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Private Equity Real Estate Funds are Slowing

Posted on January 10, 2020March 9, 2020 | Leave a comment

For the commercial real estate investor, private equity funds have historically been safe bets which can be used to invest in a volatile real estate market over the long term. Private equity real estate funds are typically purchased by high net worth individuals, trusts, and/or pension funds to build portfolio value. In recent years, as commercial and residential real estate markets have inflated to the tipping point of true value, real estate funds have lost their luster to some investors.

Today, we will review how private equity real estate funds function and why they are lagging behind when it comes to both performance and participation.

Real Estate Equity Funds 101

Private equity real estate is a type of asset which pools private and public funds into the real estate market. Similar to how mutual fund ownership entails privately owning a number of stocks, bonds, money market funds, and other mutual funds, private equity real estate funds entail owning multiple properties through a type of pooled vehicle. While the concept of private equity real estate has been around for since the post WWII era, private equity real estate funds truly took off during the boom or bust economy of the mid 90’s.

Also like mutual funds, private equity funds are a long term investment. There may be penalties for early withdrawals, funds are tied up in the funds, and investors must understand that most private equity funds come with a lock-up period where assets are unredeemable. Due to the nature of real estate equity funds, there is typically a substantial minimum investment both up-front and potentially over time. As we mentioned in the introduction, private equity funds are typically reserved for wealthy individuals, pension plans, or other long-term wealth building strategies.

CRE Equity Funds by the Numbers

Commercial real estate plays a huge role in private equity real estate funds, but it is not the only player. Let’s take a look at private equity numbers to get an insight into industry trends:

2018 saw an overall fundraising downturn of approximately 10.6 percent compared to 2017. Total 2018 investments totalled approximately $118 billion. This is the lowest annual figure since 2013.
During that same 2013-2018 time period, commercial real estate has enjoyed a steady growth rate both in terms of average valuations and total commercial real estate investments.
The 10 largest private equity real estate funds make up over 35 percent of the total investment monies raises in 2018. This top heavy trend is likely to continue as the more well-established funds are better positioned to weather the upcoming bear market.
The amount of “dry powder” holdings has also gone up approximately 15 percent year over year. This could signal that investors are losing confidence while also accounting for a lack of fundraising overall.
Despite all of this, there are still large sums of money tied up in the private equity market. Recent figures put the total valuation of the industry at approximately $244 billion spread of 670 private equity real estate funds

Why Private Equity Real Estate Funds are Losing Steam

There are a number of reasons why private equity real estate funds are slowing down. According to the latest reports, here are some of the biggest sticking points facing private equity investors looking ahead to 2020:

A crowded marketplace. Mark Twain once said, “Buy land, they ain’t making any more of it”. In today’s market, this fact of life has been highlighted by population growth, corporate buy-ups, and maturing urban markets. When it comes to private equity firms, prime real estate is going quickly as well. This is yet another reason why firms like Blackstone are dominating the market with multi-billion dollar funds focusing on the highest-value properties.

Real estate market uncertainty and likely recession. If you’ve been reading/watching the news lately, you are likely aware of some of the more grim predictions regarding a nearing recession and real estate market downturn. This has led many investors to turn to debt investments and abandon mid to long range real estate investments until the market settles.

Other investment opportunities have taken attention away from PERE. Private equity real estate funds are in a strange middle ground of being well established over decades of solid returns but without the pedigree of mutual funds or the investor excitement of new programs like opportunity zones.

Slow payouts for private equity real estate. Many real estate funds have a problem: they have too much cash. This can result in a number of hiccups, including investor payouts being delayed. This is almost a situation where the success of PEREs has led to a bogged down payout process.

Going Forward

Most industry experts agree that private equity real estate funds will continue a modest slide moving into 2020. With economic uncertainty and an already waterlogged investment environment, PEREs will likely take a few years to bounce back. Of course, it is impossible to know how economic performance, consumer spending, CRE, and other outside factors will fall into place over the coming years. Despite all of these huge question marks, private equity real estate funds meet a need for many individuals and organizations looking to buy into potentially high yield, long term investments.

The Devaluation of Traditional Real Estate Capitals

Posted on January 9, 2020March 9, 2020 | Leave a comment

In decades past, the most valuable real estate in the United States was not hard to identify. Commercial real estate in traditional real estate capitals such as Washington, D.C., New York City, San Francisco and other powerhouse markets dominated the landscape. In many ways, this remains true. However, savvy investors are frequently turning to less oversaturated, less expensive markets to make their mark. This has led to a vicious cycle where many traditional real estate capitals have depreciated relative to the overall market.

To better understand why major markets have become less valuable in recent years, today we will discuss stronger markets in non-traditional areas including the Sun Belt and why the largest real estate markets in the U.S. have suffered.

