Key CRE Points for 2017 – Q&A with David Kessler of CohnReznick

CPE sat down with CohnReznick's national director of the CRE Industry practice to discuss seven key elements to look out for this year.

The arrival of 2017 brings both questions and adjustments to the commercial real estate industry. From renewing confidence shaken up by a new president-elect and an interest rate hike, to foreign investments and the growth of urban neighborhoods, 2017 is the year for transition. Commercial Property Executive sat down with industry expert David Kessler, national director of the Commercial Real Estate Industry practice at CohnReznick, to discuss seven of the key elements that those in the industry should be aware of throughout the year.

David Kessler, national director, Commercial Real Estate Industry Practice, CohnReznick
David Kessler, national director, Commercial Real Estate Industry practice, CohnReznick

Renewed Confidence to Drive CRE Strategy

CPE: How do you think people in the industry are dealing with the rise in interest rates?
Kessler: I think people are going to start to strategize on cost of capital. Fortunately, a lot of folks were locking into longer terms at the lower rates. Hopefully everyone took advantage of that as much as they possibly could. I think it’s going to really impact pricing and values and it’s going to cause closer underwriting and higher attention to fundamentals. One of the things that we’re sensing from capital sources and institutional investors is that there’s more attention to strong fundamentals and income producing properties versus the expectation of continued low and decreasing cap rates and rising values. So we’re seeing a lot more capital steering away from opportunistic and development strategies and more towards value-add, where there can be revenue enhancement and creating value through revenue enhancement versus cap rate compression. There’s a little bit of “late cycle” strategy planning. One of the things that will create less of an impact is the amount of financing that is currently being done through the shadow banking and loan funds that are short-term, bridge-type loans for repositioning strategies, where banks have typically not been as active because of the regulatory requirements with ADC loans and the risk waiting. I think it was something that was expected but now we’ll see more attention to the real estate fundamentals and value creation versus cap rate compression.

CPE: Do you think people will be more concerned about how their properties will be handled and buying less or will it be the same as long as people strategize ahead of time?
Kessler: There’s going to be opportunities in the market as debt matures and there could be some distress situations that are created and some opportunities as a result. Whereas five years ago, if somebody got in at a much lower cap rate, took advantage of the low interest rate and is in a position to need to sell a property, there could be opportunities for a decrease in pricing. I think fundamentals are going to drive decisions and not only revenue, expense and occupancy fundamentals but more macro, such as if jobs are increasing in a particular area, or if there is population growth. I think that’s where we’re going to see some of the decisions being made.

It’s Not Just Multifamily, It’s Multifaceted

CPE: What do you see as the continued growth appeal of the multifamily industry?
Kessler: There’s a question, are we in a bubble in multifamily? This has been a question to come up over the last few years. It comes about because of the significant amount of new developments, but I think there’s still going to be appeal because we’re still not at the normal production levels in a lot of markets. Millennials are still largely renters, we’re seeing less of a percentage of homebuyers, lending restrictions and requirements are still an obstacle for first time homebuyers and now with interest rates kicking up, it’s going to make it even more difficult. There’s still such an appeal for the amenities in a lot of these live-work-play multifamily areas. Urban, ex-urban, and we are going to continue to see a demand for rental housing and mixed-use development where you have urban infill multifamily, or ex-urban, outside of the core but close enough, where there are city centers being created with multifamily, retail, entertainment, office and hotel. The question is going to be about financing this activity, but I think there is a strong demand for this type of product and the financing will play into the demand. In cities that are out of the gateway markets—outside of D.C., Boston, New York, San Francisco—people will start to focus more attention as the pricings lower. We’re seeing the biggest rent growth in Seattle, Portland, Denver, Cincinnati, San Diego, Phoenix, Raleigh, Durham, Tampa. There’s still such a migration into the southeast, so a lot of those markets will continue to be in demand.

The Retail/Logistics Link

CPE: Why are micro-distribution centers a better option rather than going for a full warehouse or factory?
Kessler: I think we’re going to see both, an institutionalization of a lot of the industrial properties where typically it was local, regional, specialty-based operations and institutional capital has over the years gravitated towards the industrial space as a result of a lot of the needs with distribution. The online and immediate shipping and whole logistics strategy that’s been taking shape, I think what we’re going to see are these micro distribution centers that are established in strategic areas to act as local warehouses. So when you order something, instead of it coming from four or five areas depending on where you’re located, I think we’re going to see the locations narrowed down to cut on the receiving time. I think that’s going to be a retail strategy we see a lot of. The industrial returns have been extremely high over the past year. I think REITs alone for returns were 31 percent year-to-date, where industrial was the leading performer through the third quarter of 2016; retail was 13 percent. We’re seeing different strategies with retail, with the conversion of a lot of the big box stores into alternative uses. Some of the other uses are just shrinking the box and creating other retail establishments in a well located center. That’s proved to be pretty meaningful for some of the retail REITs. We’re seeing a lot of aggregation of industrial properties through institutional investors.

Urban Density Dynamics

CPE: What would you say is the appeal of the live-work-play environment?
Kessler: We’re going to continue to see urban density because of the relatively low risk on the absorption side with urban development. The conversion opportunities of repurposing older offices with internal center cores, small footplates, converting that to apartments, hotel or alternative space are easier to build. The consumer demand of office will drive towards new development to accommodate user needs and the conversion of these older properties. I think we’re going to continue to see that and desire for younger folks to be in urban areas.

