New Year, New Opportunities
As the CRE business prepares to enter a new year, a number of new possibilities are emerging for investors looking to shift strategies and rebalance their portfolios.
This is the web version of a feature that originally appeared in Real Estate Forum magazine.To see the story in its original layout, click here.
On a quiet afternoon in October, the Treasury Department released long-awaited proposed rules that answered some of the pending questions many investors had about the Opportunity Zones established under last year’s tax overhaul.
With that bit of bureaucracy out of the way, the floodgates opened. Interest in these new tax incentives was, and remains, intense and potential investors were clamoring for analysis and further insight into what the rules could mean for them.
“Investor interest has been insatiable,” says Derek Uldricks, president of Virtua Capital Management. Earlier this year, even before the proposed clarifications were released, the firm was among the first to launch an Opportunity Zone fund.
A FRESH TAKE ON AN OLD STORY
As 2018 rolls into 2019 the investment picture for commercial real estate in many ways will remain the same. Industrial, especially properties that serve e-commerce operations, remains red hot. Multifamily, while its supply side is shifting a bit, is still considered a stalwart category. Retail, as exemplified by Sears’ bankruptcy, will continue to struggle, except for those retailers that are establishing new business models and an omni-channel presence.
These categories will continue to flourish as CRE investment, in general, remains on the rise. For the first half of 2018, global CRE transaction volume increased 13% year-over-year to $341 billion, according to Deloitte’s 2019 Commercial Real Estate Outlook. There is no reason to think this trend won’t continue for at least the first half of 2019.
“There will continue to be a premium for locations near transit, but the value of those neighborhoods is in more than just their access to transit infrastructure— there’s also the amenities they offer and the critical mass of people they house.”
Lee Menifee | PGIM Real Estate
At the same time, new types of properties and developments are coming to fore that will provide additional avenues for investment in 2019. Opportunity Zones are just one example. Adaptive reuse is another, as are industry clusters outside of traditional life science and biotech space that are beginning to develop in secondary markets. Also on that list is anything that takes advantage of the disruption that high tech is delivering to real estate.
Deloitte’s outlook goes so far as to suggest that these newer opportunities may be more ideal for investors nowadays. “Investors seem to realize that their investments should be tied to the changing nature of work and tenant preferences,” according to the firm’s analysts. “As such, the new capital commitment is unlikely to flow entirely into traditional commercial real estate.”
NEW(ER) TECH & BUSINESS MODELS
Increasingly, investors are diversifying their portfolios by investing in newer and emerging business models and thematic categories, according to Deloitte. For example, the firm found that more than half of the investors it surveyed reported plans to invest in, or increase investment in, properties with flexible leases, and 44% plan to do so for flexible spaces.
In general, survey respondents specializing in mixed-use and nontraditional properties plan to increase their capital commitment by a higher percentage than those focused on traditional properties. Specifically, in terms of non-traditional properties, those surveyed are likely to increase investments in data centers and health care, including senior housing facilities.
This approach to nontraditional properties does come with additional long-term considerations, according to Lee Menifee, head of Americas investment research at PGIM Real Estate. New technologies and their disruptive effect could also influence, albeit subtly, the value of properties.
“Historically we’ve prioritized and paid more for locations that gave us convenience,” such as apartments that offered shorter commute times or offices located close to amenities such as restaurants and retail. Now the distance to a physical workplace is growing less important, Menifee notes, which could eventually have an impact on valuations.
This effect will be a subtle one and he says these changes will be more evolutionary than revolutionary. “There will continue to be a premium for locations near transit,” he relates. “You’ve got infill neighborhoods that develop up around transit infrastructure and the value of those neighborhoods is in more than just their access to transit infrastructure—there’s also the amenities they offer and the critical mass of people they house.”
In short, he says, don’t bet against density.
Longer term, though, the picture gets murkier as such technologies as self-driving cars enter the mainstream. Even here, the impact is not necessarily a straightforward one. The advent of self-driving cars means that people could be living further away from their places of work, which could devalue suburban office buildings. Along that vein, he adds, the strong trend toward amenities plays a huge role—the lack thereof is devaluing a number of suburban offices.
MOBs VERSUS MICRO-HOSPITALS
This is not to say that traditional categories will languish by the wayside in 2019. Investors will continue to find opportunity in the industrial and multifamily categories for the reasons stated above. Even certain segments of the woebegone retail sector will attract investment dollars.
So, too, will that most plain vanilla of asset classes: medical office.
After examining the third quarter earnings statements of the big three healthcare REITs—Ventas, HCP and Welltower—Mizuho REITs analyst Richard Anderson came to the conclusion that these companies were signaling an intent to increase their footprint in this category.
“We have seen a number of health systems head more toward a hub-and-spoke model with regard to their facilities. Cap rate compression has really come into play for these assets.”