Suburban Sprawl and the Rise of the Sun Belt

The Sun Belt can be considered any land in the southern third of the United States. It should be noted that the Sun Belt absolutely contains powerhouse real estate markets including Los Angeles, Atlanta, and San Francisco. Yet the largest commercial real estate growth is expected to continue in less traditional markets such as Nashville, Austin, Raleigh, Phoenix, and many others. There are a multitude of reasons for these trends, including:

Domestic migration favors Sun Belt states. Texas, Florida, North Carolina, and Arizona are the top states for domestic migration over the past ten years. New York, California (a SunBelt state which is an exception to the rule), Illinois, New Jersey, and Ohio are at the bottom of that list.
Construction costs and living expenses are lower in many Sun Belt and other non-traditional markets. There is a reason why the largest companies on earth like Apple are choosing to build headquarters in Austin, TX instead of Silicon Valley. Costs are lower and employees are able to live more comfortably.
Many Sun Belt states (again excluding California) have less business and real estate regulation. Fewer regulations make for easier, cheaper CRE construction projects in addition to greater flexibility for businesses.

The Largest Real Estate Markets in the U.S. Have Cooled Off

San Francisco is Experiencing High Office Vacancies

Perhaps the most notorious real estate market in the U.S., if not the world, San Francisco’s real estate booms and busts are well documented. The outrageous cost of living is driven by insanely high residential real estate values which make it virtually impossible for long time citizens to continue to rent or to purchase new homes. The commercial real estate industry is experiencing many of the same issues. Recent reports suggest that high labor costs, poor living conditions, and very high lease rates have led companies to steer clear of office space in the Bay Area.

This has extended to store front businesses as well, where less foot traffic and higher rents mean less economically viability. Unfortunately, there does not seem to be an easy fix on the horizon. All markets have their tipping point, and San Francisco appears to be on the precipice. What remains to be seen is how the city will bounce back once the real estate market normalizes.

Traditional Retail Locations in NYC are Struggling

New York is a tough market to pin down. The largest U.S. city could be considered both the healthiest or the most tumultuous real estate market in the country depending on your point of view. And NYC has always been prepared for the recent industry shift towards infrastructure and new construction mega-projects. In this way, the already densely packed city has continued to grow its already robust commercial real estate footprint.

However, the retail sector is struggling in a local economy where retail real estate is incredibly expensive and retail business models are needing to adapt to survive. Where some New York flagships survive on tourist money alone, many are closing their doors in the wake of new economic realities. This has led to many CRE properties losing their value in recent years.

Boston’s Struggling Multifamily Real Estate

Although younger renters are willing to sacrifice other amenities for ideal locations, luxury multifamily complexes in high end Boston markets are struggling. With price points too high for many young adults and many businesses opting for non-centralized locations, downtown apartment living is becoming difficult for real estate investors. The silver lining of these trends in many expensive cities is that multifamily real estate in suburban areas is increasing in popularity and value. Savvy investors may want to look to different locations to fight against the devaluation of downtown apartment living.

Going Forward

Traditional real estate capitals continue to hold a high value when it comes to commercial and noncommercial real estate. That being said, their stranglehold on the most desirable properties has lessened in recent years, giving way for less centralized office buildings and CRE multifamily units. These trends will likely continue with the caveat that major markets like New York and San Francisco will remain extremely desirable to a certain population of businesses and individuals who value urban living.

Commercial Real Estate Lending Standards

Posted on January 8, 2020March 9, 2020 | Leave a comment

According to the Office of the Comptroller of the Currency of the United States: “Commercial real estate (CRE) loans include loans secured by liens on condominiums, leaseholds, cooperatives, forest tracts, land sales contracts, construction project loans, and—in the states that consider them real property—oil and mineral rights. National banks may make, arrange, purchase, or sell loans or extensions of credit secured by liens on interests in real estate.” All of this essentially to say that commercial real estate loans are frequently borrowed against other commercial real estate assets.

When it comes to commercial real estate lending standards, there are federal and state-wide regulations of which any active CRE investor should be aware. Today we will review some of the high level lending standards for real estate investments in the U.S.

Establishing a CRE Loan Portfolio

One of the most important aspects of securing a real estate loan for a commercial property or any other real estate purchase is building a loan portfolio. The onus to create these reports is on the insured depository institution, AKA any bank which is insured with the regulations of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The federal government has strict guidelines which regulate what must be included in these reports, including but not limited to:

Identifying and declaring the terms and conditions of the loan.
Scouting locations in terms of properties and geographical areas for which the loan may be applied.
Establishing a policy of loan portfolio diversification including parameters for investments by real estate type (commercial vs. real estate, etc.) geographic location, and more.
Identify any lending staff including personal qualifications.
Complete a risk assessment to determine any undue concentrations of risk.
Identify zoning requirements.
Identify the underwriting standards which will be used for the loans.
Establish loan-to-value limits (more on this below).
Identify the loan administration protocols which will be followed throughout the life of the loan including disbursement, documentation, collection, collateral inspection, and loan review.

There are more loan portfolio requirements than we will list here, but this is a reasonable sample to give prospective investors an idea of what the federal government expects when clearing future commercial real estate loans.

