What’s On Your Mind?
Welcome to 2025, a New Year, a new administration, a fresh start and undoubtedly new resolutions for all. I’ve heard of varied new mantras to revive, to survive, and to thrive in 2025. No doubt a new year brings with it a time to reflect on the past year and set goals for the new year. At Buchanan, we regularly ask our teams to do just that as we attend to our existing investments and look forward to what new opportunities might present themselves.
Whether our apartment, self-storage, commercial or lending businesses, each has its own set of investment criteria and market dynamics to consider. Interestingly, each operation except for apartments has had a recent closed transaction or a pending investment in process to draw some market currency to our goal setting.
Given a recent and successful capital-raising activity for our commercial team, we’ve had a chance to speak with many of our investors and understand their own views on investing, appetite for risk/return and most importantly to address their questions about the real estate markets in the new year.
We appreciate these questions as a prompt to further educate our investors in understanding our views on the market, where we see opportunity and how we manage and mitigate risk and return.
Given the diverse CRE environment, how do you differentiate amongst varied product types and their risk and return projections?
Headline news attempts to package all real estate and market conditions homogenously but this over generalization can greatly mischaracterize the niches of the many verticals. Within real estate, there is much fragmentation and hybrid usage customizations to consider. Historically, the CRE market consisted of the four major food groups: office, industrial, retail and multifamily in a primarily non-public market.
Today’s real estate market offers a much wider array of investment options in both the public and private markets as well as within the debt and equity space, emphasizing the vastly expanded segmentation and overall size of the asset class. Differentiated products today range from data centers, cold storage, marinas, senior housing, limited-service hotels, and single family rental housing to name a few. Further stratification can include such things as specific geographies, a developmental focus, mezzanine lending all framed around risk/return yields within a core, value-add or opportunistic profile.
Each entry point has its own risk characteristics which can vary greatly depending on an investment sponsor’s experience, cost of capital and macro and micro market circumstances.
For example, within two of the larger asset classes, the macro-office market has been severely impacted by its reduced demand and lack of available capital. We’ve seen the very best product in the best locations to continue to perform, while certain secondary or tertiary locations lose occupancy and relevance. To be an office investor today, you need access to contrarian capital, provide an appropriate return opportunity, and have sound specific market knowledge.
On the apartment side, the market has experienced massive new supply that was mostly met by demand but has yielded negative rent growth over the last 18 months. Conversely, new construction has now plummeted nationwide, setting the sector up for the potential for near term rent growth. The buying appetite, however, remains high for multi-family assuming sellers accept the new pricing metrics.
It is hard to succeed as a generalist in CRE today given the segmentation and differentiation of the varied product lines and geographies. A specialist needs to have product knowledge, market specific expertise, and relational access. The mistakes that we have seen in today’s current cycle are a biproduct of multiple variables including style creep (wrong capital for a particular risk), lack of necessary expertise and an often-improper capitalization of the investment given the current market cycle.
Help us understand the making of investments as it pertains to the utilization of leverage given the volatility of interest rates and how hedging, locking rates and utilization of term are incorporated into these new investments.
Many of today’s capitalization problems have been exacerbated by the misuse of leverage including over leveraging, mismatched terms to business plans or improper hedging. We do not speculate on the assumption of declining interest rates or, in the case of value-add investments, mismatch our borrowing with long-term financing which might limit a refinance or add to the cost of an ultimate exit.
Yes, the lack of predictability around interest rates adds complexity to varied investment activities but we try to remain agnostic to leverage and its variables. We focus first and foremost on the underlying investment opportunity, its supply and demand imbalances and our prior experience with a particular situation. Thematically, we utilize relational lenders, do not overleverage our assets, and make use of appropriate hedging products.
Are you concerned about mass defaults eventually impacting various CRE sectors?
Unquestionably the market is strained with overdue loans and pending loan expirations creating an unresolved refinance market. This is particularly evident in certain products like office with reduced occupancy and cash flow availability as well as apartments where extensive leverage was utilized without the anticipated rent growth.
However, regulators have learned from the prior banking crisis to allow lenders to work with certain borrowers where applicable and to extend these credits where new equity and a go forward business plan can be put in place. Unlike the GFC era, the overall health of CRE’s greater balance sheet is in much better shape to withstand these recapitalization needs given improved lending discipline and today’s access to new equity.
Opportunistically we believe that this will present new buying and lending opportunities as sellers and borrowers run out of time with their lenders and are forced to sell or refinance at the new market pricing.
What are our thoughts on multifamily on the West Coast/Sun Belt states?
As an active apartment owner and lender in the West Coast and Sun Belt areas, we remain bullish on these geographies. However, most recently we have been more active as a lender given the underwriting economics and our last dollar of risk. As an example, just last week we closed a $46.5 million construction loan on a Class A 149 unit Multifamily development in San Diego’s North park submarket. Apartments remain a resilient asset class on the West Coast, particularly in supply-constrained markets like San Diego.
Within the extended Sun Belt, we are an active investor as these markets should continue to outperform due to strong population growth, a favorable business climate, a diversified employment base and lower cost of living. Markets like Dallas, Salt Lake City, Denver and its associated front range offer compelling market characteristics for properly priced existing product.
On a selective basis, we will consider other markets if we believe the opportunity warrants our entrance with the above-mentioned characteristics.
What is an investing thesis that Buchanan pursues that other real estate firms may be missing?
Our investment thesis varies depending on the capital which we are utilizing for a particular investment. Some of our investments are more core-to-core plus in nature, providing more predictable cash flow with a longer-term investment horizon. These assets are in strong markets with long term growth potential where we can often outperform our competition at the margins through highly proactive asset management due to direct senior involvement and investment discipline.
Separately, we have been active in making situational/opportunistic investments in assets that have either an attractive underlying basis or have a conversion upside that isn’t always appreciated or underwritten by existing owners or other investors. Examples of this include a class A office building in Dallas that we acquired at a 13% cap rate due to how institutional investors redlined the asset class. We believe that certain office assets will continue to attract tenants, provide strong cash flows, and significant cash on cash returns until valuations revert to higher levels.
What is your prognosis for the impacts of the LA fires to the cost of insurance going forward and its correlation to property operating expenses within the CRE space?
This is now a question on all our minds and unfortunately it will play out for years to come. Interestingly, we have noted that commercial insurance rates fell 1% in Q3 2024 from the previous quarter which was the first time the index recorded a decline since 2017. This is largely driven by increased competition among insurers in the global property market benefiting assets in catastrophic zones or less attractive assets such as frame apartments.
Logically, we would have to assume that in the short run we will see higher premiums, reduced availability, increased claims, and financial losses as the markets stabilize and undoubtedly state regulations and varied advocacy groups influence new legislation. Coincidentally, we just received a quote this week on a new commercial asset and while no doubt a slower response time, the quote was not impacted or increased given the concrete tilt and fully sprinklered nature of the asset.
I am optimistic that going forward, innovation will take place including the adoption of public private insurance models, more emphasis on mitigation measures including AI assessments, satellite monitoring, and the utilization of noncombustible materials. Finally, I believe that we will see a further bifurcation of areas that have increased wildfire, hurricane, or tornado risk with an increased cost of doing business which can be practically factored into the underwriting of a new investment.
Thank you for your questions and the chance to provide some feedback. As we endeavor to fulfill our investment goals together and thrive in 2025, I look forward to your further inquiries and continued conversations as we build our portfolio together. We remain enthusiastic about 2025 and, to quote Abraham Lincoln, “The best way to predict the future is to create it”.