In June, the US economy reached its 121st consecutive month of economic expansion. That broke the previous record of growth, which spanned from 1991 to 2001. While this decade of sustained growth is precedented, some executives surveyed in the latest 2019 DLA Piper Annual State of the Market Survey, expect the next 12 months to continue to produce positive results.

In the prior survey (conducted during the government shutdown), 42% of respondents said they had a bullish outlook for the next 12 months. In the 2019 survey, that percentage jumped to half of participants.

Forty-eight percent of respondents expressed optimism about the overall health of the economy and another 43 were optimistic because of the abundance of capital still chasing deals.

"I continue to think that the fundamentals and the real estate market are still pretty good," DLA Piper's Global Real Estate Practice Co-chair John Sullivan tells GlobeSt.com. "Leverage is relatively low. So, I think that if we have a correction in real estate, it's likely to not be that severe."

Those who are bearish about the next 12 months, cite the unpredictability of trade policy, combined with the upcoming election, which concerned 37% of the bears.

"The CEO and chief investment officer of any business, not just real estate, will tell you the one thing they want to know is what the rules are," Sullivan says. "Then they can make decisions. The hardest time to make decisions is when there is substantial uncertainty."

Outside of political concerns, 30% of the bears were pessimistic about nearing the end of the cycle. "I think that it [the end of the cycle] is definitely playing on people's minds and has been playing on people's minds for the last couple of years," Sullivan says. "There are lots of people that look back over 50 or 75 years of history, see how long cycles typically last and know that we're already past it [the typical end of cycles]. So, they're getting nervous."

Part of the problem for the CRE industry is continuing to match the strong growth pace in previous years. With transaction volume reaching $576.1 billion, 2018 was a record high year for deals. That strong 18% growth will be tough to match this year.

As deal volume has risen, so have prices, which Sullivan says also registers as a concern for the next 12 months. "In the gateway cities and now in a lot of other places, the phrase that gets used in the real estate industry is 'priced to perfection,'" he says. "Assets have gotten very expensive and that's connected with where are we in the cycle."

Any problems with those deals could set the stage for buying opportunities beyond the next 12 months, which would give even the bears something to look forward to.

"If you have a market correction and you have a decline in price, you could see more activity by almost all investors," Sullivan says. "It's been very challenging for the Opportunity Fund investors to get the kinds of returns that they want. So, some of them are probably secretly hoping for some kind of correction to create more buying opportunities."—Les Shaver

REIT WATCH: For Non-Traded REITs, Closing Time Comes Quickly

In today's highly competitive multifamily deal environment with buyers streaming in from around the globe, there are as many as 20 to 30 bids for a value-add asset. As many as 10 groups are usually fighting it out in the best and final round of offer.

With that type of competition, buyers are seeking any little advantage that can put them ahead of their competitors. The ability to offer hard money, of course, can always be a differentiator among buyers, but the capability to close quickly can also set a bidder apart.

"An ability to close quickly is a competitive advantage because it moves the conversation away from solely sticker price," says Evan Hudson, a partner at Stroock.

Non-traded REITs not only can close quickly, they are motivated to do so. While some buyers generally draw capital as needed, non-traded REITs raise capital first, and then try to deploy it before it causes a drag on their returns. In fact, there is a penalty if they don't deploy capital quickly enough.

"The sponsor will want the non-traded REIT to cover its dividend," Hudson says. "Even with cap rates as low as they are, the yield from commercial real estate investments still exceeds the yield from cash equivalents. Cash is like ballast in a ship. It adds stability, but having too much will slow things down. Excess cash can quickly tank a dividend coverage ratio."

Could this strong focus on closing fast lead to mistakes? It's possible, but Hudson says a strong support team can help eliminate errors.

"The deal team is focused on a goal, which is to deploy the capital quickly," Hudson says. "But, with the right team in place, due diligence protocols will still be followed even on an expedited timeline."

A non-traded REIT of any size will try to deploy capital expeditiously to avoid a cash drag. But bigger non-traded REITs need to invest money in larger chucks.

"If a REIT raises $100 million per month, it might try to put a $200 million asset under contract each month," Hudson says. "A small REIT that raises only $1 million per month will be in the market for much smaller assets. But either way, the incentive to close remains the same."

Just as deal size varies with non-traded REITs, so do the geographic regions and asset classes they target. These REITs follow the investment policies described in the prospectus, according to Hudson.

"The locations vary from low-cap-rate coastal markets to growing Sun Belt markets," Hudson says. "They include global cities and secondary cities. Some REITs try to acquire older assets that they can bring up to date. Others focus on core newbuild multifamily, buying directly from the developer."—Les Shaver

Exec: WATCH

Transwestern Commercial Services has recruited Ken Smondrowski as vice president of its Healthcare Advisory Services. Prior to joining Transwestern, Smondrowski worked at Health-Pro Realty Group.