FDIC Real Estate Lending Standards

The Federal Deposit Insurance Corporation, more often referred to as the FDIC, is an independent federal agency responsible for insuring against bank failures. The vast majority of major financial institutions in the United States are FDIC insured or FDIC supervised. This is important for commercial real estate lending standards, as FDIC regulations come into play for any such organization. With this in mind, here are some high level regulatory standards set forth by the FDIC:

“Each FDIC-supervised institution shall adopt and maintain written policies that establish appropriate limits and standards for extensions of credit that are secured by liens on or interests in real estate, or that are made for the purpose of financing permanent improvements to real estate.”
Real estate loans must be considered within the bounds of standard banking practices.
All written loan policies must undergo an annual review and approval process by an FDIC-supervised board of directors.
Commercial real estate lending procedures must include detailed underwriting protocols, loan-to-value limits, and portfolio diversification demands.
All loans must be monitored by an FDIC supervised institution to ensure that the current real estate landscape continues to support the terms of the loan.
All lending policies for real estate should adhere to the “Interagency Guidelines for Real Estate Lending Policies established by the Federal bank and thrift supervisory agencies.”

Supervisory Loan-to-Value Limits

While there are certainly more details to cover when it comes to CRE lending standards, the last key concept we will hit upon today is loan-to-value limits. Loan-to-value limits or loan-to-value ratios are essentially the calculation reached by dividing the loan amount by the total market value of the investment including any additional collateral being used to secure the loan. It is vital to understand this metric not only to secure loans and adhere to lending standards, but also to gauge how viable a loan and/or real estate investment will be.

Different real estate categories carry different loan-to-value limit requirements.

Raw land investments: 65 percent
Land development investments: 75 percent
New construction: situationally dependent
Commercial, multifamily, and other non-residential property investments: 80 percent
One to four family residential investments: 85 percent
Improved property investments : 85

Transactions Excluded from Loan-to-Value Limit Evaluations

It is important to note that many commercial real estate loans are exempt from loan-to-value evaluations. Examples of these types of loans include those which have been insured or guaranteed by the federal government, those which are backed by the full faith and credit of a state government, or those which are to be “sold promptly after origination, without recourse, to a financially responsible third party.” It is vital to understand precisely how transaction exemptions work before assuming that your loan will not undergo the scrutiny of a loan-to-value limit evaluation.

Going Forward

In most cases, it is not absolutely necessary for commercial real estate investors to understand the in’s and out’s of CRE lending standards. Yet knowledge of how the federal regulations work and what questions will be asked can allow investors and other CRE professionals to better prepare for loan applications. It is also important to understand that even federal regulations are not set in stone. There is no concrete reason to believe that these regulations will be significantly altered in the near future, but the possibility of change is always present.

Medical Office Buildings Remain a Safe Bet

Posted on January 7, 2020March 9, 2020 | Leave a comment

Commercial real estate, like many investment-based industries, can experience major flux over time. Yet certain CRE investments are safer than others due to strong demand and profitable business models. Medical office buildings have been a strong choice for CRE owners and investors for many years. We believe that this trend will not only continue, but trend towards greater value for investors. Some investors are hesitant to enter into this space for fear of policy change and bureaucratic red tape making the future murky. While these are certainly relevant considerations, today we will be reviewing why the pros of medical office building investment outweigh the cons.

The Value of Medical Office Properties

In order for an investment to be a safe bet, it must first be determined that the asset has value. Medical office property values have skyrocketed in recent years. Here are just a few reasons why.

Supply and Demand Favors Property Owners

There is no question that medical office buildings are in high demand. As the nation ages and healthcare becomes an even larger industry, outpatient procedures continue to climb in both quantity and quality. That handles the demand part of the equation. As for supply, medical office buildings often require specific layouts and capabilities which must either be designed from the ground floor or retrofitted into older properties. Simply put, there aren’t enough office buildings to handle the current demand. This obviously puts a premium on those properties which do exist and even those which are good skeletons to be converted into medical offices down the road.

The Medical Industry is Booming

Say what you will about our nation’s healthcare system, but there is more than enough money to go around. No matter if we continue with Obamacare and other current policies, roll back current policies, or go in the other direction and establish Medicare for All, money will continue to pour into our medical care infrastructure. The reason is simple: the medical industry is extremely strong and will likely remain so for many, many years. When you combine favorable supply and demand with a cash-rich industry, that equates to high value investments.

Flexible Medical Office Layouts Add Value

On a more specific note, the future of medical technology is moving to a format which enables physicians to perform a wider range of tests within their offices rather than sending patients to specialists. For this and many other reasons, flexible medical office structures offer a unique value to investors and to lessees by allowing for greater capability and flexibility of care.

Why Medical Office Buildings are a Wise Long-Term Investment

There are many reasons to believe that medical office buildings have strong value in today’s marketplace, but how can we be so sure that they will be a wise long-term investment? Medical office properties offer a unique safety net for investors for the following reasons:

Customer convenience means location is becoming more and more important. Nobody likes going to the hospital. This is particularly true when medical offices are more convenient from a location and practical standpoint.

The aging population will require more regular check-ups and routine health care over time. The U.S. population is aging. This is particularly true in areas like our own Western PA region where one in five residents will be 65 or older by 2025.

Outpatient procedures are outpacing hospital stays. Outpatient procedures are viewed as more favorable by patients, healthcare systems, and doctors alike in the majority of cases. Obviously some medical procedures absolutely must be performed in hospitals. For more minor procedures and checkups, the future is trending towards medical offices and away from hospitals.

