Independent Thinking^®

Q&A An Evercore Real Estate Roundtable, Hosted by Stephanie Hackett

Editor’s note: Evercore Wealth Management supplements its core investment capabilities with carefully selected outside funds across the range of the firm’s asset classes, including illiquid assets such as private equity and real estate that have the potential for higher returns than the public markets. The following is extracted from the September 24 client webinar, Reappraising Real Estate: An Evercore Investment Roundtable, hosted by Evercore Wealth Management Partner and Portfolio Manager Stephanie Hackett.
 
The three guests, Garett Bjorkman (GB) of the CIM Group, Jon-Paul Momsen (JPM) of Harbert Management Company, and David Silvers (DS) of U.S. Realty Advisors, each run an external fund represented in many Evercore Wealth Management portfolios. CIM Group is well known as a lender, operator and developer of commercial real estate assets in urban areas, in particular areas undergoing revitalizations, including Qualified Opportunity Zones. Harbert’s U.S. real estate team focuses on value-add or opportunistic real estate investments across offices, apartments, mixed-use, and industrial properties in high growth cities. U.S. Realty Advisors is a triple net lease investor (meaning that the tenant commits to paying all the expenses of the property, including real estate taxes, building insurance and maintenance) and focuses on single tenant leases for office buildings and distribution facilities.
 
To view the full replay, please click here.
 
SH: We believe real estate has the potential to generate excess returns through both cash flow and capital appreciation, and also tends to be uncorrelated with equity markets. Each of your firms is actively investing in commercial office spaces, so let’s start there. We’ve all seen the pictures of empty office spaces and heard stories of people who are planning to work from home forever. But let’s separate out the hype from the headlines. What are the risks you are seeing?
 
JPM: Office today is one of the most intriguing spaces to be investing in because there is a lot of headline risk, and that risk comes with a kernel of truth. But that risk is being priced into the market, and there are opportunities to find great value with assets that are somewhat mitigated from the risk. The combination of a pull-back of equity, a pull-back of debt capital and very conservative underwriting makes for a material effect on value. If we can underwrite assuming all the downside risks, but buy assets according location and size – and find an insulated underlying tenant base conservatively, use less leverage, and underwrite them to higher return – the opportunity for outperformance is very strong.
 
GB: One of the interesting dynamics in urban areas that really differentiates this cycle from previous ones is that the underlying health of our tenants remains strong, in terms of collections. We’ve seen new leases in New York, San Francisco, Chicago and the other major metros basically dry up, and contracts that were signed pre-COVID in New York have been re-traded with discounts of about 15%. But everyone else is hanging on; there is a real desire to wait. For people who are forced to sell into a market of uncertainty over the next 18 months, those valuations should be low. That presents a lot of opportunity for buyers.
 
DS: In this kind of environment, single tenant net lease real estate (which is one tenant paying for a long term – never less than 10 years – at an agreed rent with all of the operating expenses) looks attractive on a risk-adjusted basis because the flows are predictable. Net leases tend to focus on mission-critical assets, such as a headquarters building and research and development facilities, which makes it difficult for companies to walk away. The advantage we have with net leases is that we have very long remaining terms. Oftentimes, in the panic of a six-month historical perspective as we have with the pandemic now, people tend to project infinitely into the future that the same results will occur. We know there will be more telecommuting and the need for fewer people in the office, but companies will also require greater social distancing in their facilities. We just have to be very careful in our underwriting.
 
SH: Let’s cast the net a little broader, across the real estate market. How does 2020 compare with other investment periods?
 
GB: The market shutdown across all sectors has really differentiated this period. The question now is how long can people hold on, as the carry costs in real estate are extremely high. How long can people continue to carry full-service hotels or luxury condos? Although I really believe in the long-term value, the short-term liquidity crisis has yet to play itself out. On the positive side, the nature of this pandemic means that the end, with a vaccine, will also allow us to rebound much more quickly than in any other downturn.
 
DS: There are always opportunities out there. The [key] is to be able to evaluate the particular asset in question. Now there are locational developments, such as central business areas, that are perceived as less desirable. But views do change. It’s a function of underwriting the credit and the real estate asset, stress-testing the deal, and asking how we are being compensated for the downside.
 
JPM: It is a good time to be very patient. There was an early sense that we all needed to work together to get through this exogenous shock, and everyone played nice. I think we are at an inflection point, as this is morphing from a short-term crisis to a real recession. Lenders are no longer playing nice; landlords are no longer playing nice; and the federal government from a fiscal stimulus point is no longer playing nice because they can’t play nice with each other. The only agency still playing nice is the Fed – but they can’t do it all. There will be more pressure placed on owners of real estate, and if you are not well positioned to work through that distress, you are going to be a forced seller. And then there will be opportunities. But most of that hasn’t worked its way through the real estate sector yet. It’s happened in hospitality, but not yet in offices and in multifamily where collections have been very strong. But that will come.
 
GB: I don’t think people have the patience any more. The banks aren’t going to be willing to provide additional relief. This is the beginning of what will be real distress throughout the marketplace, which presents a lot of opportunity – but it’s time to be very low levered, to have dry powder, and to be patient.
 
SH: The Fed has committed to keeping interest rates low, but the environment is very uncertain. What are you thinking about that?
 
JPM: We view this as a time to use less debt because of the uncertainty out there. But because of the distress, we can still find our returns using less leverage. I think that’s the right approach to take over the next 18 to 24 months while we work through this uncertainty.
 
DS: If something goes wrong, if your tenant blows up, would you rather have more equity invested in that deal or less? Higher leverage means less equity invested. We continue to follow this constraint: no more than 75% leverage, even with a very long-term lease. In fact, the leverage that we get from lenders is typically about two-thirds, and we think that is prudent.
 
GB: In this environment, we would rather take on incremental risks at the asset level to achieve greater return than take on assets with which you are relying on near-term performance to serve as debt cash flow on your leverage to meet your return objectives.
 
SH: Let’s hit another major asset class within real estate. Are distributions facilities and warehouses still attractive or are they getting overpriced?
 
DS: There is a great tendency of people wanting to own Amazon warehouses, just as there was demand for Walmart stores 30 years ago, and 40 years ago everybody wanted to buy Kmart stores. But the pricing for some of those properties out there, from our perspective, makes them unattractive investments, even when you can get terrific leverage. Have patience and wait it out.
 
SH: Is this a buyers’ market or a sellers’ market?
 
GB: We are, for the most part, waiting, but there are more buying opportunities that we foresee than selling opportunities. Lending in this market, given the dearth of capital, has been a very attractive place to play, and there will be a lot of opportunities to be buyers and to create solutions for people with liquidity issues.
 
JPM: We are always buying and selling. When we have a stabilized asset, we are sellers of that asset. Right now we are net sellers of multifamily, which we think is mispriced, and office, because long-term predictable cash flows are very financeable. By the same token, anything that is not long-term stabilized income today is on sale at a discount. But we are going to be patient buyers and conservative in how we underwrite.
 
DS: We are more transactional and opportunistic than most. Every week we look at our portfolio and ask if we want to sell or own each asset. There are certain places where there is crazy money out there and we are happy to sell, to let them have it. There are other opportunities where we want to buy and that’s where we want to be.
 
Stephanie Hackett is a Partner and Portfolio Manager at Evercore Wealth Management. She can be contacted at [email protected].