CAPITAL MARKET VIEW: Debt Funds Overtake Life Cos.

This year debt funds hit a milestone: for the first half of 2019 they represented a larger share of the commercial mortgage markets than the life insurance companies, according to Real Capital Analytics.

Life insurance companies still represent a larger share of lending for core investment strategies than do debt funds, but the levels are close, RCA notes: a 10% share for life companies vs. 9% for debt funds. It is in the riskier investment styles, however, where debt funds are more competitive, allowing them to capture more market share than insurance company lenders this year. ♦

BEHIND THE DEAL: Valuations Unclear as Flex Office Leases Shift

Flex space could account for 13%, or nearly 600 million square feet of total US office supply by 2030, according to a recent report on the asset class by CBRE.

As this category grows, its model is shifting to take into account more innovative lease structures. As they do, the capital markets are watching closely, unsure of what these changes could mean to buildings' valuations.

There is reason for some concern on valuations. Eventually, CBRE predicts in its report, there likely will be far fewer traditional leases between landlords and operators with more onus on landlords to accept and manage risk.

For example, today most third-party operators enter into a traditional long-term lease agreement with the landlord. In the future, CBRE forecasts, the third-party operator and landlord will be just as, if not more, likely to enter into a partnership agreement sharing any profit and loss. We are already seeing this model at work at 75 Rockefeller Plaza in New York City, between WeWork and RXR.

Indeed, WeWork is a leader in the flex office space in terms of size and growth with nearly 11 million square feet added to its portfolio since Q2 2018, CBRE reports. However, change in the flex model is also being driven by smaller—even the smallest—of competitors. Spaces and Knotel are two more major operators, each adding more than 1 million square feet during that same time period. And smaller players such as CommonGrounds are securing venture capital to fund rapid growth.

All told, there are hundreds of flexible space operators in the ethos right now, Julie Whelan, CBRE's Americas Head of Occupier Research, tells GlobeSt.com. "These bold operators that are beginning to forge the next generation of flexible office space aren't always the biggest but they are the ones thinking critically about what will sustain them into the future," she says.

"Both consumer demand and therefore property markets have cycles that flexible space operators must contend with. This reality is causing an evolution towards landlord partnerships, owner-operated space and even franchise agreements taking the place of traditional lease agreements," she concludes.

To be sure, flex office space only takes up a small percentage of the overall market. To reach 20% or more of total supply by 2030 would require a large conversion of traditional corporate leased space into flexible space, CBRE said, noting that although flexible office supply grew by 34% for the year ending Q2 2019, it still accounts for just under 2% of total US office inventory. The two most penetrated and high-growth markets in the US—San Francisco (4%) and Manhattan (3.6%)—have yet to reach the 6% level achieved in London and Shanghai.

Within this relatively small percentage of flex offerings though, different variations of the model are beginning to emerge. Some landlords are even introducing flex offerings under their own brands. Although traditional leases remain most prevalent, partnership and operating agreements between landlords and third-party flex operators are growing in popularity with landlords such as Hines and RXR Realty pioneering these deals, CBRE said. Concurrently, some landlords are introducing their own flex offerings, such as Studio by Tishman Speyer and Flex by BXP (Boston Properties).

Eventually, CBRE posits, the capital markets will evolve their valuation models in turn. One significant drawback right now is that it can be difficult for capital market to value and understand these models.

However the research in this space to date does point to ultimately favorable valuations for properties with flex office space. A report earlier this year from CBRE looked at office transactions, and found that 40% of buildings with flexible space traded at a higher value than the average office building in the market while 52% of buildings traded on par with the market average. This was, though, not a definitive link. As CBRE pointed out, flexible space is more common in newer or renovated office buildings, and that could account for the boost in pricing among some of the properties. Also, office spaces in general have seen an upward trend in pricing as well.

Still, as flex office space becomes more mainstream, lenders and investors are starting to see the benefits of moderate exposure as part of a well-diversified tenant roster, according to Alex Colpaert, Head of Offices Research at JLL EMEA. In short, he wrote in a research note, buildings with a high percentage of flexible space are increasingly seen as viable investment propositions. This is a point also found in Deloitte's 2019 Commercial Real Estate Outlook, which said that these newer opportunities may be more ideal for investors. "Investors seem to realize that their investments should be tied to the changing nature of work and tenant preferences," Deloitte wrote in its report. "As such, the new capital commitment is unlikely to flow entirely into traditional CRE."

Deloitte found that over half of investors it surveyed have plans to invest or increase investments 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.—Erika Morphy

SECTOR WATCH: The Seven Deadly Sins of CRE Investment

Most of you have heard about the Seven Deadly Sins that include; pride, envy, gluttony, lust, anger, greed and sloth. There are also Seven Deadly Sins of CRE investment, and these are not so-called psychological sins but errors or misjudgments in the art of investing in commercial real estate assets.

