|

 

|

The last time C-III Capital Partners did a 421-a deal [a NewYork City property tax exemption for new multifamily buildings] itwas in Long Island City before the recent rent regulations wentinto place. Since then, the math for a project to pencil has gottenharder, said Paul Hughson, executive managing director of the realestate investment company.

|

To do 421-a, you generally pick where 70% of the units are freemarket and 30% are affordable, he explained. Now though, "in orderto be out from under the rent stabilization law, you need to have$2,775 [per month] or greater rents."

|

"So, if you want to build affordable housing in the Bronx,you're not going to do a 421-a deal because you're not going to beable to get $2,775 [in rent] on 70% of your units, which means thatthose units also will be subject to the rent stabilization law. Soit won't get built. So, the 30% [of the units] that would have beenthere" won't be built.

|

Hughson made his comments at a recent symposium held byTranswestern and GlobeSt. Real Estate Forum in New YorkCity. Other participants included top level executives fromBentallGreenOak, AXA Equitable Life and Clarion Partners.

|

For these and other investors, rent control has become a keyissue to watch, and is creating, in some markets, what Hughson andhis colleagues are calling a hostile environment for commercialreal estate.

|

"A lot of the prime markets today are openly hostile tocommercial real estate owners," Hughson said. "So, where you haveregulatory environments, you have taxing environments that are notbeneficial. Chicago is not beneficial. New York is notbeneficial….California."

|

It is not solely rent control that has these and other investorsworried. At the same time, they are battling additional forces,such as declining returns and other onerous new regulations thatalso can make a market seem hostile to the industry.

|

How are investors handling these issues? With forethought and alot of caution. In some cases, they are recalibrating thecomposition of their total returns in order to fit the currentmarket environment. In other cases, they are exploring entirely newmarkets that better meet their investment profile. In almost allcases, they are watching as events evolve and determining what thatmeans for their underwriting.

|

 

WHAT WORKS RIGHTNOW

One line of defense that some of these investors have in place,is a changing composition of total return. "In a market like this,where you think it's peaking, we'll try to get greater than 50% ofour total return from current cash flow," Hughson said. "We won'thave a residual basis."

|

Compare that to a value-add deal from five or six years ago,where there would be a 40% return from cash flow, or maybe 30%, andthere would be a large pop on the residual, he explained. "Today,especially given where the debt markets are, you can dotransactions where you have 60%, 65%, 70%, 75% of your total returnfrom cash flow and very little risk on the residual."

|

 

|

 

|

A similar shift can be seen in the definition of core and coreplus and how these assets are being priced. For example, atBentallGreenOak, core plus is viewed as core but paid for withhigher debt, Paul Boneham, managing director and co-head of assetmanagement, said. BentallGreenOak is more willing to explore coreand core plus for secondary markets, he claimed, adding that thecompany is forming a fund to focus on this strategy. Anotherchange: Core plus has taken on some leasing risks that wereassociated with the core space, but not to the extent that it waswith value-add. That, too, has shifted pricing a bit. "Whenever welook at a value-add opportunity, we find that it prices for us, atleast for when we underwrite the deals, more along the side of acore plus transaction, Brian Watkins, Clarion Partners managingdirector and head of acquisitions, said.

|

It should be noted that many of these new strategies are due notnecessarily to a suddenly hostile marketplace—as investors mightfind California and New York to be—but due to the cycle's longrun.

|

AXA Equitable Life, for instance, has been a publicly-tradedcompany for a little over a year and thus is dealing with adifferent set of issues, said Nicki Livanos, director of realestate investments for the firm. These issues include lendingaccording to where the cycle is. "We've actually increased ourallocations with commercial mortgage loans, as well as to equitylimited partnerships," she says. In 2019, she adds, the firmexpects to close about $1.5 billion, up from about $1 billion ayear ago. Still, AXA Equitable Life is keenly aware of the risksassociated with such strategies of core plus and, say, value add.It has taken additional risk in construction-to-perm loans. Inparticular, secondary markets that are highly infilled are thelender's sweet spot right now, while it is typically not doingconstruction-to-perm loans in the primary markets. "Since we arepretty late in the cycle, we are taking very measured risks,"Livanos said.

|

Another move related to the cycle's position: many investors areseeking out new markets to stay competitive. Clarion Partners, forinstance, is open to smaller cities for some of its funds, such asNashville and Austin, according to Watkins. "We're looking tobranch out into those secondary markets as a way of increasingyield," he said. "Obviously, the low interest rate environment hashad a really strong pressure on pricing, and the demand is focusedin the certain asset classes and certain asset types, whichincreases the demand for a particular asset that we may be goingafter. So it's a very competitive marketplace for us."

