to see cap rate expansion in the future? What does this mean for some pricing of the deals out there?

Fasulo: It varies by property sector. Multifamily makes me a bit nervous because rents have basically come back to an all-time high, expenses are going up, and taxes are through the roof. So, if debt costs rise for multifamily, you’re not going to be able to squeeze out as much income to negate higher debt cost.

But for retail, industrial properties that need a lease-up situation, rents are still 15% to 20% below former peaks. You have some room to run on the NOI side if rates do go up.

Given the wall of capital we’re tracking on both the equity and debt sides, there is a scenario where rates come up a bit and cap rates still fall, given the historical spreads we’re seeing out there.

Hughes: Olivier, as you look to rising interest rates, what are you expecting to see in the market in terms of your underwriting?

Thoral: When we underwrite over time an increase of cap rate because we want to be on the safe side. We are losing deals for that reason as well, but Dan is right. In some cases, there is so much capital that it puts into question a lot of the traditional views on markets.

However, we can’t see how cap rates could not increase at some point. The question is when and by how much? There are various scenarios. That’s where you need to build and study on the right thing to assess the level of risk you can take depending on your client objectives and those specifics of an individual property. There is a price point beyond which you don’t go. Either it works or you lose.

Fasulo: There are a lot of other wild cards, too. I heard in D.C., the 1031 exchange is in play here in America, which makes me nervous. I’m sure it makes everyone nervous.

Hughes: What is making you nervous as you look out at the market with pricing today?

Sabatini: Given our business, how we’re a long-term holder and we actually set our debt for a very long term at the inception of the lease as well, short-term rises in interest rates don’t affect the assets we already have on our balance sheet. Now, if this scenario that Dan laid out with rising interest rates and falling cap rates would actually occur, we would become a seller very quickly. That would be a sure sign that the market is overheated. My guess would be that interest rates will rise, as everyone is expecting, and cap rates will follow at some point. The question is how quickly they will move up in lockstep.

Hughes: With a crystal ball in hand, would you be able to predict where transaction volume is going to be 2014 and looking out over the next couple of years?

Fasulo: Q1 was strong. It was up year over year, the largest quarter we’ve had since 2007 for the first quarter. The debt markets continue to perk up as we talked about. CMBS is back in a big way. Unless something blows up, we’re going to see continued momentum.

Sabatini: The momentum will continue as the equity is there and continues to come in; the debt markets remain good. Different people have different reasons they need to sell at all times. All the conditions are there for a continued, strong market.

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