CRE Analyst

Here are the trends and events that we think will define commercial real estate in 2024.

Another research firm appears to be calling the valuation bottom for commercial real estate… MSCI Real Assets is showing waning declines in transaction volumes and pricing, with a recovery in sight. You buy it?

"Falsehood flies, and the truth comes limping after it." ---- Hatchet job ---- Two years ago the Washington Post ran a big story that claimed Invitation Homes was putting tenants at risk by cutting corners during renovations. “We’re paying $4,000 a month to live in hell…” “They hire people who will just do anything without doing it to code.” ---- "Sell Invitation Homes" ---- ...then a widely-followed hedgefund pundit labeled Invitation Homes as a top short idea, concluding... "As clearly as we can state it: THIS IS REALLY BAD." And... "An independent and highly credible third-party news organization conducted its own research and due diligence and found enough data and evidence to publish this very high-profile and damaging story." The pundit's analysis suggested that Invitation could take an $80-100M hit to NOI. i.e., $2B on a capitalized basis. ---- Voice of reason? ---- At the time, Green Street told its clients: "[this] appears to be a case of social media and a retail trading community blowing a sensational headline out of proportion.” Nevertheless, Invitation's market cap fell by about $5 billion following the report. ---- A resolution ---- Earlier this week, Invitation issued a press release saying the firm had agreed to settle all claims related to the WaPo investigative report. So how bad was it for Invitation Homes? The stock market's prediction of damages was a few billion dollars, perhaps influenced by the hedge fund pundit. And, if these renovations were as egregious as reported, you might think Invitation couldn't escape this without admitting fault. But the final judgment was less than $20M. i.e., less than 1/10 of 1% of Invitation's current market capitalization. And INVH admitted no wrongdoing. ---- Interesting backstory ---- Where will the $20M payment from INVH go? -- $4M to the plaintiff's attorneys -- $7.5M to various California municipalities -- $7.5M to Blackbird Ventures Blackbird Ventures is 'serial entrepreneur,' Neil Senturia's investment firm. Neil is the big winner here. He spearheaded these claims against Invitation Homes under California's whistleblowing laws, which reward legal vigilantes for identifying corporate falsities. ---- Our takeaways ---- 1. WaPo's report got a lot of attention, and the fallout is a good example of how sentiment can outrun value. 2. How did Green Street get it right? A framework-based approach to evaluating real estate value. 3. Was this story really about renovation quality or permitting or was it about an easy villain? PS - Although the recent judgment confirms actual liabilities were materially less than originally implied, we haven't seen any retractions, clarifications, or marginal distancing from original positions. WaPo ran the settlement story under the following headline: "One of nation’s largest corporate landlords to pay Calif. cities $20 million"

"Private wealth rushes in..." -- Many investment managers believe "private wealth" will account for a disproportionate share of capital inflows going forward. -- Blackstone is the 800 lb gorilla with a 300 client sales/service team. -- Other investment managers are moving into the space. Here's how Blackstone recently addressed increased competition in the space... ---- Blackstone Q&A ---- Analyst: You were obviously very early and very prescient in terms of building the retail platform; however, there has been a very big pickup of focus and new players into that. As you look ahead, how do you see the evolution of the wealth management opportunity? How do you think the competition shakes out? Jon Gray: It’s definitely an area of large-scale opportunity and everybody in the industry is recognizing this now. Credit to our firm to get into this well before other people to focus on financial advisors and their underlying clients to build out a 300 person global team, led by Joan Solotar, that’s focused on serving individual investors and also innovating creating these perpetual products that brought cost down very significantly from what had existed historically in non-traded REITs, non-traded BDCs, and really innovating to create things that would work… I think we will see more competitors move into the space. The advantage we have is our brand. …Investors know us, trust us because we’ve done such a great job investing capital for four decades. And the relationships and reservoir of goodwill we have with individual investors in the products, in the results we’ve delivered in BREIT and BCRED and in the drawdown funds that we have sold into the channel, have built up a lot of positive feelings. I think others will show, but we’re continuing to innovate here. The one advantage I’d say in this market versus the institutional market: There you can have thousands and thousands of individual private equity firms or real estate firms, credit firms. I think when you get to private wealth, the brands are going to matter, the scale, the ability to service. And we have a pretty meaningful first-mover advantage. …and we are absolutely committed to delivering great performance and great service to the underlying customer. We recognize it’s going to be more competitive. Others will try to do things in the marketplace. We respect them, but we really like our first-mover position in this very large and growing market. ---- Questions ---- 1. Are retail channels really the future of real estate fundraising? 2. Will some other investment managers chip into Blackstone's lead in this space? 3. Will other big investment managers get into this game?

