Investors who have been through multiple cycles understand that opportunities to generate outsized returns often follow periods of extreme market stress. Typically, in real estate, such opportunities follow fundamental repricing of risk and leverage-induced dislocations at the property or the corporate level. Being able to identify mispriced assets with compelling underlying value and having the conviction, as well as capital, to act in the absence of perfect clarity are critical to capitalizing on these opportunities.
The current environment is one that certainly possesses these qualities. As if the global pandemic is not enough, we now face unprecedented wildfires on the West Coast, an economy struggling to regain its footing, a zero interest-rate environment that might persist for some time, and a Presidential election that is casting uncertainty over the outlook for 2020 and beyond. We are confident attractive investment opportunities exist within this chaotic confluence of events. We also believe that this is a period that calls for a balanced, patient approach to investing that reflects the fact that we are going through a period where risks are abundant - in some cases quite novel - and hard to quantify.
Barbell of opportunities in commercial real estate
One of the defining attributes of the current environment is the disparate impact COVID-19 has had on different property types. Imagine a barbell. At one end of the barbell are multifamily and industrial properties. Both enjoy strong underlying demand for space, which in some respects has only strengthened during the fallout from COVID-19. With healthy market fundamentals, strong operating cash flow, and attractively priced debt financing, investors are drawn to the yield and defensive characteristics that these properties offer.
At the other end of the barbell are hospitality and retail properties. Both have suffered distress of historic proportions, as measures taken to contain the coronavirus quite literally resulted in many of these businesses having to close their doors or substantially curtail their activity.
Despite the current performance of hospitality and retail, we believe that these two property types have meaningfully different trajectories going forward. On the one hand, with a vaccine or medical breakthrough, hospitality could recover as travel resumes. Predicting the timing and speed of that recovery is virtually impossible at this time, but this has not stopped opportunistic investors from preparing to acquire hospitality at distressed prices for the potential to ride the eventual recovery in the sector. On the other hand, the decline of traditional brick-and-mortar retail has only accelerated as the crisis has resulted in surging ecommerce demand, further boosting its share of American household spending. With no sign that this trend is abating, the outlook for owning most retail is relatively bleak.
And finally, in the middle of the barbell is the office sector. Office properties have generally benefited from cash flow due to long-term leases, but they also face a market in transition due to the weak economic outlook, as well as the prospect of changes in how and where office space is built or leased. Consequently, while the office sector is not to be written off, a stockpicker’s approach to asset selection represents the prudent approach to participating in the sector.
At Cadre, we believe that these considerations should underpin any savvy investor’s strategy for deploying capital in this environment. Since Cadre’s inception, we have employed a value-add investment approach with a defensive orientation - constructing a portfolio primarily comprised of properties purchased at a discount to replacement cost with in-place income that can be improved through better management and modest capital expenditures, as well as selecting markets with attractive growth prospects and potential for above-average price appreciation. This approach is highly applicable to the current environment which also offers the potential to selectively capture greater alpha from the unique opportunities that could emerge from coronavirus-related distress.
Executing value-add with a defensive orientation
Delivering value-add returns is especially prized today, given the run up in equity valuations, continued volatility of the stock market and the near-zero returns available from fixed income investments. From our perspective, being deliberate about allocation to each asset type across the barbell described above is key to building a portfolio that is well positioned to perform by properly balancing risk mitigation with risk taking.
Multifamily, which is intended to generate a fairly predictable cash flow with potential for growth, can serve as the foundational property type within portfolio construction. Assembling a portfolio overweight in multifamily provides the flexibility to opportunistically source other property types such as office, hospitality, and industrial assets (especially industrial development). These property types may have higher variability in cash yield from year-to-year, due to the type and timing of value-add, but can offer the potential for greater capital appreciation and higher total returns.
Investors must remember that deploying capital within this type of environment requires patience - not necessarily because one is trying to time the market, but because risk increases when there are no clearly identifiable secular trends within that property type. Said differently, we believe investors can increase their chance of winning by waiting for the right deal within office and hospitality, whereas multifamily and industrial have stronger fundamentals, on which one can capitalize immediately.
