How Real Estate Investors are Navigating a “Fully Priced” Market

For institutional investors, 2016 was a year of portfolio rightsizing. In 2017, this cascaded throughout the commercial real estate sector, which has seen an increase in flight-to-quality strategies, a widened bid-sell gap and uncertainty related to the effects of monetary policy. It appears the industry may be coming to terms with a slowing market.

For more in-depth understanding of the challenges and opportunities the industry is facing right now, NREI spoke with Rick Chichester. Chichester is the president and CEO of Faris Lee Investments, an Irvine, Calif.-based real estate investment advisory firm founded in 1996.

NREI: Investment sales for April stood at $22.8 billion, according to Real Capital Analytics—a 25 percent decline from April 2016’s investment volume totals. And year-to-date in 2017, total sales volume is down 17 percent compared to the same period last year. What is your opinion regarding the current slowdown in investment sales? What is causing it? How long do you think the current slowdown might last?

rchichester_webRick Chichester: In terms of changes year-over-year, last year was an election year and historically in election year, business activity improves. There was a bullish feeling of optimism and change in the markets. I think that in particular had to do with the rally in the finance sector. Specific to real estate, real estate started to become fully priced in 2016. I think people began to be cognizant of that and built that into deals, as we saw historically low cap rates. It pushed some to sell and others to buy. We had a higher quality of buyers and sellers, and institutional investors were rightsizing their portfolios and shedding assets that matured. That built up a lot of activity last year.

This year we saw a flight-to-quality, on the heels of a long economic recovery, strong absorption and strong rents. But now we are not in an election year. After the initial excitement in stock markets, now we are seeing a lot of investors trying to figure out what it all means.
Following the portfolio resizing and flight-to-quality, there are now not as many high-quality institutional-grade properties on the market. More of supply today is mid-tier and value-add. In the fall of 2016 the buyer mindset shifted. Investors got very disciplined in underwriting; they are underwriting in today’s market without so much expectation of growth. That is because assets are fully priced today, and I would say some assets might be overpriced. There is concern this year about the Fed, but the effects of higher interest rates are not yet being seen. The anticipated cost of debt in the future is being underwritten into deals today. There is a question regarding the influence of monetary policy: will it slow down the economy? To summarize my thoughts about the slowdown this year, the commercial real estate sector is dealing with the unknown of interest rates, fully priced assets and more discipline by investors.
NREI: Faris Lee Investments is known for is its work as an investment advisor to high-net-worth investors (HNWIs), among other things. How are HNWIs viewing commercial real estate investments right now? Which property types do they prefer to invest in at this point?
Rick Chichester: We have seen our investor pool take a lot of risk off the table. HNWIs often structure their transactions via 1031 exchanges, but now we are seeing them sell and not reinvest when they right-size their portfolio. They are feeling that now is the time to pay taxes and not make the trade. Most HNWIs and family offices we are working with are moving into second- and third-generation planning, with the patriarch making decisions for the coming generations. A lot of decisions are moving to offload risk. They still see multifamily as strong because it doesn’t have the same execution requirements as office or retail (not having to deal with large tenants or co-tenancy issues). HNWIs will stay in multifamily, [and] be active there. For them this asset class is more hands-on and easy to manage. They do like triple net lease (NNN) investments, so are looking at retail and office NNN assets. Industrial single-tenant net lease is also popular with them, but demand for multifamily seems strongest.

One issue for HNWIs with other assets is their view of long-term leases as a negative now, because those leases could result in less rent growth. And if interest rates rise, growth could be held down further. But multifamily is a flexible class, with tenancy that can turn over every 30 days to every 12 months. However, pricing for multifamily is exceptionally strong and cap rates are compressed. Because of this, some HNWIs will dispose of multifamily properties for another asset that has better yield.

NREI: Faris Lee also specializes in triple net lease investments. How is this asset class performing compared to last year?

Rick Chichester: Single-tenant net lease is still very strong, and one of the least-risky of the asset classes, as long as you are selling an asset with a 10-year lease term and strong creditworthy tenant. Investors are buying those for cash flow, with residual value at the end of the lease. They look at is as buying an income stream, similar to buying a bond. The asset provides a risk-adjusted opportunity for return that is predictable. This market is robust and the buyer pool is very good; I see that continuing even if the market slows down.

Starting last fall, some single-tenant REITs, such as Spirit Realty and VEREIT, started defaulting on these properties and their stock values declined significantly over the near term because their tenant profile was perceived as less credit-worthy. The challenge with single-tenant net lease is that you’re either 100-percent leased or you’re 100-percent vacant. If your tenant profile has been challenged, that will be underwritten downward by the markets.

NREI: What is your perspective on cap rate movement this year? Where do you anticipate retail cap rates will move in the next 6 months?