Narrative vs. reality: Dry powder Narrative: "Private Equity Funds, Flush With $300 Billion, Stand Ready To Pounce as Recession Fears Fade" (CoStar, Dec 2023) Reality: All of that dry powder was raised with big return expectations. Most of it needs returns 20% above what is currently achievable. There are only four potential paths to more balanced capital markets... Category A: More cash for owners 1. Operating cash flow growth 2. Higher reversion values (lower exit cap rates) 3. Reduced borrowing coupons Or Category B: 4. Further price declines Commercial real estate markets will unquestionably find a new balance at some point in the future. But via what path?

Apartment cap rates: 3% —> 5% with a much slimmer exit cap rate spread. Another indicator of a bottoming market? Source: CBRE Good find, Gavin Campbell.

Perspective…

Fresh CRE commentary from Blackstone's Jon Gray (7/18/24)... ------------------------------- Negative sentiment: "We have been an outlier..." "The sentiment we think will stay negative because there still will be some troubled assets to work through the system. But on the ground, prices have cleared and some of these headwinds have gone away and that creates a favorable environment." ------------------------------- Property values: "...the near-term thing that has really impacted price and transaction volume has been cost and availability of capital." "If you look at the Green Street Property Report, six quarters where things have been flat and rising and the sentiments improving." "...people are recognizing that prices have reset and that it's an interesting time to get back in." ------------------------------- Fundamentals: "Vacancy rates in office today are sort of mid-20s, and it's going to take a while to work through that." "...demand has softened a bit, but pretty steady I'd say in both of those areas [multifamily and industrial]. Very positively, supply has come down 50-ish percent in multifamily starts, 75% from the peaks in warehouse starts. So, that's very good long-term." ------------------------------- Capital deployment: "Real estate is a little more episodic, but we are definitely leaning in..." ------------------------------- Redemption queues: "In our Core institutional business, we've seen a little bit of a pickup. It's still single digit in terms of the redemption queue across our BPP product line." "...open-ended funds will take some time before investors feel a little more confident. We're starting to see some interest, particularly folks thinking about could they buy in at a little bit of a discount." ------------------------------- Capital raising: "....my expectations on inflows here would be a little bit muted over the near term." ------------------------------- Private wealth investors: "It's definitely an area of large-scale opportunity and everybody in the industry is recognizing this now. I think credit to our firm to get in to this well before other people to focus on financial advisors and their underlying clients to build out now a 300 plus person global team..." "...we have a pretty meaningful first- mover advantage, $240 billion of total assets, and we are absolutely committed to delivering great performance and great service to the underlying customer. So, we recognize it's going to be more competitive. Others will try to do things in the marketplace. We respect them, but we really like our first-mover position in this very large and growing market." ------------------------------- Election consequences: "...we've operated in blue environments, in red and purple environments, and the constant for us is delivering great returns for our customers."

The multifamily market has covered a lot of ground over the last year…

Finding the trough: Value indexes, bid/ask gap, and marginal pricing... --- Value estimates ---- What's the "average" institutional commercial property worth? Depends on your approach... 1. Repeat sales index "RCA CPPI measure[s] the actual price movements for commercial properties based on exclusive transaction data using repeat-sales regression methodology." 2. Appraised value indexes National Council of Real Estate Investment Fiduciaries (NCREIF): "Each property’s market value is determined by real estate appraisal methodology, consistently applied." 3. Estimated sales index "Green Street’s timely CPPI index reflects real-time changes in commercial property values as soon as we hear about them, as it’s based on the transaction activity and asset pricing currently being negotiated and contracted in the market today." 4. Bid values [<< we made this up for this discussion] We identified a basket of relatively conservative assumptions and another of more aggressive assumptions. ...then integrated market cap rates, along with JPM's core discount rates over the last 20 years. Why? It provides a consistent way to handicap the relative aggressiveness of the various benchmarks. [We focus on 3 and 4 for the exercise outlined below.] ---- Observations ---- 1. Between 2004 and 2021, Green Street's index (on a relative basis) fit within the range of our core estimates. 2. Core asset pricing migrated to the aggressive side of our range during the pandemic recovery. 3. Core pricing exceeded our upper bound of reasonableness since rate hikes began 2 years ago. Why the divergence? Traditional non-core buyers (Blackstone and KKR) are outbidding core buyers, suggesting (i) their cost of capital is migrating lower and/or (ii) they are more aggressively underwriting future cash flow. ---- Quick survey of core buyer profiles ---- Active players: -- PE shops that own insurance operations (KKR) have defined multifamily purchases so far this year. -- Closed-end funds have dry powder but struggle with limited debt. Others: -- Public REITs, with stabilized NAVs and immediate access to capital, will probably lead the field when brave owners of quality assets test the market. -- ODCE funds are sidelined with redemption queues. -- Same story with non-listed REITs (e.g., BREIT). -- Same story with institutional separate accounts. ---- Why are core buyers so critical? ---- ...because sale prices are defined on the margin, not on average. The high watermarks that define quality real estate pricing are set by the players with cheap capital, and most of these buyers remain on the sidelines. However, capital markets conditions and fundamentals have strengthened over the last 18 months in this corner of the market, and both of these emerging conditions are prerequisites to a recovery.