The CRE investment process is a multifaceted procedure to analyze, acquire, finance, manage, lease and sell a commercial property. There are many steps in the process from evaluating a broker sales package, to analyzing the market in which the property is located, touring the property, raising the appropriate amount of debt and equity capital, closing the acquisition and managing and leasing the property. Each of these steps is critical to a successful CRE property investment. However, there are many sins or errors committed along the way and our list of seven of these are listed below.

Buying at Low Cap Rates. Acquiring CRE at low cap rates is one of the biggest sins that an investor can commit. This is typically done when interest rates are at artificially low levels, investors don't understand the various risks in CRE investment and investors have uninvested capital that needs to be used. In acquiring commercial real estate assets, it is more important to buy a good asset at a great value than a great asset at a good value. The most important criteria in a successful real estate acquisition are to buy the asset below its intrinsic value. Buying a CRE asset above its value or at a low cap rate, is rarely in the long term, a route to a successful transaction.

Poor Due Diligence. The due diligence process conducted before the closing of a real estate acquisition includes all the procedures to make sure the property, financial and market data provided by the seller and broker are accurate and form the basis upon which the purchase price is based. During the booming CRE market of the last few years, the due diligence process has been condensed and, in some cases, not even performed. Sellers have compressed the time to close a transaction, which leaves the buyer with less time to complete a thorough due diligence program. This is especially true of large portfolio transactions with dozens of properties. Shoddy due diligence can result in poor financial proformas, missed negative lease provisions and critical issues with the property's physical condition. Poor due diligence can lead to lower investment returns and reduced cash flow for the property.

No Market Analysis. One of the key procedures in the due diligence process per above is a detailed analysis of the market the property is situated. This involves looking at property data such as supply and demand for space, rents, vacancy, new construction, cap rates, competition and a highest and best use review. As many of us know, technology is changing consumer behavior, which is affecting the CRE industry, both positively and negatively. Many class A properties that were once tops in their local market and in great locations are finding that the local real estate market has changed and demand for the property has waned or changed substantially. A proper market analysis should uncover these key market issues and reduce the risk of market changes on the value of the property.

This Time It's Different. These are the most dangerous four words in the investment world and are associated with every market bubble and financial crash. CRE investors that overpay for a property by buying at low cap rates will often utter these four words to justify their investment. They will comment that the real estate market is changing and if we don't buy this asset at a low cap rate, somebody else will and our investors will redeem their funds. Or we think we can raise the rents substantially during the next few years and that justifies the high price and low cap rate or the cost of debt is so low even borrowing at floating rates, we will be able to flip the property for a nice profit before interest rates rise. This sin is occurring right now in the booming industrial market, where space demand is very strong and cap rates on industrial properties have declined 1.5% to 2.0% in the last few years.

Using Excessive Leverage. Acquiring CRE assets with high leverage is one of the most common investment sins. This was particularly common during the early 2000s and up to the middle of the Great Recession in 2010. Many properties bought during this period had a securitized first mortgage, several levels of mezzanine debt, preferred equity and finally the owner equity. The worst CRE deal ever completed in 2006 and chronicled in our editors' first book, "The 50 Commandments in CRE Investment" had this same convoluted capital structure. The property was the Peter Cooper/Stuyvesant Tower Apartments complex and was capitalized with a securitized first mortgage, 13 different mezzanine loans and 15 different equity investors. The property was acquired in 2006 and defaulted on its debt in 2010. After the financial crisis, the amount of leverage on CRE assets in general has decreased, however, it is still a sin to overleverage a property.

Poor Management and Ownership of a Property. As is any industry or business, there are good owners or managers and bad owners or managers. This is very apparent in the CRE industry, especially with apartments. Apartments are the most management intensive of all real estate assets due to the large number of tenants and leases, high levels of employee turnover and poor management policies. There are a large number of bad apartment managers whose shoddy policies and procedures lead to low occupancy and subpar net operating income and cash flow. There are also bad owners in the CRE industry—even some of the largest and most prestigious real estate investment managers. As real estate private equity firms grow to immense size with tens or hundreds of billions of CRE assets under management, they become marketing machines and asset gatherers instead of real estate managers. The unwritten goals of a lot of these firms are to just raise more and more capital, increase the 1.5% to 2.0% asset management fee and acquire more and more assets regardless of the price and performance.

Need to Invest Idle Fund Cash. In today's frothy CRE market, there is an abundance of unused powder or cash that needs to be invested. Per consulting firm Preqin, there are over 200 real estate private equity funds in the U.S. with more than $200 billion in capital looking for deals. The pressure on the sponsors of these deals from their investors to use the funds and justify the 1.5%-2.0% annual asset management fee on these funds and generate the projected internal rate of return is immense. Many of these sponsors will break one or more of the other sins above and begin making bad investment decisions, just to place the capital to work. Sometimes the best deal in CRE is the one you don't do.

Joseph J. Ori is executive managing director of Paramount Capital Corp.

Instant Insights /

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