Pittsburgh’s Medical Industry and Aging Population = Strong Medical Office CRE Market

As we mentioned in the previous section, our region’s population is aging rapidly. An aging population leads to greater medical care demands. Pittsburgh is also well known for offering world class healthcare. What this means for investors is that the demand for office buildings in our area is expected to climb for decades to come. As this demand climbs, well-funded organizations such as UPMC will have more than enough desire and capability to either purchase or lease medical office buildings at a premium.

Given the Pittsburgh region’s population trends, there is perhaps no safer commercial real estate bet than medical office properties. There is every reason to believe that UPMC and other local medical research facilities will continue to attract the best medical professionals from around the globe to keep our local medical economy strong.

Going Forward

It is impossible to speculate on the future of real estate, no matter how many positive indicators exist. As far as safe bets go, medical office buildings are about as close as you can hope to get. Aging populations, a demand that outpaces supply, a medical industry flush with cash and resources, and the national trend of outpatient procedures overtaking hospital procedures all add value to medical office properties. Medical office buildings are a unique beast, and all investors are also encouraged to understand the intricacies of medical office layouts and realistic expectations before taking the plunge.

Amazon, Google, and Apple’s Impact on Commercial Real Estate Value

Posted on January 6, 2020March 9, 2020 | Leave a comment

Amazon, Google, and Apple are three of the most important companies on earth in terms of total impact. This certainly extends to the realm of commercial real estate. In Pittsburgh, Amazon and Google alone are leasing or building about two million square feet of commercial space. It can be tempting to think of these companies as somewhat ethereal as most of us never have an in-person, real life interaction. The reality remains that all three of these companies require huge commercial real estate investments for office space, warehouse space, research and development, and much more. With this in mind, today we will review the impact that Amazon, Google, and Apple have on the US commercial real estate market.

Amazon Commercial Real Estate Footprint

A funny aspect of finding information about Amazon’s impact on the US CRE market is that most of the results are actually books, DVDs, and other materials about commercial real estate sold on the Amazon platform. Digging deeper, you will find that Amazon has perhaps the largest global real estate footprint in the world. In Seattle alone, the original headquarters of the e-commerce giant, their total square footage surpasses ~13 million. All of this before they announced plans to open a second, perhaps even larger American headquarters in Arlington, VA.

The new headquarters is expected to create approximately 25,000 jobs in its first decade or so of operation. Construction alone has been estimated to employ some 50,000 workers with an estimated budget of $5 billion. These two mega-headquarters garner all the headlines when it comes to commercial real estate, but the footprint extends much farther.

In Amazon’s own words: “More than 175 operating fulfillment centers and more than 150 million square feet of space where associate pick, pack, and ship millions of Amazon.com customer orders to the tune of millions of items per year. Specifically, in North America we currently have more than 110 operation facilities with a variety of employment opportunities.”

Google’s Impact on Commercial Real Estate

Google carries perhaps the smallest impact on commercial real estate of our three mega-corporations, but also impacts the industry in other ways. Google boasts over 70 office locations in 50+ countries around the globe including notable offices in Pittsburgh, San Francisco, and San Bruno, CA. Google employs over 100,000 employees both domestically and overseas. Where Amazon’s impact on CRE is relatively straightforward with massive warehouses and nearly 8 times the number of employees, Google’s impact can also be felt through their many data centers.

Google has over 20 data centers around the globe in locations such as Douglas County, GA, Mayes County, OK, and Hamina, Finland. As one can imagine, the data storage needs for a company like Google are comical. These data centers and other non-traditional commercial real estate needs are likely to grow in the coming years. This, alongside more traditional office growth and warehouse needs, means that Google will continue to drive CRE value for many years to come.

Apple Locations Impact Local CRE Markets

To examine how Apple impact local commercial real estate, let’s take a look at Apple’s recent decision to plant their second headquarters in Austin, TX. The new tech campus will include a $1 billion construction budget to develop a property covering approximately 133 acres. Local citizens have expressed both excitement and concern for the future local economy boon and the likelihood that prices will likely skyrocket for local real estate resources.

There is no question that when a sudden influx of cash and employment opportunities hits a mid-major market, the ripple effect touches every aspect of not only real estate, but the local economy overall. Real estate investors and current owners of local real estate can look forward to their property values climbing dramatically. For individuals who are renting their homes or businesses who are renting commercial real estate, this can pose a very real threat.

Situations like Apple’s decision to move to Austin is similar to the recent Amazon bids put in by medium sized cities like Pittsburgh. Local citizens expressed consternation that already rising pricing for real estate and other commodities would become downright unaffordable. That is the balancing act that must be struck when considering massive CRE and construction bids from any of these three powerful corporations.

Going Forward

The complexities of how Amazon, Google, and Apple affect the American real estate market are too many to distill into a neat article. Rising costs of living in tech cities like San Fransisco create situations where the wealthy are moving in and the average citizens might be leaving for greener pastures. These injections of local economic growth can also revive cities with lagging economies. Commercial real estate has trended towards the energy sector, tech sector, and infrastructure in recent years. Major corporations will continue to drive significant changes in CRE market value in the foreseeable future.

Will Commercial Real Estate Adopt 5G?

