Even amidst a pandemic, there is no shortage of capital sources for the right sponsors.
The pandemic continues to devastate portions of the U.S. economy, but investor confidence is expected to return in 2021 with the rollout of COVID-19 vaccines and more stimulus funding.
Signs of a returning investment market are already evident, according to industry sources. Investment sales activity increased in the second half of 2020, and investors continue to seek acquisition opportunities, as well as equity and debt sources to support their goals, according to John Chang, senior vice president and national director of research with brokerage firm Marcus & Millichap. In a recent optimistic report on investment levels, he noted that while transaction activity in the last quarter of 2020 was below that of fourth quarter of 2019, it still surpassed transaction activity in 2006, at the height of the last real estate cycle.
“Investors are beginning to focus on upside potential and fueling that drive will be an unprecedented wave of capital,” Chang says, noting that currently there is about $5 trillion available in U.S. Money Market Mutual Funds and $16 trillion in U.S. savings deposits. Chang contends that the rollout of vaccines, along with the upcoming stimulus package, should begin to erode investor uncertainty, unlocking this wave of capital for investment.
There are other signs of a returning investment market, according to New Jersey-based Nathan Florio, a principal with Deloitte Risk & Financial Advisory Sponsorship. He cites that some debt funding sources that had paused activity during the pandemic are now back in play, in particular participants in the securitization market and mortgage REITs. The CMBS market, in particular, is providing very advantageous terms for certain property types, such as data centers, notes Florio.
Meanwhile, there is an ocean of capital available from a range of equity sources, including small private investors, friends and family groups, high-net-worth investors, family offices, pension and sovereign wealth funds, banks, insurance companies and REITs, says New York-based Richard Katzenstein, senior vice president and national director of Marcus & Millichap’s Capital Corp.
The type of equity partner available to any given real estate investor depends on the firm’s investment strategy, asset class, risk appetite and size of the deal, Kazenstein adds. Hotels, multi-tenant retail centers, speculative office construction and office assets with short-term leases are currently considered among the highest risk real estate investments.
While small- to medium-size equity sources are willing to do single-asset deals valued between $2 and $20 million, large private and institutional investors are looking for opportunities, such as portfolio buys to place large amounts of capital—starting from approximately $25 million and going up to hundreds of millions of dollars—at once.
The investment darlings currently are industrial, multifamily, and grocery-anchored retail, but Katzenstein says that equity sources and lenders are interested in most property types, with the exception of hospitality, as “no one is dipping their toes into that market right now.” But money can be found for other sectors hard hit by the pandemic, including office and retail.
Jeffrey Horowitz, senior vice president of investments for Los Angeles-based real estate investment management firm the Cottonwood Group, notes that there have been success stories in both the office and hotel sectors during the pandemic. “Despite the headwinds, we have seen these asset classes continue to perform and meet return expectations,” he says, stressing that asset performance is not uniform across the entire industry or all geographies.
“We’ve also seen situations where current owners and investors need to divest of a particular asset at attractive prices due to issues in other areas of their portfolios… [But they] continue to see viable opportunities in these asset classes in 2021,” he says. However, “patient capital” is key to executing these types of deals.
Although there is plenty of low-interest money available for financing, lenders are being cautious in underwriting deals. Florio says that in the current economic environment the sponsor’s experience and a strong track record are more important than ever. “Lenders want borrowers with stabilized assets that are encumbered by long-term leases with companies that are ‘essential’ businesses and/or high-credit tenants,” he notes.
Lenders are also requiring more equity in deals, with loan-to-value (LTV) ratios dropping from about 75 percent to 50-60 percent, as well as stronger debt service coverage ratios (DSCRs) than prior to the pandemic.
Additionally, Marcus & Millichap researchers predict that lenders will continue to closely examine rent rolls and will do deeper due diligence on property tenants.
Where to raise money
High-level, well-capitalized private and institutional investors have long-standing relationships with equity partners, such as pension funds, and deal directly with them or with originators that represent them when seeking equity capital, according to Katzenstein. But he notes that small- to medium-size investors must find equity and debt sources through other channels or intermediaries, including investment bankers, attorneys, accountants, broker groups, mortgage brokers, networking, and increasingly online crowdsourcing platforms.
Horowitz says that the biggest shift in raising capital during the pandemic has been on the foreign investment side. “Those dollars are harder to obtain, given the fact that investors and lenders without a U.S. presence cannot travel overseas,” he notes. As a result, less foreign capital entered the U.S. last year.
“Domestically, brokers have been able to leverage virtual meeting platforms effectively but gone are the days of roadshows where it is easy to interface with multiple investors in a foreign locale expeditiously,” he adds. “Reaching overseas investors without a permanent U.S. presence has also proven to be more difficult due to time zone differences, language barriers and general technology concerns,” Horowitz continues.
Foreign investors did not completely exit the U.S. market in 2020, but transactions have been less frequent and tended to involve larger check sizes, as overseas investors were only willing to travel and quarantine under local guidelines for very large deals. For example, Horowitz notes two very large recent transactions by South Korea-based Hana Financial Group, which acquired office buildings in Charlotte, N.C. and Seattle for $201 million and $669 million, respectively.
Targeted return expectations vary by investor, and can range between 8 and 25 percent, according to Katzenstein, with the highest returns expected for transactions carrying the greatest the risk. Horwitz notes that Asian investors, for example, generally look for minimum 5-6 percent cash-on-cash returns at the deal level and 8-15 percent of upside.
Due to the amount of capital available in the marketplace, a low interest environment and a large number of investors waiting to deploy capital, cap rates on are expected to remain stable going forward, says Katzenstein.