Investment bankers discuss real estate capital market drivers for 2016.
11/9/2015 | By Dawn Wotapka
REIT magazine: November/December 2015
REIT magazine spoke with five investment bankers to find out their thoughts on the real estate capital markets:
- Jeffrey D. Horowitz, global head of real estate, gaming & lodging corporate and investment banking, Bank of America Merrill Lynch
- Schecky Schechner, managing director, Americas co-head, real estate investment banking, Barclays
- Rex Rudy, executive vice president, national manager commercial real estate, U.S. Bank
- Ashi Mathur, head of investment and corporate banking for North American real estate, BMO
- Vick Seth, vice chairman of investment banking, Raymond James
Remember when real estate transactions ground to a halt during the Great Financial Crisis? For bankers, those days are quickly becoming a distant memory. Near record amounts of capital continue looking for a home in real estate, which is seeing strong interest from coast to coast from larger players who can—and need—to write supersized checks.
“While capital raising by real estate private equity firms has decelerated slightly, it is still a very competitive acquisition market with transaction volumes approaching 2006 levels,” says Andrew McCulloch, a managing director with real estate research and advisory firm Green Street Advisors. “And, with most public REITs trading at sizable NAV discounts and debt capital readily available, the market is ripe for M&A.”
That’s good news for anyone who relies on deals.
REIT: REIT stock returns have slowed this year, but interest in U.S. real estate remains the strongest it has been in some time. Will this continue?
Jeffrey Horowitz: Over an extended period of time, there are moments when REITs trade above or below asset value. We’re currently at one of those junctures when many companies feel that their stock is trading below what the underlying assets are worth.
As a general matter, I believe demand for real estate will remain strong and the bid for assets will be firm given the continued need for yield, the stability of our markets and positive fundamentals.
Rex Rudy: Public versus private valuations are always in fluctuation. Today, we’re at a point where stock exchange-listed REIT shares are trading below NAVs/private values. It’s very perplexing to REITs out there today. You may see them stay away from new equity issuance until there is parity in the market. I also think you’ll continue to see them shift to a development focus, versus acquisition.
Ashi Mathur: Yes, for the foreseeable future. Stock exchange-listed REITs are currently one of the only investment vehicles that provide investors with yield as well as growth and exposure to an improving U.S. economy.
REIT: Looking toward 2016, what has you worried about the REIT space? What has you most excited?
Horowitz: I believe that REIT stocks are becoming more interest rate sensitive. …What we’re optimistic about is that the REIT market continues to evolve, the companies are becoming more and more creative, and, as a result, the space is likely to continue to grow significantly over time. RUDY: REITs are healthy, and there’s not anything from an operating perspective that gives me pause.
Mathur: Generally, there is a lot of private capital looking for real estate assets; it may be difficult for REITs to compete with [private equity] funds due to their relative cost of capital and return requirements. It is particularly challenging for those companies that are subscale. With limited market liquidity, it is difficult to attract a broad base of analyst coverage. Today, most subscale players are trading below NAV, thus pursuing acquisitions on an accretive basis becomes even more difficult.
In a [record] low interest rate environment, investors can no longer rely on falling interest rates to achieve cap rate compression and value bumps, so the focus will be on improving organic growth. M&A activity is expected to weed out weaker or poorly managed REITs going forward – and that is exciting. More of our clients are “kicking the tires,” and we expect things to continue to heat up.
REIT: Are there any new markets or sectors drawing increased interest from buyers? Why?
Rudy: Prices have gotten so high in the primary markets that investors are increasing the potential markets they are evaluating for new investments.
Mathur: The health care/senior housing sector continues to draw buyers at a record pace. While it is not necessarily new, we’re seeing an increased interest in the manufactured housing space. Demand for inexpensive housing is strong, particularly among baby boomers looking to buy in the vacation home and retirement markets. Also, rising rents and home prices have caused more people to consider manufactured housing as a feasible alternative to traditional site-built housing.
Seth: The single-family residential rental sector attracted a lot of attention in the last couple years, and I think will continue to do so after the brief pause over the last six-to-nine months as the sector matures and achieves critical mass.
REIT: Interest rates: Worried or not? Where will they be at the end of next year and how will that affect stock exchange-listed REITs?
Schechner: Most, if not all, REIT CFOs have factored a small rise in interest rates into their capital structure strategies. Given the significant refinancing over the past three years, where most REITs have lengthened the duration of their outstanding debt, most REITs have very little short-term exposure right now. So, a rise in rates will have little impact on the REITs’ cost of capital.
Where a rise in interest rates could affect REITs is the potential affect on the tenant’s business. If the rise in rates significantly negatively lowers the tenant’s growth, their demand for space could be adversely affected. However, most REIT management teams are not expecting such an outcome.
Mathur: Interest rate increases typically occur with an improving economy and growing rental rates. Typically, the first REITs to see growth in this type of market are multifamily, hotels and other assets classes with shorter lease terms.
Seth: I am watching interest rates very carefully. I personally believe that all of the interest rate increases are priced into the stocks. I don’t think long-term interest rates will be much higher than they are today, and we could see a maximum of 50 basis points increase in short-term rates.
REIT: What role will foreign investors play in the space next year? Where will foreign capital into the U.S. primarily come from?
Schechner: On a global basis, if an institutional investor wants to invest in commercial real estate, the perception is that there is no better place than the U.S. The fundamental underpinnings of the economy, the demand for space, the supply-demand balance and the low level of new construction all are quite favorable.
One would expect the capital to come from sovereign wealth funds. Most likely sources of capital include the Canadian and Asian investors.
Mathur: We are definitely seeing an increase in foreign investor interest, especially from Asian investors drawn to the “safe haven” nature of our North American market. It will mainly come in the form of direct asset investment – income-producing assets as well as development deals. Changes to U.S. tax laws may accelerate the amount of foreign capital coming into the market.
REIT: Do you expect more companies to go private? Why or why not? What sectors could be at play?
Horowitz: We expect more companies will clearly go private. Though not likely to be property sector specific, it will likely be more company-dynamic specific. Reasons could include succession issues, perennial trading below net asset value combined with activism, and management and a board’s view that the markets are about to change from a valuation perspective. Given where assets are currently priced, we need more core and core-plus money to make these deals work. Also, with interest rates at low levels, the cost of debt is clearly attractive.
Schechner: When REITs are trading at a 15 percent or greater discount to NAV, that is when lots of discussions occur. Will many happen? Unclear.
In the past, the equity participants in a “go-private” scenario were the opportunity funds with their higher cost of capital. With the rise of new core-plus funds (and their lower cost of capital), more transactions may work from a financial modeling perspective. The question is whether the quality of the assets will meet the requirements of the core-plus funds. Hence, the real focus will be on the higher-quality assets, regardless of sector.
Rudy: I do think you’ll continue to see some public-to-private activity. The primary reason is that public valuations are below private valuations today - and that the operating fundamentals continue to be pretty good.
Private investors are looking for places to put their money to work in real estate, looking more toward pools and companies, rather than seeking single-property acquisitions. You’ve also got investors starting to look for platform plays, looking to buy companies and acquire management teams to build platforms in those property types for future investments.
Seth: If interest rate fears are overblown and continue to depress REIT stock prices, then privatizations will continue since large amounts of cost-effective capital - both debt and equity - are available for the well-established private buyers. Frankly, all sectors will be in play.
Dawn Wotapka is a former real estate writer for The Wall Street Journal.