Posted on January 3, 2020March 9, 2020 | Leave a comment

5G is the future of cellular service. Like 4G before it, 5G will revolutionize how we use our phones and other mobile devices online. The next generation of web-service will not just impact individual users, however. It will also lead to the rise of smart cities, autonomous cars, immersive education solutions, and much more. With these added capabilities also comes a greater demand for infrastructure support and technological planning.

The world of commercial real estate will see a massive impact upon the arrival of 5G. Whether or not the industry chooses to wholeheartedly embrace 5G is probably not a reasonable question. 5G is on the way, and CRE investors, builders, and planners must all take it upon themselves to prepare for the future of wireless technology.

What is 5G?

5G is a next generation cellular network that provides extremely fast web service for mobile users. The “G” in 5G stands for “generation”, denoting that 5G is the fifth major leap in cellular service technology. Each new generation marks a technological advancement which is incompatible with previous technology. 5G will be fundamentally different than 4G on a technical level.

While 5G is not yet available commercially, major players in the telecom industry including T-Mobile, AT&T and Verizon have rolled out pseudo-beta tests for 5G. The jump to 5G may be a tumultuous one, with new infrastructure and widespread technological upgrades being required before launch.

The practical differences between 5G and 4G capabilities stem from two key improvements:

Extremely low latency: 5G drops latency (the delay while a network processes information) by 10 times or more compared to 4G wireless service. Latency can be as low as 1 millisecond.

Vastly improved bandwidth: traffic capacity for 5G will improve by ~100 times compared to 4G. Network efficiency will improve by 100 times, and spectrum efficiency will improve by up to 3 times.

What does all of this mean? Lightning fast speed coupled with the horsepower to download, upload, stream, and everything in between to keep up with modern consumer and business demands.

How CRE is Preparing for 5G

Commercial real estate will have to adopt 5G in one form or another. Whether that means planning construction around 5G hotspots or understanding how smart car technology will impact travel times, this new technology will be a disruptive force in the CRE industry. Here are some of the ways that CRE professionals can prepare for 5G in the coming years.

The Importance of Understanding 5G Fundamentals for CRE

Before we take a look at any of the details of 5G preparation when it comes to commercial real estate, it is important for all industry professionals to have a baseline understanding of what 5G is and how it differs from your existing 4G tech. For example, many CRE investors, owners, and managers, punt all technology related issues to their IT staff. This makes perfect sense for the vast majority of situations. However, with new and disruptive technology, having an understanding of your current properties 5G preparedness and what improvements can and should be made is a great place to start. This begins with understanding how 5G works and how you can optimize your buildings to accommodate the technology.

Data Needs Will Continue to Increase Exponentially

Statistics on data usage on technological devices is staggering. Multiples quintillions of bytes of data are created each day from billions of users around the globe. Each year, the amount of data we collectively produce goes up exponentially as more users create more data with higher detail, density, and regularity. It is estimated that the world produced 18 zettabytes of data as of 2018. That number is expected to grow to 175 zettabytes per year by 2025. The ludicrous amount of data stored within a zettabyte is not the point here — the larger point is that data production and demand is expected to grow by ~1,000 percent in less than a decade. Building owners must take this into account when planning their IT infrastructure, staffing, and so forth.

5G Will Continue the Trend of Tenants Wanting an Improved IT Experience

Current renters, office space lessees, and hotel guests all expect a certain standard of connectivity from their spaces. As commercial real estate investors, owners, and managers, it is our responsibility to keep our eyes on the horizon for incoming technology. When 5G hits its stride a few years from now (estimates vary), individuals will expect their 5G compatible devices to work seamlessly at their workspaces, homes, or hotel rooms. By keeping up with 5G news and working with IT professionals, providing 5G connectivity can be seen as an opportunity for CRE investors rather than a potential weakness.

Going Forward

5G is not a matter of if, but when. Someday soon your phone will be able to stream high quality video with virtually zero load times, latency, or interruption. Smart cars and smart transportation systems will depend on this next generation technology to keep them connected. Commercial real estate investors will need to adjust to this new reality or be left behind by those who do. The real question will become how best to feasibly adopt 5G technology in a way that is cost efficient and maximally beneficial to tenants. As the technology continues to develop, the answer to this question will reveal itself more and more.

Sears Continues to Dump Brick & Mortar Locations

Posted on January 2, 2020March 9, 2020 | Leave a comment

Sears has undergone a well publicized downturn in recent years, culminating in Sears Holdings Corporation filing for Chapter 11 Bankruptcy. As a result the once retail stalwart has closed huge percentages of their brick and mortar stores including both Sears and Kmart locations. The impact on retail commercial real estate has already been felt and will continue to make waves in the months and years to come. From the perspective of CRE investors, the news of Sears closing another set of stores isn’t all bad news. Sears is not in trouble simply because they operated as a big box/department store in the modern market, there were large organizational problems which led to the downturn.

Let’s look at the latest round of Sears and Kmart location closures, how these closures are impacting commercial real estate in Western Pennsylvania, and explore why Sears and Kmart retail failures are not necessarily indicative of the state of brick & mortar viability moving forward.

