FEATURE ARTICLE, SEPTEMBER 2006

PRIVATE INVESTMENT OUTLOOK
Investors are awakening to the fact that “trees don’t grow to the sky.”
Ned O’Hearn

O’Hearn

Things are different now. Good product is still available, although some investors sense a diminishing supply. Prices generally are holding firm, an annoyance to some buyers who feel they should be slipping. And buyers, though plentiful, are exercising more caution, either through self-discipline or under the ever watchful eye of their lenders.

While just about everyone senses the change and can recite the reasons why, there’s not much consensus on how to react. Investors in this way are much like hurricane watchers — they all get the same reports, but respond differently. Some shrug and go about their business as usual, others hunker down and prepare to brave the storm, while still others drop what they’re doing, close shop and head out of town.

Interestingly, the hurricane analogy is seemingly not overstated. When asked for their 12- to 18-month investment outlook, the greatest number of western investors sampled by Western Real Estate Business chose “obscurity & concern.” Some opted for the somewhat less fatalistic “volatility & uncertainty,” and one created his own less than cheery category — “cautious & guarded.” As might be expected, a few investors selected a more comforting option — “balance & stability.”

Among buyers, this cautious, if not overtly gloomy, long-term outlook belies an unabated interest in looking at deals. Few investors have retreated to the sidelines. Most religiously browse the scores of offerings that brokers deliver to their computer screens every day, always searching for the perfect fit.

Among the most active pursuers are the 1031 exchange buyers — investors “on the clock” to close a deal. This large group of buyers has been both praised for energizing the market and chastised for driving up prices. Jerry Banks, portfolio director of real estate investments for Lozier Corporation, is blunt with his assessment, maintaining that 1031s have “artificially or improperly driven up prices beyond true or intrinsic value.”

What 1031 investors lack — by prescription rather than choice — is patience. According to most investors contacted, patience is now the name of the game.

“Patience is a virtue,” advocates Andrew Kaplan, president of San Diego-based PacVentures Inc., a private investment firm. “There’s too much capital chasing deals; people are absorbing excessive risk without adequate compensation.”

Banks observes time-conscious 1031 buyers focusing almost exclusively on yields. “You just can’t chase yields,” he says. “1031 is the tail wagging the dog. It’s the intrinsic value of a property that will determine long-term value.”

Jim Ingebritsen, a 15-year industry veteran and partner at The Shidler Group in San Diego, thinks in lockstep with Banks on that point. He advocates “aligning expectations with the returns that can reasonably be expected.” And his advice if that can’t be done? “Don’t invest at all.”

“I don’t pay much attention to cap rates,” admits Michael Prochelo, president of Financial Management Group in Los Angeles. “Starting about 3 years ago, cap rates drove every deal. I tend to look past cap rates at what the tenant is paying in rent versus the market, costs per square foot and upsides.”

Prochelo has an appetite for retail deals with plenty of shop space. “That’s where you get bumps in rent,” he says. “I know people who brag about buying name brand pharmacies and the returns they’re getting. But with rents flat, those deals have no hedge against inflation. Let’s face it, escalations are an owner’s only hedge against inflation. I don’t even trust Wal-Mart as a shadow anchor. They’re now putting Wal-Marts within 5 miles of each other. They can go dark and that can doom your center. Look what happened with the Kmarts.”

Focusing exclusively on yields can lead to other bad habits, like pushing the underwriting to generate better yields. Banks believes that financing is “overused as a tool to drive returns.” Ingebritsen is more alarmist, calling the practice a “recipe for disaster.”

Banks maintains that focusing on a property’s intrinsic value means taking the time to look past basic rent rolls by meticulously scrutinizing tenant qualifications or paying much closer attention to what’s happening immediately around a property. “Real estate is local,” he says, repeating a much acknowledged but oft-ignored industry tenet. “You can’t apply national statistics and trends to every market. You have to dig deeper and really know your neighborhood.”

But knowing your neighborhood is fast becoming a reason for wanting to look beyond it, particularly in the pricey major markets of the West. Deals that radiate intrinsic value and are priced appropriately are becoming harder to find than a poultry farm in Petaluma.

Some investors, like Chris Jones, president of Warmington Capital Partners in Irvine, California, have started adjusting their geographic lenses. Lamenting that “it’s tough finding deals at pricing that makes sense” — a sentiment he shares with most of his investment colleagues — Jones initially redirected attention from his native state to focus on investments in Las Vegas and Phoenix. That tactic proved illusionary; he found that California cap rates followed him to those cities.

Rolling the windows down and cruising for sweet deals in less familiar markets is a strategy that some investors have embraced, albeit reluctantly. For example, Kaplan, whose interest is multi-tenant, value-added properties, unloaded his assets in California and Arizona and now focuses his attention on some less crowded markets in the Midwest. While acknowledging that smaller markets can be short on tenants, he sees untapped opportunities in non-mainstream cities that are “growing nicely.”