|

The asset class, to state the obvious, also matters greatly.Industrial is still viewed as a slam dunk, for instance. Watkinsnoted that Clarion Partners likely did about $4.5 billion inacquisitions last year, about 40% of which was in industrial. Thefirm also has invested about $1 billion in the biotech officemarkets.

|

On the other hand, panelists were quick to identify a slowdownin the pace of suburban investments—again due to where the cycle isright now. Much depends, though, on the definition of suburban,Hughson pointed out. C-III Capital Partners may buy an office thatis not located in the center of a city but still is situated withinan urban core that has walkable amenities.

|

"I think the terms that we look for to describe the suburbs areurban, suburban, transit-oriented, walkable to retail amenities,you know, creative office," Hughson said. "Those are the suburbanoffice buildings that we would be looking to acquire. The truecommodity suburban office building, we are not interested in."

|

A lot of it has to do with Millennials that don't really want todrive, don't own cars, and want to rent everything, Livanos said."So, the transit-oriented development in a suburban setting that isclose enough to an urban environment or looks, feels like an urbanenvironment, is actually doing fairly well."

|

Another strategy that appeals to many of these investors isworkforce housing. It can check the boxes on a lot of issues,including affordability, and it also positions some companies to bemore competitive. "Shifting strategies to workforce housing allowsyou to renovate, not necessarily currently but years down the road,so that you're not competing against a full value-add player allthe time," Watkins said. "But you're going to do that renovationseven, eight years from now just before maybe a sale in year tenand still be able to position 30% or so below the top end of themarket."

|

 

RENT CONTROL'SBITE

Perhaps the most significant cautionary step that theseinvestors are taking is a more judicious approach tounderwriting—especially in markets where rent control has enteredor will likely come into play.

|

"You just have to make sure that you're comfortable that thereis a risk that the laws might change in the future, which undermineor hinder the performance of the asset," said Watkins. "Pricingthat [risk] upfront to the best that you can is the way that we'retrying to handle it," he adds.

|

BentallGreenOak, for its part, is not avoiding any specificcities because of these new rules, according to Boneham.

|

On the other hand, the transactions people know that they needto be able to defend their underwriting assumptions and investmentlevel, he continued. "It's self-select."

|

Rising taxes serve as another challenge facing real estateinvestors, according to Livanos. But the affordability issue evenseems to trump that to a certain extent. In general, she said, "theunfriendly environments that we've seen so far are obviously NewYork, Chicago, California and Washington State." The problem isthere is more and more divergence in incomes and there is really nopublic answer to affordability, she continued, and there's also nopublic-private coordination to solve the affordability issue.

|

"We've seen historically that a public answer isn't necessarilygoing to work. We've seen historically that a lot of private-onlydoesn't work. So, there has to be some coming together of the twoparties to resolve the issue," Livanos said.

|

Even the opportunity zones, which she said were a great idea,are not really solving any affordability issues.

|

Other regulations are also hindering real estate developers,Watkins added, citing environmental impact rules and insuranceissues.

|

"We're seeing insurance be a large factor in our underwritingthat's got to be taken into account, and the areas that we want tobe investing in, West Coast and Florida are the high risk areas forearthquakes and hurricanes." Watkins reported thata ClarionPartners is very actively pursuing an insurance program to makesure that it has the best policies in place.

|

Panelists also pointed to regulations underway in Portland, inwhich new developments must include an area for the homeless torest. This applies to all projects including multifamily, office orretail.

|

"What it's doing is making [certain] deals more attractivebecause people don't want to be in the area where there's peopleloitering," said Hughson. "It's challenging for tenants. They don'tlike it."

|

With all the concern about rent control and other regulations,these investors are still adhering to the basic rule of com-mercialreal estate, which is to follow the demand—and now that often meansdeveloping in the heart of some of these "hostile" markets.

|

Tech and biotech are the two biggest drivers in demand foroffice space, and Clarion Partners is actively investing aroundthese drivers, Watkins says. That includes Cambridge, SanFrancisco, Seattle and Portland, he said—markets that are lookingfor those creative office spaces. And yes, they're looking formultifamily to support that office growth, whether it's top tier orclass-B, he added. It would be ironic if the stakes weren't sohigh. But, as regulations mount, we can expect this dichotomy storyto play out in market after market.

Want to continue reading?
Become a Free ALM Digital Reader.

  • Unlimited access to GlobeSt and other free ALM publications
  • Access to 15 years of GlobeSt archives
  • Your choice of GlobeSt digital newsletters and over 70 others from popular sister publications
  • 1 free article* every 30 days across the ALM subscription network
  • Exclusive discounts on ALM events and publications
NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.