Investors Eye Inflation-Protected Opportunistic Deals

NEW YORK CITY—Results from the Q2 2014 United Realty/Zogby Real Estate Confidence Index suggest that commercial real estate investors expect opportunistic and value-add properties will better weather a rising interest rate environment.

Namely, some 77% of respondents expect interest rates to remain flat or rise over the next twelve months, with 45% anticipating a 50 basis-point increase, and 15% anticipating increases of more than 100 basis-points in the 10-Year Treasury.

At the same time, over the next twelve months respondents believe that value-added opportunities will be most attractive (88%), closely followed by opportunistic assets (70%). Core investments were seen as the least attractive of the three property types surveyed, on a relative basis, with 63 percent of respondents considering core investments attractive.

In an informal survey of its own, GlobeSt.com followed up on this finding to ask a few more questions. Why exactly is value-add the best play in an interest rate environment? Conversely, if it isn't the best investment position, then what is? And perhaps even more fundamentally, are rising rates even something to inherently fear, assuming, of course, you are not a borrower. We'll be looking at each of these questions over the next three days so please come back.

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The case for value-add and opportunistic investments in a rising rate environment is fairly straightforward for several reasons, Seth Weissman, a partner with Jeffer Mangels Butler & Mitchell LLP in Los Angeles, tells GlobeSt.com.

Starting with the basics--rates rise to reflect a tightening of credit and a fear of inflation, which are by-products of a growing economy. Stabilized properties, therefore, are in high demand, including those that a few years ago would be classified as distressed. "Many investors are selling those properties and looking to complete tax-deferred (1031) exchanges. This is creating increased demand for stabilized properties for investors who are looking to protect their tax basis and not have to invest substantial additional capital in the replacement properties.

Prices for those properties are rising based more on the need to close an exchange than because of the underlying fundamentals, Weissman continues. As rates rise, if that exchange market tapers, there will be price pressure on top of a generally lower going-in expected return, such as buying at low cap rates.

"Conversely, if a property has more up-side potential going in, and there is a supportive underlying economy, there is more chance to add value, which may off-set the price pressure that rising interest rates may cause. Of course, if the 1031 market remain strong and the stock market continues to taper, we will likely see continued demand for real estate assets of all types. "

Another issue to consider is that opportunistic and value-add plays will have more room to adjust to price and assumptions on exit cap rates and still keep deals attractive, Chauncey M. Swalwell, a partner with Stroock & Stroock & Lavan LLP in Los Angeles, points out.

Meanwhile with core and similar assets, "sellers already are pushing the pricing and cap rate limits in the current market so much that even small increases in interest rates will push tight underwriting over the edge for those buyers."

These arguments are hardly secret though and one problem with opportunistic and value-add investments is that there can be a lack of them.

Value add that has been repositioned tends to do well in a rising interest rate environment because their rental income stream will more than offset the increased interest costs, Jack Lowell, EVP of Miami-based commercial real estate firm Pointe Group Advisors, says.

But "because of rapidly rising prices, good current returns are low and opportunistic investments are increasingly hard to find," he tells GlobeSt.com.

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Come back tomorrow for Part 2 when we discuss the case for other investment styles.

Part 2 can be found here.