JackChat July 2024

Hard Questions (and Answers) For This CRE Current Reality

Oh my. What have we gotten ourselves into? IF we only read the headlines when identifying the risks we face, we would be thinking that there is some sort of commercial real estate crash happening or about to happen. Investors seem to be asking for fund redemptions, CMBS is running up delinquencies, Multifamily bridge loans, ostensibly on solid real estate assets, seem to be upside down (vis-a-vis capital stack), and no one can finance an office building. Woah.

Life is hard if you just do the easy stuff; it’s easy if you do the hard stuff.

I simply don’t understand why people aren’t asking a whole set of different questions. Many at the top of my list:

• When investors look at their investment processes, as well as the investments that they made during 2019-2024, what have they learned? What worked? What would they have done differently?
• ALL of us backed projects and sponsors during this period that ultimately played out very differently than we thought. Some played out better, some played out worse, than we thought. What can we learn from this?
• EVERYONE must accept we mispriced the risks. Did we actually misprice the risk or did we under appreciate those risks? Hindsight is 20/20, but a good teacher, nonetheless. When we look back and assess do we understand now what deals we did do that we should not have? What deals did we pass on, what sponsors did we think were not up to the task, that we didn’t finance them and yet those deals turned out well?
• Was the sponsor up to the task? Did he/she have the capability, capacity, willingness to execute on her/his plan? Was the plan weak? Did the sponsor really run out of time, really caught in a massive increase in rates; or was the sponsors’ plans to merely hang around the hoop while interest and cap rates dropped and made him/her rich?
• I posit, the biggest problem investors face today going forward is figuring out which sponsor brought to them by which intermediary should be banked. Did we learn this time that in good times real estate floats to weak hands, only returning to strong hands when times get tough? Have we actually learned how to discern what a good business plan looks like and whether or not that sponsor has the capability, capacity and willingness to deliver on their promises? Wishing and hoping for interest and cap rates to drop is not an investment thesis any of us should put money behind.
• Do people finally accept that price is what someone will pay for a property, but value is intrinsic (determined by economic cycle, capital markets cycle, property markets cycle, proper underwriting, and basis) and that value is not merely what a sponsor can afford to pay for a property?
• Can we finally agree that cash flow matters? That our space – Commercial – is defined by income producing real estate. That means we actually must underwrite tenants’ capacity to pay rent as well as a sponsor’s ability to manage expenses properly.
• Can we all agree that markets matter? Vintage matters. Structure of the deal (including reserves) matters.
• Have we finally learned the difference between a partner with deep pockets and a partner with both deep pockets and long arms!

Bad experience is due to bad judgement; however, if we are good learners, bad experience creates good judgment and therefore creates better experiences.

Our Current Reality is chock full of global unrest, policy uncertainty, headline risk, a banking crisis, a Presidential Election that is simply indescribable, regulatory reaction; but mostly, we suffer from a short game approach to a historically long-term asset class.

SOFR has gone up and today the marketplace is mostly financed with short term floating rate loans. Did we not learn this lesson in the 1990’s with the failure of Long-Term Capital Management? The punchline is to match duration of assets with liabilities. Borrowing short on a long-term asset has its risks.

You cannot legislate against greed or stupidity.

Our current reality is NOT a byproduct of force majeure; it’s a byproduct of greed and stupidity. Generally speaking, today, our real estate asset, property fundamentals, and market dynamics are solid. What we may have is too much debt sitting on a property that cannot repay its debt solely with a debt refinance. More cash equity is calling. More equity means weighted average cost of capital goes up which makes the property price go down. But if you aren’t selling, if you are not refinancing, there is no need to mark to market.

I hear about high rates and high inflation. WHAT? A 4.25% 10 year suggesting a 6% mortgage rate is not egregious. Further, inflation at 2-3% is not out of control. Especially if the leases on income producing real estate can pass through some of that inflation! A strong GDP with low unemployment is GOOD for commercial real estate.

In my 43+ years in this industry the current crisis is NOT about weak tenants, over building, failures of financial institutions, or property markets. Our issue, our opportunity, is getting the time for good assets managed by strong sponsors to season; for these income producing properties to grow their NOI and earn back their value>price status.

History may not repeat itself; however, it sure does rhyme.

My answers to the final exam:

1. Bank the sponsors that pass the litmus test of capability, capacity, and willingness to execute based on historical experience.
2. Hold assets for 7-12 years and end the traders’ mentality that CRE is a fix and flip 2 – 3-year hold. Price those assets off a 10-year treasury plus a spread that reflects the risk associated with holding an asset.
3. Find equity that will partner with you for the long haul. Ten plus year capital seeking apropos returns for that real duration.
4. Bring back amortization and end the interest only scam thus again forcing more real cash equity into the deal.
5. Wishing and hoping is not a solid investment strategy. Do the work!

While it has been indeed a while since I last wrote a JackChat, my new book “The Freedom Frameworks: Infinite Possibilities to Achieve Career Success On Your Own Terms” is now available on Amazon and other platforms for paperback and e-book. Audio book will be available later in the summer. I hope you will enjoy my sharing of these frameworks, tools, to help you optimize your own journey.