Sizing Up Investment Opportunities: What Lies Ahead?
- Dec 07, 2020
Real estate investors have taken a prudent approach amid the new economic climate and have adjusted their financial strategies when it comes to evaluating investment opportunities. With certain asset classes considered “safer” than others, investors’ preferences have certainly shifted.
Jonathan Needell, president & CIO of KIMC, a real estate investment company with a long-term orientation on value-add plays, spoke to Commercial Property Executive about trends and changing investor interest amid times of volatility. Needell discussed the performance of the main property types and what’s in store for them heading into 2021 while noting that “incredible opportunities” do not come without “some pain, distress and dislocation.”
How has your company adjusted its framework for considering investment opportunities over the past months?
Needell: The investment process hasn’t changed, but we have the luxury of being pickier investors in this environment. Anytime you enter a market like this, where there is more uncertainty and risk, it’s prudent to raise the bar. In addition, we’ve seen the scarcity of capital and decreased competition that has allowed us to negotiate more favorable terms. The investments we have made during the pandemic are more senior in the capital structure, incorporate minimum multiple requirements and the underwriting has focused even more heavily on being able to make money under downside scenarios.
Have you learned anything about longstanding financial strategies that you should possibly reconsider, taking into account the new economic environment?
Needell: Financial engineering has become commonplace in real estate over the past decade, due in part to low and falling interest rates. However, those that were overleveraged and underprepared have put themselves in a precarious situation due to that financial engineering. Lower collections, lower occupancy and tighter lending standards mean many property owners aren’t going to meet debt coverage covenants, won’t be able to refinance and may have to sell, recapitalize or give the keys back to lenders.
The industry is relearning that it is more important to match leverage to the asset risk of the deal than to optimize leverage for maximum underwriting return. We will start to see investors appreciate deals that make money under multiple leverage scenarios, business plans and exit strategies as optionality becomes more valuable during periods of uncertainty.
Hotel and retail are among the most affected real estate sectors. How has the pandemic impacted prices for these asset types and overall investor sentiment?
Needell: Investor sentiment really depends on the investor you talk to. I know there have been some groups that have had success raising opportunistic hotel funds during the pandemic, while other investors say if they bring a retail investment to their investment committee, they’ll get fired. It really comes down to investor outlook for these sectors, specific properties and how contrarian they are willing to be at this point in the cycle.
The reality is this has been a difficult year for retail and hotel and there hasn’t been much to make me think that will change materially in the near-term. These sectors have seen pricing pressure, but the degree of downward pressure has been situational.
For hotels, “downtown urban” has been hurt much more than “drive-to resort town.” For retail, white tablecloth restaurants have been hurt much more than grocery-anchored properties. The bottom-up details and intra-sector dynamics are as important today as they’ve ever been when pricing an investment. This is particularly true given we do not have a good sense of how much longer properties that are underperforming will have deficits to fund.
In terms of distressed hotel and retail properties and a potential wave of defaults, how does the COVID-19 crisis compare to the 2008 recession?
Needell: What I think is different about this recession is the speed and the dispersion. During this crisis, the government effectively shut down travel and brick-and-mortar commerce in a matter of weeks to help combat COVID-19, which led to a sharp increase in delinquencies. In 2008, the ramp-up of delinquencies was more measured. However, the hope and expectation is that the rebound from the COVID-19 crisis will also be much quicker than in 2008. The other difference between now and 2008 was that the effects of 2008 were far more indiscriminate.
What we are seeing during this crisis is a large dispersion between the “haves” and “have-nots.” As previously mentioned, grocery-anchored retail and resort-town lodging are holding up much better than their peers. Similarly, suburban and strong secondary markets are holding up better than urban markets. As a consequence, lenders have worked with the most-impacted sectors so far in the hopes of a steep recovery, which has meant less near-term action in delinquency situations. It is just not here yet, but it will come if the recovery does not ignite soon.
From a big-picture perspective, what changes do you expect to be temporary and what will most likely be permanent when it comes to the hotel and retail industries?
Needell: The business community has become very comfortable functioning virtually and that is going to impede the recovery of business travel. This will be a longer-lasting—potentially permanent to some degree—change for the hotel industry. The outlook for leisure travel is rosier and has already begun a strong rebound. Hotels that cater to these guests can expect a more temporary setback from COVID-19. Also expect more adoption of mobile check-in/check-out, keyless entry, contactless room service, etc., in the hotel industry to keep human face-to-face interaction to a minimum.
Retail is and has been in a secular downtrend for a long time. COVID-19 has just accelerated it. E-commerce and the “Amazon effect” has limited the need for brick-and-mortar retail to only the most essential businesses. We expect there to be a more permanent shift in demand in retail because of the pandemic. For hotel and retail, we believe excess supply needs to make its way out of the system. We are starting to see some rebalancing of that supply through repositioning of hotel and retail properties for better uses like industrial and multifamily.
On the other end of the spectrum, the industrial sector has proven resilient in the face of COVID-19. Going forward, what do you consider is in store for the sector?
Needell: We really like the long-term trends for industrial. It should see a massive wave of demand from e-commerce and last-mile uses for a long time to come. However, we are wary of some of the pricing we are seeing right now. We don’t believe industrial is completely insulated from the pandemic. The market may be underappreciating the stress on retailers and the flow-through effects on their distribution networks. All told, we believe the industrial sector is poised for growth, but we are still cautious on the sector due to pricing.
Looking ahead, how do you expect the real estate investment market to perform in 2021 and which sectors should investors “bet on”?
Needell: Next year will be a very interesting year in real estate and should bring about incredible opportunities for investors. However, we don’t get those opportunities without some pain, distress and dislocation, and that is our expectation for 2021. We believe we are still in the early innings of the real estate distress cycle and therefore are placing our “bets” in areas of relative safety. We have liked high-credit, single-tenant net leases in the industrial sector and first-mortgage positions in hotel and retail. As we enter the later innings of the distress cycle, we’ll look to be more aggressive across property types and capital structure.