Multifamily
Situation: Multifamily continues to be supported by short- and long-term structural advantages.
Given the essential need that housing serves, recent stimulus and broader support from government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, multifamily continues to be a focus area for capital deployment near-term. While spreads between multifamily cap rates and the 10-year Treasury note are at their widest point in 20 years, careful attention should be paid to the impact of discontinued economic stimulus, as well as signals of major household consolidation. Anecdotally, the observed slowdown in rent growth to-date has been somewhat offset by cap rate compression due to the low interest rate environment, but multifamily investors’ perceptions of risk could change. That said, in the 6 months since the onset of COVID-19, rent collection and occupancy within the Cadre multifamily portfolio have averaged ~97% and ~94%, respectively.
Long-term justification for the sector is supported by the below-average housing completions over the last decade as well as a widening affordability gap. The resulting effect is that demand has consistently outstripped new supply.
Approach: Prioritize multifamily in growth markets with de-risked, value-add business plans.
In addition to the typical submarket drivers of value such as barriers to supply, affordability, and location (e.g. walkability, schools, points of interest, etc.), we believe that the current market is mispricing lease-up risk. We believe that opportunities exist within Class B apartments (i.e. workforce housing) where the going-in cap rate is reflective of in-place rents that could potentially see significant growth as the broader economy recovers. Additionally, we see the possibility to opportunistically acquire recently built, Class A assets in lease-up that are currently held by developers seeking liquidity during these uncertain times. Lastly, we are selectively looking at ground-up development where there is no entitlement risk and minimal pre-development risk - opportunities where the sponsorship already has significant capital in the project and there is transparency into construction costs, as well as structure of the construction agreement.
Industrial
Situation: Secular growth of ecommerce underpins sector outperformance, and in turn, continued capital formation.
COVID-19 continues to accelerate consumer trends already observed over the past decade. These consumer preferences for “free, next-day delivery”, quickly trending towards “free, same-day delivery”, are forcing a massive investment into the U.S. distribution and logistics network. By Q2 2020, ecommerce penetration increased to over 15% of total retail sales from slightly above 10% in 2019. There seems little doubt this trend will persist beyond COVID-19, especially as traditional retailers reinvent themselves in the wake of COVID induced bankruptcies and store closings.
The investment in the industrial sector comes in the form of upgrading and repositioning existing buildings as well as constructing new distribution space. Interestingly enough, while rents have increased an average of 5.6% over the last 5 years, construction starts in Q2 2020 have decreased by 37% from Q4 2019, which we believe supports rent growth near-term. Collectively, these observations potentially support continued net absorption with sustained rent growth, especially in secondary and tertiary markets near gateway cities, where labor is cheaper and land is cheaper with fewer constraints on development.
Approach: Ground-up development of industrial presents one of the best opportunities for yield upon stabilization and appreciation upon sale.
We believe an emphasis on state-of-the-art ground-up development provides one of the best opportunities for generating alpha. Financing remains available for well-underwritten development projects backed by solid sponsorship. Light industrial (e.g. distribution) is typically a more straightforward construction than other property types in terms of time, cost and complexity. Opportunity exists by focusing on the right growth markets with multimodal transportation access and affordable labor costs. We believe projects with no entitlement risk, limited pre-development risk (i.e. near shovel-ready), and yield-on-cost to cap rate spreads of +125 bps are the preferred deals within this strategy, especially given the interest of many institutional buyers for industrial properties for core-like stabilized (i.e. leased-up) product.
Office
Situation: The office sector is evolving to adjust to new norms of how and where work gets done.
