FEATURE ARTICLE, JANUARY 2005

LENDING ACTIVITY: THE REST IS THE BEST IN THE WEST
Private equity bridges out of California into second- and third-tier markets.
Stephen Blue and Craig Reed

Blue

The private equity (PE) investor operating west of the Rockies is starting to see some fundamental changes in the market that will make investing in the second- and third-tier markets more attractive in 2005. These non-California markets offer not only geographic diversification opportunities for players historically focused on the Golden State, but also yield enhancements when compared to California’s currently diminished cap rate environment. As PE investors enter these markets, local owners and developers will also gain in the form of access to more capital.

The Golden State Boils Over

Reed

California’s current commercial real estate market in many ways resembles the historic gold rush days as investors have converged on all types of commercial product up and down the state, staking their claim on the “sure thing” promised by the success of the prospector before them and the fertile ground of the state’s strong fundamentals. California real estate has been buoyed by the long-term economic factors of a diverse economy, international trade links, limited land for new development, high replacement costs and a population that is expected to grow from 42 million to 48 million people by 2020.

But just like the gold rush, there comes a time when too many prospectors are combing over the same claims and the nuggets are getting harder to find. As the pool of quality institutional assets diminishes, heightened focus has been placed on identifying below-market and value-added assets, leaving very little room for competitive yield enhancement. Even experienced regional owners and developers in California are finding it nearly impossible to find deals that achieve anything above a 5 or 6 percent cap rate.

California yields have been held down by a perfect storm of factors. Historically low interest rates made deals possible even as vacancies increased and property values soared. Investor appetite fleeing the stock market for a safe harbor after the “tech wreck” has kept momentum up even as traditional fundamentals weakened. Institutional investors are operating under the assumption that California is risk adverse because when the state recovers in the long term, returns will merit the high prices they paid based on replacement costs and high barriers to entry.

This belief in risk-adverse future returns has led to massive capital infusions in the California real estate markets by the institutional investors, Wall Street funds and tenant-in-common (TIC) syndicates. Flush with capital, these deep pockets are chasing any California deal that is located in the Los Angeles, Orange County, San Diego and Bay area markets. They are in the market long-term and will continue to embrace the same valuations in 2005 as they did in 2004 and 2003.

Because of their appetite for all things Californian, institutional investors have essentially created a climate where PE investors find themselves competing for core-plus and value-added opportunities against what were historically core-asset players. No one is counting California out, but it is no longer the growth market it once was.

Where Do We Go From Here?

This same California “gold rush” has also created PE investment opportunities outside of the state in the other western markets. Many of the institutional investors will continue to see California as the “play-it-safe” market and continue paying the record-setting prices to do business there. This will keep the institutional players out of the other western markets, with the exception of a few key trophy office markets and other proven central business districts (CBD). But for a less risk-adverse investor, like a PE investor, opportunities in these unsaturated markets are becoming more appealing through a joint venture with a local operating partner.

Asking values more closely reflect fundamentals in the other western markets and are beginning to draw interest from equity sources for the simple fact that they fit the traditional value-added or market opportunity cycle investment play. Also, there is a capital vacuum in the markets outside of California, and this bodes well for the PE investor currently competing with the flood of capital in California from institutional investors and TIC syndicates.

Reports and forecasts are indicating that the tepid national economic recovery is strengthening fundamentals in most every major city market in the West. This, in turn, is leading to the emergence of opportunities in cities like Las Vegas; Phoenix; Tucson, Arizona; Denver; Salt Lake City; Seattle and Portland, Oregon that were off the radar during the California boom. Most of these states and metros were harder hit than California in the recent recession, but are now equally well-positioned for an upside as the general economic recovery takes hold.

Since low interest rates are common to any market, the goal today is to find properties priced appropriate to their fundamentals. Since competitive demand is not driving prices up like it has in the California market, cap rates from the 7 and 8 percent range can still be found in the markets outside California that have strong urban concentrations. These more promising cap rates are based on current vacancy and pricing trends more realistically approaching net operating income and anticipated market corrections.

This perception is supported by the fact that the general economic recovery is once again strengthening most major city markets throughout the West. In the quarterly market reports, major brokerage houses are showing absorption in the Phoenix, Denver and Las Vegas office and industrial markets, a promising sign based on restraint from the development community in these sectors. Also, strong occupancy and limited product supply are becoming evident in the multifamily markets in Las Vegas, Portland and Denver, to name a few markets with strong fundamentals for existing product. This creates tremendous upside for investors who get into these markets early as occupancy is positioned to grow in well-positioned assets.

These markets for many reasons — most of them operational — do not appeal to the institutional investor, but still have strong offerings for the entrepreneurial real estate investor. Institutional investors like to concentrate their holdings in markets where there is ample stock of institutional grade product with which to build a portfolio. They need these locational synergies to support the necessary operational structure to underwrite and oversee their assets.

Conversely, many of the larger western developers based in California are beginning to seek growth opportunities outside of the state, and doing so with institutional backing. But this trend could also help bolster the opportunities for the PE investors in the same expansion markets as regional players will want to become more competitive and secure joint venture partners who can help them compete with capital infusions to support their acquisition and development efforts.

Regional owners and developers in the second-tier markets have had to compete for a limited amount of trophy real estate opportunities during the past 2 years — the only deals that made sense in a downward trending market during the recession. Without the same access to capital that is available to established national owners and REITs expanding into their markets, these regional firms could only bide their time.

The well-capitalized interests have been approaching the second-tier major city markets throughout the West for the low hanging fruit that exists in every city, including trophy assets in CBD markets, high-occupancy properties and new development opportunities in the suburban growth markets. This competition will only increase as opportunities become more and more limited in California and other popular institutional markets across the nation.

But these investment criteria only scratch the surface of opportunities available in any major city market. There are many challenged or under-performing assets in all of these markets that with the right management can return value and yields far outpacing what is available today in California. These complicated transactions do not appeal to the institutional investor, who lacks the infrastructure or local partners to underwrite these value-added deals.

Also, rising land and construction costs for future developments will make infill, value-added and redevelopment opportunities feasible in many of the second-tier markets that typically do not have high barriers to new development, especially communities surrounded by expanding suburban submarkets. Established property concentrations will fare well under these conditions. These one-off projects are too small to appeal to institutions and large developers.

Existing properties with value-add plays and market upside will always be on the radar of the local owner or developer well-versed in their local market dynamics. Since equity investors work best with experienced operating partners, this yield-driven migration from California bodes well for the potential partners regionally located in these non-California markets. Before long, private equity should provide these local firms with many of the same portfolio growth opportunities that have driven the success of firms specializing in California real estate and development during the recent boom.

Stephen Blue and Craig Reed are vice presidents at Buchanan Street Partners.


©2005 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.