Sears to Close Over 1/3rd of Their Remaining US Locations

The news in Q4 2019 is the announcement that Sears is planning to close 96 Kmart and Sears locations by February 2020. This announcement comes not long after the Sears Holding Company filed for bankruptcy in 2018. To put the latest round of closures in perspective, there were over 2,000 Sears and Kmart locations in 2014. After the 96 Sears and Kmart stores close in early 2020, only 182 locations will remain in the US. Quick math tells us that over 90 percent of retail locations for the company have closed within a 5-6 year period.

There are a few key takeaways from this total story and latest announcement, all of which we will go over in greater detail below:

Brick and mortar locations for “superstores” has been losing value for years. Commercial real estate investors are using new and creative solutions to fill/repurpose these locations. Sears and Kmart closures are an extreme example of an overall trend.
Sears filed for bankruptcy due to terrible business decisions, not their meat and potatoes business model. Poor executive hires, mismanaged assets, and lack of spending have all led to Sears’ downfall. Other similar stores such as J.C. Penney, Kohl’s, and Best Buy are surviving and thriving.
Commercial real estate has been impacted by these closures, but not necessarily in a bad way. Occupancies in prime real estate have been turned into lucrative opportunities from shrewd property owners and investors.

Sears and Kmart Closures in Western Pennsylvania

Bringing the attention to our region: how have Sears and Kmart closures impacted local real estate? The retail giant closed 13 stores in late 2018/early 2019. The latest wave of closures is also leading to 2 Kmarts and one Sears expected to close by end of year 2019. In Pennsylvania, Kmart locations in Leechburg, New Castle, Armstrong County, & Lawrence County are all expected to close by winter’s end. The Washington Crown Center in Washington, PA will be closing as well.

It goes without saying that Sears is in big trouble nationally and locally. For commercial real estate investors, this might have an impact for those with vested interest, but likely will not have a huge impact overall. Retail locations continue to offer a solid return on investment, albeit with a slight downturn in profitability in recent years. The key regionally and nationally might fall on investors to move away from huge, warehouse style locations and develop CRE into move profitable layouts.

What Went Wrong with Sears?

This all begs the question, what the hell happened to Sears? The retail giant began in the late 1800’s and enjoyed more or less on a steady climb for the first 100 plus years of its operational existence. While many point to a joint venture with IBM and CBS called Prodigy as being the beginning of the end, the fact of the matter remains that it took many egregious missteps over many decades to fall so far so fast. Here are just a few:

Sears lost its message and its value proposition. If you are anything like me, you might not remember the last time you thought “Sears is actually where I need to go for x product”. Once a one-stop shop for tools, lawnmowers, and TVs, Sears truly lost its way when they over diversified. Muddying the waters and confusing customers in the process.

Sears made multiple poor investment decisions. At the time Kmart merged with Sears in 2004, the holding company owned massive swaths of commercial real estate. In subsequent years, they have sold off much of this valuable real estate for cash. These locations are worth far, far more today than they were at the time.

Sears executive team doesn’t know how to run a retail business. CEO Eddie Lampert is a Wall Street guy through and through. Unfortunately for him and for Sears/Kmart, large retailers do not operate like hedge funds.

Going Forward

There is likely no short term solution for Sears and Kmart. Store closures may continue or they may freeze, but the damage has been done. Nearly all of the billions of dollars of assets owned by the company has been sold or liquidated in recent years with very little in the way of reinvestment into the business. From the perspective of local and national commercial real estate, Sears may be less of a cautionary tale than a pariah. If Walmart can successfully operate nearly 5,000 locations in 2019, superstores themselves are not the problem.

The Effect of Rent Control Laws on New Housing Development

Posted on January 1, 2020 | Leave a comment

It is widely believed that an affordable housing crisis is currently affecting the United States. Even when homebuyers and renters can find available housing and rental properties, often they find that the prices are too high for them to afford. The high cost of living has led to increased homelessness, especially in big cities. The problem is not epidemic in Pennsylvania, or Pittsburgh specifically, but the political and civic leaders in Western PA have identified affordable housing as a problem to be solved in order to provide economic prosperity for all. Thus far, no one on Grant Street or Harrisburg has proposed putting controls on the housing market but the city has made affordable housing a requirement for developers receiving subsidies for their projects. What is the future of such intervention? Look at California’s new initiatives to get a signal.

In order to address these social issues, Gavin Newsom, the governor of California, signed into law a new statewide rent control law that will take effect January 1st, 2020.

Understanding the New Rent Control Law

With its new rent control law, California is now the third state to pass statewide rent control this year, the other two being New York and Oregon. California’s bill is set to last for 10 years (through 2030), and it caps annual rent increases at 5%, with the cost of inflation included. It also makes it more difficult for landlords to evict tenants. Some experts say that California’s law is one of the strongest in the country at controlling rent increases and protecting tenants.

The California Apartment Association (CAA) believed that the state should instead focus on building new housing for those who need it, however Newsom has decided to do both, and then some. According to Newsom, rent control, tenant protections, and new construction make up his three pronged approach for addressing affordable housing.