Investors who don’t have the time to cozy into new, perhaps smaller, markets are at risk. Lozier’s Banks, a Midwesterner himself, is one of them. “If someone has to place money, then that strategy might be an option. But, the costs associated with oversight and the price paid by not knowing the market or not having demand when it comes time to sell may end up overshadowing the advantages gained on the front side.”

“You have to have boots on the ground,” says Shidler’s Ingebritsen, invoking an image that Larry McMurtrey might construe as cowboy talk. “Real estate is a very parochial business, and one can make very serious errors in judgment by moving into smaller markets in search of higher yields. [Also,] liquidity is critical. In the smaller markets you have to ask yourself — where’s the liquidity on the way out?”

Cap rates are chasing some buyers out of the glamour markets of the West into less familiar territory — cap rates that stubbornly refuse to climb despite methodically ratcheting interest rates. Very few investors interviewed said that “cap rates are reasonable and for the most part justified.” The majority of investors surveyed felt that cap rates “should be somewhat higher.”

Marc Goldman, vice president of acquisitions for Fowler Property Acquisitions, whose current main focus is Colorado, feels that cap rates “should be much higher” than they are. From his perspective, liquidity in real estate markets is the culprit, citing liquidity at historic highs while cap rates hold at historic lows. He contends that “the cap rate environment won’t change until the amount of liquidity in the market dissipates.”

What Goldman is inferring, of course, is that the familiar complaint about the price of beer at the ballpark applies to real estate as well. Fans complain bitterly about the outrageous price of beer, but mostly to each other as they wait in line to order their favorite brew. Goldman doesn’t observe much of a pricing difference at real estate’s minor-league cities, maintaining that “there’s only a marginal premium on the cap rate for acquisitions of all product types in the secondary or even the tertiary markets.”

A majority of investors seem to feel that cap rates will eventually be forced upwards by further increases in interest rates. Adrian Evarkiou, senior vice president of Orsett Properties in Phoenix, predicts the retreat of institutional buyers to other investment options will herald a hike in cap rates. “They should bump up,” he says, “because the institutional money won’t tolerate a rise in interest rates.”

Another sign of change is the more visible presence of lenders at the negotiating table — lenders less occupied with projected yields and more focused on fundamentals. Bill Pantazopoulos, vice president of dispositions for ORIX Real Estate Capital, has seen a major shift in lender attitudes. “Lenders are applying a lot more scrutiny to deals. On the disposition side, we’re much more cautious in vetting investors, and, as much as possible, we’re trying to engage their lenders early on in negotiations.”

Despite the noticeable change permeating the real estate investment market and investors’ uneasiness about what might lie ahead, business goes on. It goes on because investors — especially the private ones — are generally resilient types, able and willing to make adjustments, toss out old notions, and try out new strategies.

What makes private commercial real estate investors a particularly interesting lot is that they don’t like to play “follow-the-leader.” To begin with, there really are no leaders. Every investor sees the same signs and gets the same reports, yet every one of them — like hurricane watchers — responds in his or her own way.

A good deal to one is not such a good deal to another. A random sampling of cap rate expectations on different product types revealed wide discrepancies of opinion. On multi-tenant office product, the range of acceptable cap rates ranged from 6.5 to 8.5 percent. For net-lease office space, the range was 6.5 to 7.5 percent; 6.5 to 8.5 percent for multi-tenant industrial; 6 to 8 percent for net-lease industrial, 6.5 to 8 percent for multi-tenant retail; and 6 to 7.5 percent for net-lease retail. With such widespread levels of tolerance, there’s little wonder why liquidity remains at what Marc Goldman perceives to be “historic highs.”

Besides exhibiting different yield expectations, investors again defy a sheep’s mentality when it comes to product type. Unlike toys and designer jeans, commercial product types don’t surge in popularity then universally fall from favor. Investors contacted for this investment story reflected the diversity of thinking on product type that permeates the industry as a whole, with some focused only on office, others on office and flex, others on industrial and retail, others on office and retail, etc.

This diversity of thinking extends itself to types of deals as well. Every investor contacted acknowledged a keen interest in “multi-tenant, value-added” properties. “Upside” is definitely “in.” Beyond that, diversity reigned, with some investors focusing on “triple-net, long-term” properties while others, comfortable with the bright lights and high prices, targeted the glitzier “multi-tenant core” properties.

The relentless pursuit of higher yields among buyers, a truculent resistance to raising cap rates among sellers and a general aversion to paying capital gains taxes have yet to create a serious, widespread standoff in the industry. Deals are still being made — some good ones, some bad ones and for some only time will tell.

But, the market, as alertly analyzed by investor Jerry Banks, is definitely more “pensive” than it was a year ago. It’s likely to get even more pensive when both buyers and sellers come to terms with the fact that, as Greg Fowler, principal at Fowler Property Acquisitions in Dallas is fond of saying, “Trees don’t grow to the sky.”

Ned O’Hearn is a principal at Scottsdale, Arizona-based Boulders Realty Advisors.

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