Continuing economic uncertainty keeps the door open for middle market investors – Trade Observer
Historic federal stimulus levels have kept commercial real estate assets at a stable level that contrasts with what many of us feared in the spring of 2020 – a collapse in prices in the midst of a second Great Depression.
Instead, the second quarter of 2021 could be called exuberant, with multi-family and industrial valuations, in particular, hitting record highs.
However, the last weeks of July brought a noticeable change in market sentiment. Earlier in the summer, hopes were high, people were traveling, and CEOs made bold statements about the return of white-collar workers to their offices.
Now concerns about new coronavirus variants, infection rates and inflation dampen any optimism that should be inspired by the continued pipeline of historic-level government infrastructure spending.
We are back in the realm of uncharted territory – an unstable and unpredictable macroeconomic situation. While it can be daunting, there is a proven approach to commercial real estate investing in such an environment. This includes structuring transactions with embedded capital and other protections, and finding untapped niches in the market.
One of those niches is the mid-market, with property types encompassing multi-family, industrial, office, retail and hospitality buildings.
Most institutional investors, with hundreds of millions and sometimes billions of dollars to allocate each year, compete only for deals over $ 100 million. Anything less than $ 50 million is often too small to be interesting.
As a result, there is a vacuum in the capital markets for middle market commercial real estate transactions, despite the fact that the middle market accounts for the vast majority of commercial real estate as an asset class.
This inefficiency presents an opportunity for higher risk-adjusted returns for investors who can research and value these types of opportunities.
Of course, finding mid-market deals can be labor-intensive. Unlike mega-trades typically executed by large institutional investors like public real estate investment trusts (REITs), mid-market operations by definition involve smaller, lesser-known properties or properties without any public visibility.
Local knowledge is essential to identify and access these “under the radar” investment opportunities. For this reason, many mid-size commercial real estate investors are local operators.
This local specialization, however, is a double-edged sword. Working in a smaller geographic area means a smaller pool of potential transactions. It also makes the local investor more vulnerable to negative trends in the local economy as well as the wider real estate sector.
This creates something of a paradox: the ideal situation for a middle market investor is to have intimate knowledge and connections in the local market, while being geographically diverse enough to mitigate local market risks.
For those who know how to square the circle, the structure of the transaction should vary depending on the characteristics of the local market.
In high value, high liquidity markets, the optimal approach is to invest less in the capital stack, take less risk and trade higher for capital protection, and one way to do this is to invest in structured preferred stocks.
In markets with low value and limited liquidity, the approach is to invest more in the capital stack, taking a little more risk as well as greater upside potential, through joint ventures and preferred holdings. in actions.
To maintain greater flexibility over investments in a changing market environment, an investor should retain the rights to approve major decisions, such as exit decisions, capital market decisions, and plan revisions. business.
An investment strategy that can take short-term uncertainty into account means entering and exiting investments quickly and easily, or structuring investments as more risk to ensure sustainability if markets deteriorate during the holding period. investments. It also means considerable profits before the equity of a transaction gets a return on its capital.
The demand for capital from middle market sponsors increases with increasing volume of transactions in the middle market due to the great macroeconomic uncertainty and the desire of many investors, especially those concerned about future tax increases, to exit. of their wallets.
This dynamic should continue for the foreseeable future and generate attractive investment opportunities.
Sam Isaacson is the Chairman of Walker & Dunlop Investment Partners, an alternative investment manager focused on mid-market commercial real estate investments.