While it remains to be seen how persistent work-from-home arrangements will be, changes are to be anticipated in how and where people will work. We believe that office space will likely be less densely occupied as companies rebalance their workforce across more locations, including hybrid models which combine in-office and in-home work arrangements. We envision that suburban office markets could be the first to experience return-to-work scenarios given lower density and drive-to access. While not all markets have solid suburban office fundamentals and not all tenants can easily relocate, on the margin, some markets such as Denver, Atlanta and Charlotte, among others, are likely to benefit disproportionately. We have already seen vacancy rates within suburban office decrease substantially in the last decade (i.e. -568 bps), and suburban office is at an advantage to more quickly be repositioned to accommodate new health & safety standards in a post-COVID-19 work environment.
Approach: Patience is key. Remain disciplined about tenant credit, market selection, and asset quality. Capitalize on opportunities in niche sectors such as life science.
As previously mentioned, the approach to office is about patience. This is not the time to take significant leasing risk, so being mindful of tenant credit, average lease length, and viability of vacant space is critical to minimizing exposure of the portfolio to unnecessary risk. We believe that starting with a set of 10 to 15 markets with strong fundamentals around growth, net absorption, industry diversification, etc. provides enough transactional flow to close on the handful of office assets needed to populate a portfolio. These markets should already factor in the fundamentals that would allow the suburban market to absorb demand from urban cores. Moreover, we are particularly interested in niche office space, such as life science and/ or space that can easily adapt to COVID-19 physical or operational best practices.
Hospitality
Situation: The hotel sector remains mired in the worst downturn in memory. Opportunities will emerge from this distress but there is little advantage to being an early mover.
Near-term fundamentals for hospitality are challenging at best. U.S. domestic airline passenger volumes are down by 64% and international travel down by 84%.[1] Additionally, RevPAR (or revenue per available room) declined 70% in Q2 2020 from the previous quarter, and CMBS loan delinquency in August 2020 was 16.8% for the sector.[2] We agree with most industry prognosticators that RevPAR may not fully recover for 24 to 48 months, meaning the full implications of the downturn have yet to be fully realized.
For would-be travellers, the importance of brand affiliation has arguably never been more important. At the beginning of the pandemic, leading hotel brands issued statements reinforcing their commitment to COVID-19 preparedness. As the market recovers, we anticipate that travellers will be even more likely to seek out trusted and established brands with well documented and clearly articulated safety protocols.
The pace of recovery will differ by segment, i.e., price point, type of property and geographic location. To date, economy/limited service hotels have maintained relatively strong performance while higher end and luxury properties have been the weakest. Similarly, large group-oriented hotels and destination resorts, i.e. those dependent on airlift, are likely to be slow to recover in the months and years ahead. And not surprisingly, regional markets, which benefit from drive-to demand are expected to outpace gateway cities which, among other things, are more dependent on international travellers.
Approach: Focus on broken capital structures, not broken properties. Acquire high quality select service and full service hotels which can ride the eventual recovery.
Otherwise high quality properties may face foreclosure due to the sustained collapse in room night demand which has occured in the wake of COVID. Focusing on those properties that can be acquired at deep discounts to replacement cost and need little in the way of capital improvements is an effective way to participate in the recovery of the sector. We advocate sticking to mid-sized (250-400 rooms) select service or full service hotels in regional markets where occupancy is disproportionately driven by transient and leisure oriented demand. Partnering with operators with a strong track record of operational excellence (revenue management and expense controls) and marketing prowess is critical. However, timing is everything and there is no rush to enter the market in 2020. We expect both the supply of opportunities and market conditions will slowly improve making 2021 more conducive to investing.
Market selection
Across property types, a key driver of investment performance is market selection. To this end, Cadre has developed a proprietary market selection process, using a combination of quantitative and qualitative analysis that marries the predictive analytics generated by Cadre’s data science team with the on-the-ground intelligence and experience of Cadre’s investment team. The result is ‘The Cadre 15’,[3] fifteen markets which we believe offer compelling prospects for growth and value appreciation.
From the West Coast to the Deep South to the Northeast, these fast-growing markets have diverse demand drivers and ample liquidity. The Cadre 15 includes Seattle, Los Angeles, Las Vegas, Phoenix, Denver, Dallas, Austin, Houston, Nashville, Atlanta, Tampa, Orlando, Miami and South Florida, Charlotte, and Washington, D.C.