Tom Bannon, the CEO of the CAA sent the following comment to CoStar News regarding the next steps to take in this initiative:

“Now that California has adopted the nation’s most sweeping statewide tenant protections, it’s time to fix the root cause of our housing crisis, a chronic lack of supply.”

Newsom said at the bill’s signing:

“We’re living in the wealthiest state in the country and while we’ve made progress in reducing our poverty rate, it’s still the highest in the nation. This is the issue that defines all other issues in this state.”

Impact of Rent Control on Californians

California currently has 17 million residents who rent, and of those, more than half pay more than 30% of their monthly income on rent. There are also millions of Californians who pay more than half of their monthly income on rent. A renter is considered cost-burdened when they spend more than 30% of their monthly income on rent, so this demonstrates how significantly the affordable housing crisis has hit California. It also helps to explain why California has the highest homeless population of any state.

The new law does have some limitations. As mentioned previously, it will be in effect for 10 years. It also does not affect any housing or rental properties that were built in the last 15 years, single family homes, and duplexes where the owner is one of the tenants. Single family homes owned by corporations or REITs would still be impacted by the bill however.

These limitations were put in place to incentivize builders and developers to construct new housing. Even with these limitations, however, Assembly member David Chiu predicts the law will help at least 8 million Californians. Chiu adds that “it’s historic legislation, but folks, our work is not done…In the long run, we have to build millions of new units at all levels of affordability to solve this crisis.” Chiu doubles down on the governor’s statements that construction of new homes is an important part of the future state of California’s housing.

Impact of Rent Control on Real Estate Investments

According to real estate investment analyst, Alexander Goldfarb, the rent control law could loom over real estate investments. While he does begin by saying the three states’ rent control laws “likely won’t have a revenue impact until next cycle, which might as well be next century given that most investors are judged on an almost weekly basis in the current market.” He goes on to say the following:

“But this is something we believe investors should pay more attention [to] as regulatory threats are likely to increase…We believe the rent control debate will continue across the country as renters face rising housing costs. While we think national rent control is unlikely, it will be an increasing campaign talking point, casting a shadow on market rate landlords and making life tougher for currently regulated units.”

Going Forward

The rent control laws passed by California, New York, and Oregon are set to make housing more affordable for millions of Americans. These laws are only the first step, however. In order to further assist the homeless and cost-burdened residents of the country, construction of new housing must be, and is, next on the agenda. The message this sends to investors is one of caution. New housing should be on its way, however, rent control will impact market rates for the next ten years.

Younger Renters Value Location over Square Footage

Posted on December 26, 2019March 9, 2020 | Leave a comment

There is no question that location has long been a primary driver of property value. When it comes to millenial and Gen Z renters, this has never been more true. Compared to Gen X and Baby Boomer generations, younger individuals and families tend to have somewhat different demands when it comes to choosing a place to live. Whereas property value, square footage, and affordability were primary drivers of the past, younger renters are more willing to pay a premium for location, convenience, and amenities.

This trend has already altered the residential and commercial real estate landscape in many major markets. Today, we will explore why younger renters tend to shop for location, other rental trends, and how these trends look to continue or slow down moving into 2020 and beyond.

Location, Location, Location

You have probably heard that young adults have been flocking to urban apartments and homes in record numbers. This is certainly true, but not necessarily for the reasons you might have assumed. The reality is that suburban life was the typical American dream for decades because it was the most practical and affordable for most Americans. In the current economic environment where student debt and stagnant wages are stifling young adults, affordability and convenience are still huge factors when it comes to young renters settling on a home. One small example of this is how few young adults choose to own cars compared to prior generations.

Here are a few location factors that young renters look for when searching for an apartment:

Commute length and cost to work and/or school.
Access to public transportation such as bus lines, trains, and subways. These two obviously go hand in hand and are tied into the trend of young adults relying on mass transportation over their own car.
Local amenities such as nightlife, entertainment, shopping, grocery store convenience, etc.
Convenience to friends and family members. This is another obvious reason which has actually shifted in recent years. While previous generations were getting married and starting families at earlier ages, young adults today are more likely to stay in an urban setting to remain close to their peers.

Population Trends of Young Renters

Whether or not it has happened at the time of this article’s publication, millennials will supplant baby boomers as the largest generation in American history. While baby boomers continue to hold the majority of our nation’s wealth, the purchase power is slowly but surely shifting towards the younger generations. As we mentioned in the introduction, young adults are certainly migrating towards urban environments. However, they are not moving towards “traditional” large cities such as New York, Chicago, and Los Angeles in the same numbers as previous generations. Instead, millennials are finding that more affordable cities provide more convenience and amenities for the price.

Millennials are moving to the Sun Belt. Perhaps the biggest overall trend in millennial migration is that a large number of young adults have chosen Sun Belt states such as Arizona, Texas, Tennessee, and Georgia. This is partially due to commercial real estate and businesses trending towards these locations, but also due to the fact that young renters can afford urban apartments in these states.

Millennials are moving away from major markets. New York, California, and Pennsylvania rank near the bottom when it comes to net population migration. By proxy, we can deduce that major cities such as New York City, Los Angeles, San Francisco, and Philadelphia are pricing out many young renters. This again shows that young renters on the whole are more interested in urban living than specifically living in certain cities.