CPE: Are there any particular areas or regions that are doing this well? Some that need improvement?
Kessler: It’s phenomenal to me that in places like D.C., Boston and San Francisco, there is a significant amount of condo development and conversions as well as multifamily rental. Really just a revitalization of areas with live-work-play, close to office. The creation of luxury housing, hotel and retail within these urban pockets and areas that have been surprisingly slow is Atlanta, for instance. It’s taken off in these other areas and several submarkets. Even in Fargo, N.D., the entire downtown is being redeveloped. We’re seeing it in the gateway cities as well as secondary, tertiary locations. I think the areas with business centers that are more spread out, like Atlanta, are slow to doing this because there is so much infrastructure and development activity in a sprawling area, versus cities that have deep cultural and business activity and are building around that population, so that there becomes the residential, entertainment and retail experiences that are 24/7 living.

Global Volatility and Foreign Investors

CPE: Since you say that foreign investors are looking beyond Class A properties, where do you think the hot spots for investment will be this year?
Kessler: The gateway cities are still popular for foreign investors because they are safe, familiar and there is an enormous amount of inflow of capital in the U.S. as a safe haven. Canada has been a huge investor, with $3.8 billion in New York City real estate alone, doubling last years and surpassing the $2 billion record set in 2007. China has slowed down but there’s still an enormous amount projected to be invested over the next five years. There’s a bit of a slowdown as a result of the economy, but we’ll see things pick back up. Chinese investment in U.S. commercial real estate was $8.5 billion in 2015, which was a record high. China ranked number three in U.S. real estate for foreign investors, behind Canada and Singapore. With the FIRPTA relief, that’s going to provide more incentive for U.S. investment. We’ll probably see some more from foreign pension funds and an increase in REITs.

The Role of REITs

CPE: Which are the particular geographical areas or segments you see REITs focusing on?
Kessler: Demographics once again takes center stage when it comes to determining the success of sectors and geographies. High quality retail and Class A malls are highly sought after and will continue to be at premium, whereas Class B retail continues to struggle and be ripe for repositioning and alternative uses. De-malling to open air centers with trendy shops and restaurants remain a hit with Millennials and Boomers alike. These types of street level, place-making retail environments are in demand. Likewise, America’s aging population makes health care properties and senior housing an attractive draw. Investors have experienced high yields with industrial sector properties and the demand will continue to rise with the logistics sophistication trend. Multifamily fundamentals remain strong with rising rents in many markets, whereas gateway markets are seeing a tapering off of rent growth, but occupancy levels remain high. Self-storage properties, which closely follow new multifamily development, remain a popular strategy.

CPE: What other changes do you see REITs involved with throughout the year?
Kessler: Although interest rates are on the rise, currently they are still low and investors are still looking to REITs for lucrative returns. To date, the total market capitalization of U.S. REITs has nearly tripled over the past decade, to just over $1 trillion. Last September, in fact, that growth helped real estate attain a whole new category of investment status with the Global Industry Classification Standard, which officially recognized real estate as its own economic sector. With this change, the number of funds and other vehicles that specialize in REITs will inevitably multiply. We are predicting more privatization transactions as REIT stock prices may fall below the underlying asset values, and couple this with the enormous amount, $230-plus billion, of dry powder with private equity firms looking for opportunities to invest. One of the factors REIT managers will be focusing on in 2017 and beyond is the unfolding effect of FIRPTA, in terms of attracting more inbound investment to the U.S. real estate sector. The major change this key legislation brings is the increased threshold for investment in publicly traded stock from five to 10 percent, enabling all overseas investors, including sovereign wealth funds, pension funds and insurance companies, to double their positions in publicly traded REITs without being subject to tax on the sale of shares or on receipt of capital gains from the REIT. As REITs utilize this increased capital from foreign sources to expand their portfolios, U.S. investors will likewise be attracted to new opportunities for greater returns.

Headwinds, Tailwinds and Crosswinds

CPE: What do you think people in the industry need to keep their eyes on the most throughout 2017?
Kessler: Property fundamentals will carry the day, now that interest rates will be on the rise and cap rate compression can’t be counted on as a component of future value. Great properties in great locations, with great market fundamentals including good health care, population growth and job growth will be good bets. Urban infill development and repurposing obsolete office product to retail, hotel, condo, and/or multifamily rental will create opportunistic and value-add opportunities. Expect continued liquidations and distributions from PE funds. Expect continued interest both from U.S. and international investors in the real estate sector, and increasing allocations of capital from pension funds with increasing payout obligations. Late cycle discipline and caution will be important. Secondary and tertiary will continue to provide discounts to gateway market transactions.

CPE: Any large impact changes you see coming in the following months?
Kessler: Yes! Our very own U.S. economy could certainly become the biggest single factor to impact growth throughout 2017 and beyond. REIT market cycles are closely tied to GDP growth, and a hopefully improved economy going forward means rent growth, lower vacancy rates, stronger property fundamentals, improved employment, lower spreads and higher loan-to-value amounts. Our past sluggish economic growth has caused REITs to overuse bank debt to refinance, which led to higher draws on revolving credit available, and reliance on unsecured term loans. While this lack of excess capacity has hindered their capacity to ride out potential market volatility, once the economic picture improves, REITs could attract investors with a whole new level of confidence. Other factors include the CMBS debt maturities in 2017 and 2018 with rising interest rates, and a dramatic reduction of CMBS originations, higher bank regulations, and potential declining valuations, which could provide pressure for borrowers, and opportunities for buyers, PE funds with debt and equity strategies.

Image courtesy of CohnReznick