The Cadre difference
The above reflects our latest thinking regarding investing in commercial real estate in today’s market. Once we determine what we want to invest in (property type) and where (market selection), we then drill down into individual properties.
Our investment team sifts through hundreds of opportunities annually across our network of more than 300 seasoned, on-the-ground operators. The team leverages differentiated, proprietary technology and insights from relationships within the local market.
Properties are quickly and automatically screened by more than 50 metrics including discount to replacement cost, expense growth, and mark-to-market rent growth potential to name a few.
We look at hundreds of properties each year and filter them through a multi-tiered vetting process. Fewer than 2% of the properties that we consider make it through our screening. We close on only a handful of those properties.
We only invest in properties where we can partner with exceptional operators or developers that we believe will add tremendous value and insight into the market and asset class. Above all, these partners have demonstrated an ability to execute their business plans through multiple economic cycles.
We invite you to learn more about us by visiting www.cadre.com.
Airlines for America, “Tracking the Impacts of COVID-19” (2020) ↩︎
STR, Fitch (2020) ↩︎
The Cadre 15 is a list of metropolitan statistical areas periodically identified by Cadre as commercial real estate markets with strong potential for risk-adjusted returns. The Cadre 15 is developed through a combination of quantitative and qualitative analysis, including predictive analytics and on-the-ground intelligence. Quantitative analysis involves forecasting two-year growth projections for each market and asset class based on various variables known to drive market appreciation including but not limited to population growth, employment, rent growth, new construction, and occupancy. Qualitative analysis involves a review of quantitative data by our industry experts. There is no guarantee that an investment in a Cadre 15 market will be successful. ↩︎
Disclaimer
Educational Communication
The views expressed above are presented only for educational and informational purposes and are subject to change in the future. No specific securities or services are being promoted or offered herein.
Not Advice
This communication is not to be construed as investment, tax, or legal advice in relation to the relevant subject matter; investors must seek their own legal or other professional advice.
Performance Not Guaranteed
Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections are not guaranteed and may not reflect actual future performance.
Risk of Loss
All securities involve a high degree of risk and may result in partial or total loss of your investment.
Liquidity Not Guaranteed
Investments offered by Cadre are illiquid and there is never any guarantee that you will be able to exit your investments on the Secondary Market or at what price an exit (if any) will be achieved.
Not a Public Exchange
The Cadre Secondary Market is NOT a stock exchange or public securities exchange, there is no guarantee of liquidity and no guarantee that the Cadre Secondary Market will continue to operate or remain available to investors.
Opportunity Zones Disclosure
Any discussion regarding “Opportunity Zones” — including the viability of recycling proceeds from a sale or buyout — is based on advice received regarding the interpretation of provisions of the Tax Cut and Jobs Act of 2017 (the “Jobs Act”) and relevant guidances, including, among other things, two sets of proposed regulations and the final regulations issued by the IRS and Treasury Department in December of 2019. A number of unanswered questions still exist and various uncertainties remain as to the interpretation of the Jobs Act and the rules related to Opportunity Zones investments. We cannot predict what impact, if any, additional guidance, including future legislation, administrative rulings, or court decisions will have and there is risk that any investment marketed as an Opportunity Zone investment will not qualify for, and investors will not realize the benefits they expect from, an Opportunity Zone investment. We also cannot guarantee any specific benefit or outcome of any investment made in reliance upon the above.
Cadre makes no representations, express or implied, regarding the accuracy or completeness of this information, and the reader accepts all risks in relying on the above information for any purpose whatsoever. Any actual transactions described herein are for illustrative purposes only and, unless otherwise stated in the presentation, are presented as of underwriting and may not be indicative of actual performance. Transactions presented may have been selected based on a number of factors such as asset type, geography, or transaction date, among others. Certain information presented or relied upon in this presentation may have been obtained from third-party sources believed to be reliable, however, we do not guarantee the accuracy, completeness or fairness of the information presented.