What Renters Value in 2020 and Beyond

There is no question that most renters value location over square footage in today’s market. Of course, this does not tell the whole story. The main thing that young renters value in their apartments, townhomes, and house rentals is convenience. This includes locational convenience, washer and dryer amenities, access to high speed internet services, air conditioning and central heating, etc.

Larger spaces and “high end finishes” such as granite countertops, fireplaces, hardwood floors, parking, and more are often viewed as luxuries which many young adults cannot afford or are unwilling to pay a premium to enjoy. The primary takeaway is that cash strapped young adults have been forced to become practical and pragmatic when looking for their rentals. As young adults came into the workforce in the wake of the Great Recession of 2008, they have adjusted to this reality of pinching pennies to make ends meet.

Going Forward

Barring a seismic shift in the American economy, there is every reason to believe that young renters will continue to look for location first and foremost when apartment hunting. Younger adults are willing to pay a premium for convenience and amenities, but are less interested in larger, more luxurious apartments. For commercial real estate investors, this may inform decisions on values of properties based on locations and price points. Sun Belt and other “non-traditional” urban markets remain bullish in the face of millennial migration away from ultra-expensive cities.

How a Recession Would Impact Commercial Real Estate

Posted on December 23, 2019March 9, 2020 | Leave a comment

When it comes to recessions, it is not a matter of if, but a matter of when. The average American tends to view recessions as massive periods of history such as The Great Depression. In reality, recessions are quite frequent with varying degrees of impact on the individual and on different industries. Based on historical precedence, the US is due for another recession in the coming years. What is more difficult to calculate is the severity and duration of the next recession.

As real estate investors, recession can be viewed as both a scary proposition and also as an opportunity. Today, we will examine past recessions to better understand how investors can prepare for the impact of a future recession on commercial real estate.

The Inevitability of the Next US Recession

While nothing is inevitable beyond death and taxes, a recession is pretty damn close. Beyond the conceptual inevitability of economic ebbs and flows, recent recession indicators have shown that the US is due in coming years. Examples include:

Inverted yield curve: In a healthy economy, a long term, 10-year yield is expected to outperform a short term, 3-month treasury rate. In 2019, the 10-year yield dipped below the 3-month yield for the first time in 12 years. The last time this occurred, the 2008 financial crisis was looming around the corner.

Unemployment rates belie the reality: One of the strongest pillars of the current US economy is historically low unemployment rates. This is a great sign of stability of the nation’s economy. However, a worrying trend is that 2019 saw huge cuts to employee hours. This is often the first step towards higher unemployment rates, as employers tend to cut hours first, before ultimately having to downsize.

New York Federal Reserve recession probability model: The New York Federal Reserve puts out one of the most comprehensive and respected predictive models when it comes to future recessions. According to this model, the likelihood of a recession has approached 40 percent for the first time since 2009. Previous predictions have been accurate with a nearly perfect track record.

2008 Great Recession’s Impact on Commercial Real Estate

The residential real estate market gets most of the attention when it comes to the Great Recession of 2008-2009, and for good reason. Foreclosures and purchasing habits took a massive hit during the following years. However, the commercial real estate industry was hit nearly as hard. In fact, the average price of office space has been slower to recover than average rental rates. While office prices in 2017 had recovered to 30 percent above their 2007 highs, rental rates were performing at 60 percent above their 2007 highs.

Another grim aspect of the 2008 financial crisis was the impact it had on vacancy rates within commercial real estate. 2010 saw peak vacancy rates at 17.4 percent for office space, 10.1 percent for industrial space, and 10.8 percent for retail space. It is important to note that the impact on CRE markets seems to have been a bit more delayed than within the residential market, potentially accounting for some of the slower recovery noted above.

From the years 2007 to 2009, total investments in real estate went from $460 billion to $70 billion. This is one straightforward trend which will likely translate for commercial investment in any coming recessions. The impact may not be so severe, but total investments will almost certainly slow when a future recession hits.

How CRE Investors Can Prepare for a Recession

With all of this in mind, how exactly can commercial real estate investors prepare for this inevitability? While predicting the future is obviously a fool’s errand, there are two primary strategies that CRE investors can use to stay ahead of the curve.

Liquidate assets now to turn investments into cash

The signs of recession are certainly there. Some investors who have seen solid returns on their current CRE investments might want to take a turn-to-cash approach. This essentially takes your skin out of the game until the economy is back on the rise. The fringe benefit of turning current investments into cash is that savvy CRE investors can once again get back into the real estate market when property values hit their lowest points.

Retain real estate assets and weather the storm

Recessions are scary, but as all things, they too will pass in time. Most long-term investors understand that half the battle is staying in the game. All of the figures we have quoted earlier show horrible downturns and also eventual recoveries. In fact, one of the “bad” statistics for CRE was a mere 30% increase in value over a 10 year period.

Going Forward

Recessions are as American as apple pie. They are not to be feared, but they certainly call for some preparation and smart decision making. Commercial real estate is every bit as susceptible to an economy in recession as residential real estate or any other forms of investment. Smart investors will view coming economic downturns as just a part of the greater picture. Just as the CRE market recovered from 2008, so too will it recover from the next recession.