Jim Koman | ElmTree Funds
HCP took pains to emphasize its joint venture with Morgan Stanley that’s aimed at investing in medical office, as well as a new partnership with HCA. Meanwhile, Welltower is expected to close about $500 million of MOB transactions in the short term. The firm, Anderson relates, “has always talked about using its senior housing portfolio as a quasi-hanging carrot for medical office,” in terms of acting as a sort of medical office.
As for Ventas, it’s reigniting its exclusivity arrangement with PMB Real Estate Services. The healthcare REIT, which inherited the medical office developer when it merged with Nationwide Health Properties many years ago, reupped its agreement with PMB for another decade.
To many bystanders, the renewed focus on medical office space may seem odd, if not contrarian. For one, cap rates on the medical office assets that are trading hands are still quite low. Then there is its reputation as a relatively lackluster, albeit stable, sector in terms of growth, particularly when compared with the high-risk/ high-return potential of skilled nursing.
Anderson’s tentative takeaway: a return to a risk-off mentality may be around the corner for healthcare REITs. “Maybe REITs are becoming buyers of medical offices simply because of their low risk orientation, even though the asset class remains quite expensive,” he asserts.
There’s another variation of healthcare real estate to consider: the micro-hospital. Already boasting its own set of adherents, this newer category is also expected to perform well in 2019. Generally comprised of inpatient facilities with a handful of short-stay beds, micro-hospitals offer a few of the same services as their larger counterparts, such as emergency services, imaging, pharmacy, lab work and, in some cases, outpatient surgeries and primary care.
What’s making them particularly attractive, though, is the fact that they’re typically less expensive to operate. “We have seen a number of health systems head more toward a hub-and-spoke model with regard to their facilities,” says Jim Koman, managing principal and founder of ElmTree Funds.
As this is happening, micro-hospitals are critical for hospital systems to be able to designate the surrounding free-standing emergency rooms as hospital outpatient department facilities—also known as HOPDs, he adds. The HOPD facilities are branded under the same health system as the micro-hospital, and are slightly smaller in terms of size and scope of services provided.
One significant advantage of HOPDs is that they can accept Medicare and Medicaid, which “significantly improves a facility’s brand image to commercial payors in the surrounding market due to the affiliation with a large health system,” Koman points out. These facilities also allow health systems to expand their geographic footprint into areas not well served by larger hospitals, thereby increasing their patient base.
For all these reasons, he predicts that investment—particularly from net lease investors—in micro-hospitals will be increasing along with the broader medical office building sector. “Cap rate compression has really come into play for these assets,” Koman says, precisely because most are backed by an A-rated healthcare system. They also tend to have 20-year leases with strong annual increases in the rent. “They are becoming very sticky assets.”
CLUSTERS COME TO SECONDARY MARKETS
At the beginning of November, the Riverhead Town Board of Calverton, NY, voted to approve the sale of a 1,643-acre undeveloped parcel in eastern Suffolk County to Calverton Aviation & Technology. Located in an Opportunity Zone, the acreage included the former Naval Weapons Industrial Reserve Plant at Calverton. Over the next decade, CAT intends to tap several billions of dollars’ worth of private investment to transform the site into a hub for aerospace technology, innovation and high-tech manufacturing.
In other words, it is hoping to develop a new aerospace cluster.
Such clusters are common in the biotech and life sciences industries. Alexandria Real Estate Equities, for example, has turned creating these hubs into an art form. Now real estate futurists say this model will expand into other fields and secondary markets, a trend that will start to become apparent in 2019.
“There’s been a movement toward the diversification of industries from the primary markets of Boston and San Francisco,” says Anne Kinsella Thompson, a visiting lecturer at MIT and author of “Commercial Real Estate at the Crossroads,” a report commissioned by Capital One from MIT’s Center for Real Estate. “Places like Cleveland, Denver, Milwaukee and Indianapolis are competing to draw industries into their markets.” Some of the companies they lure are refugees from the Bay Area and its high costs, she says, but startups are also choosing to move to, or form in, those locations. “There is a lot of movement.”
Thompson points to a number of cities to illustrate her point. Syracuse is home to a burgeoning business in drone testing and innovation. Central Indiana is seeing growth in agriculture, biotech and life sciences, similar to what Boston has built up over the years. And the strong presence of the US Navy is supporting San Diego’s strong cybersecurity hub. These clusters are not being created in a vacuum, Thompson says. Local governments and businesses, including real estate developers, are actively encouraging their formation, often through offers of incentives and cheaper space, as is usually the case when an industry cluster is formed.
The activity is robust enough that she believes there will be significant investment opportunities in the coming years. “Secondary markets, especially those that have not come back from the recession, tend to be underpriced and tend to have a stock of housing that is affordable,” Thompson relates. “The startups can work with existing commercial properties, refitting the assets, or build new ones.”