Rick Chichester: Generally, cap rates are going to be neutral, or moving up. Absorption is strong, interest rates are moving up, markets are fully priced and people don’t know how much growth they will see in leased rates besides what’s built in. We are also long into the recovery— opportunities for real estate values to increase are not as strong as they were. I think cap rates and pricing will remain neutral in core assets, and I see them moving up in value-add, class-B assets and in assets in secondary and tertiary markets. In anything non-core, cap rates will move up and, of course, as cap rates move up, pricing moves down.

I see the same in retail, but [with] more pressure. [Cap rates] on core retail assets will remain flat; I don’t think there will be further compression. But I think there will be enough upward pressure on cap rates to creep up 25-35 basis points in secondary and tertiary markets. This has to do with the quality of tenants and being over-stored. In particular to retail, location has never mattered more than it does now; the significance of location to retail is more than I’ve ever seen my career. That’s because we are over-stored, we are seeing the new reality of e-commerce unfold. Retail is going through change. But I think this presents a time of great opportunity. If it can’t move to being more experiential, it might have to move to a different use or lower quality tenancies. So location is most critically important to retail right now.

NREI: Which property types do you consider the most resilient at this point in the cycle and why?

Rick Chichester: I still think multifamily is very resilient. Demand is still there. The Millennial generation is now bigger than that of the Baby Boomers. I still see multifamily demand in the markets I work in, because of the need to increase supply to meet that generation’s anticipated needs. Industrial distribution is also very resilient. Its growing consumer base is the Millennials. Consumer buying power is still very strong and that is helping to keep moving the economy forward. Ironically, Internet companies are some of the largest users of brick-and-mortar space in the country. Amazon and Wal-Mart are the biggest users of industrial distribution [space] and they will continue to grow their use. So industrial distribution is a very safe class.

Now, office space is often considered in our industry to be the most sexy, but it requires a unique skill and discipline relative to other assets. Tenants now have more choice on where to relocate.  That puts pressure on lease rates and increases ownership expenses. There’s plenty of competition in space for tenants when the lease goes up, and they are able to demand tenant improvements. The cost to the operator can [swing] more with office properties, you have to be very disciplined.

I’m still bullish on retail, but there are fewer players in that space now, compared to two or three years ago, because of this era of repurposing. But those that are still in it, love it. They see this as a time of opportunity. However, although the competitive set of investors is smaller, they are very sophisticated.

NREI: Please tell us about some of your biggest challenges this year in closing investment deals, expected and unexpected. What have been some of the most interesting transactions you’ve completed this year?

Rick Chichester: One of the biggest challenges with this change in the market is the need for the investor/buyer to be more disciplined in solving for yield in underwriting. The expectation gap between seller and buyer is widening. The buyer is trying to get the value he or she might have gotten nine to 12 months ago, and the seller is being more conservative in underwriting. That widening gap between buyers and sellers has slowed transactions down for us, and prevented some from happening.

One interesting trend we are seeing is that transactions seem to be taking longer because the underwriting takes longer, so cycle tie is increasing. The margin of error for the buyer is non-existent. The buyer pool is also smaller. In most transactions the real qualified buyer pool has been very small — no more than three people. There are maybe two or three really qualified buyers, and sellers need to be aware of that and engaged, because if they lose one, they could be losing their sole opportunity.

One interesting transaction we’ve done is the $24.8-million sale of Gateway Center, an 89,625-sq.-ft. retail center in Escondido, Calif. Two big tenants—Michael’s and Barnes and Noble—comprised 80 percent of that footprint. Now, Barnes & Noble is a challenged company in a highly challenged category, and the question was asked if they can really occupy 25,000 sq. ft. as a bookstore. Michael’s is in a similar situation, but is not quite as risky. Underwriting for both had to be done locally. Barnes & Noble did extremely well in that location, with strong sales, as did Michael’s. We needed to put a business plan into our underwriting to the buyer pool, to say what the alternative uses were for the space even if Barnes & Noble went out or Michael’s downsized. We worked with a group from the local retail leasing agency. An example for what could take over for Barnes & Noble could be a specialty grocer. For Michael’s, it could be specialty retailers, food or medical space. At the end of the day, we had four offers. It closed at a 6.5 percent cap rate. The buyer got good real estate, and the seller had good pricing.

NREI: What is your year-end outlook on commerail real estate fundamentals? Which assets may be a stronger bet for investors?  

Rick Chichester: I think fundamentals are going to be strong even if interest rates go up a bit. We don’t have that large competitive set of new development; surplus new development has been the thing to end cycles, historically. But going into this cycle, we did not overbuild. Retail could slow down by the end of the year, but not single-tenant net lease retail. With retail, the main issue is we are over-stored. Office has had a strong year, at least in trading. Multifamily, single-tenant net lease and industrial assets should be the best bets, in my opinion.


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