REUSE IN RETAIL CAN REAP REWARDS
One form of redevelopment that is gaining in popularity among investors is adaptive reuse. This is certainly the case in some segments of retail, says Coleman Morris, Atlanta-based director of retail agency leasing for JLL. More than just the redevelopment of historic or very old properties, the ultimate focus of adaptive reuse is on place-making, as various projects throughout the US show.
”We are going to see fewer flagship stores and more retailers incorporating their brands into specific projects that cater to the surrounding community.”
Morris Coleman | JLL
Retailers appreciate the projects in particular since, in many cases, they align with the brand’s own positioning efforts. Morris points to Nike with its concept of Nike Live, which it is testing on Melrose Avenue in Los Angeles. The store concept has a pop-up vibe and will operate similar to an experimental digital-meets-physical retail environment. The products and services sold in the store will be tested, the retailer explains, based on a deep understanding of the neighborhood.
“You’re going to see less of the flagship stores that retailers typically have and more of what Nike is doing with Nike Live,” says Morris. “That is, taking its brand and incorporating it into a specific project to cater to the surrounding community.”
It is likely that more adaptive reuse projects will spring up in the 8,700 certified Opportunity Zones in the US. The recently released rules show that broadly, rehab projects in these zones will be more affordable as the bar was lowered significantly in terms of how much money needs to be invested in order for it to qualify, according to Charles Clinton, chief executive officer and co-founder of EquityMultiple.
Investors have to double the basis when improving a project, and the new rules made clear that they’re not excluding the value of the land in calculating whether the value of the property has been doubled, he explains. “So if you buy a property, then all you have to do is double the value of the actual improvements to building, not the land and the building,” he says.
It may seem like a nuanced point, but Clinton predicts it will have a significant impact on how much money flows into the rehabilitation of existing properties in the Opportunity Zones versus new development. “Spending as much as the building is worth is still a lot of money to put into a new project, but taking out the land cost is a meaningful reduction,” he relates.
PORTFOLIOS REBALANCE AS OZs BECKON
In general, the new rules clarified what a lot of investors had been hoping for, Clinton says. One example: it was unclear whether debt could be placed on the properties (it can). “What the rules did was illustrate that the government really wants this program to work,” he says. “They’re going to create the practical flexibility you need to maximize the number of dollars sent in.”
Another clarification Clinton points to is the type of gains eligible to be rolled over—namely, gains realized when investors sell their stakes in partnerships. Did all the funds have to be rolled over, or could individual partners roll them over? Treasury affirmed that individual partners could make their own decisions, rather than having the partnership collectively make a move.
This is a distinction from the 1031 program, Clinton says, and it highlights the flexibility offered by the Opportunity Zone program.
This particular point was important to Clinton, as the new guidance would determine whether EquityMultiple would move ahead with its plans to enter into a JV for an Opportunity Zone fund. It is now partnering on a $500-million vehicle with New York-based developer Youngwoo & Associates, which is developing two new projects within Opportunity Zones.
“Institutional investors don’t care much about the tax benefits of Opportunity Zones; they just want to underwrite deals that have a social impact.”
Derek Uldricks | Virtua Capital Management
Virtua Capital’s Uldricks can relate. Before the release of the guidance, there had been a roadblock in fundraising, he says. Now that there’s some clarity, there has been a massive uptick in investment. “On the retail investor side we’ve averaged about $125,000 worth of investments per investor, which is pretty good,” he shares. “On the ultra-high net worth side, it’s about $370,000, on average, and it’s going up.”
There is a third, somewhat surprising, group of investors in these funds beyond the qualified purchasers and family offices, Uldricks observes. Though they won’t get the same tax benefits as taxable investors, institutional are still expressing interest in the asset class. Many of them have mandates for ESG (environmental, social governance) and an investment in an Opportunity Zone can check that box. “They don’t care much about the tax benefits; they just want to underwrite deals that have a social impact,” he says.
Virtua has made a few investments already through one of its Opportunity Zone funds, including an apartment building it’s developing next to Arizona State University in Tempe, AZ. There is an allocation to affordable housing within the apartment, which both the Tempe community and the university encouraged.
As it happened, Virtua already had this transaction in its pipeline because it was such a good deal. When it became clear that it qualified under the Opportunity Zone guidelines, “it became much quicker for us to raise the capital for that transaction,” Uldricks reveals. And without the Opportunity Zone qualification, he adds, it’s debatable whether the company would have been able to pencil in the affordable component.
For these very reasons it is clear that more of these types of deals will come to the market in the coming years, resulting in a significant rebalancing of portfolios as investors rush to take advantage of these new opportunities. One could, in fact, make the case that in 2019, portfolios will rebalance not only for Opportunity Zone transactions but for other emerging categories of investment as well.