Where We Are

We are in the most peculiar real estate market within the last few decades… with no clear path. There is only one clear thing: we are in a belief fork. One direction leads down a lower interest rate and/or compressed cap rate environment (likely lower rent growth from recession), the other, higher-for-longer interest rates and expanded cap rates (but higher rent growth). You get to choose your direction.

A good place to start is to describe today’s market. In not so many words; a slog. Slow-moving and confusing. Right now, transaction volume is down 34% relative to the Ten-Year average.

(While deals are trading, the true symbol for the current market is the volume of deals not selling - a more ambiguous stat.)

Since properties are nearly all more valuable by $/psf compared to the 10 years prior (minus office), the transactional world (or lack thereof) is even more pronounced given less deal-by-deal trades have occurred. For clarity’s sake, that’s to say where 10 deals may have equated to $100M ten years ago, those same 10 deals may be $300M today. This is especially true in Multifamily and Industrial, the darlings of capital attention and value appreciation.

We feel the lack of deal flow directly through heightened attention and pricing. There are hundreds of billions in fund-raised equity on the sidelines waiting to pounce on the right deals. These funds typically have shot clocks with an incentive to deploy capital. But they haven’t been able to as the available deals to purchase are down dramatically. With time passing, and transaction volume so low, these fund groups are shifting into buy mode.

You could say any quality deal trading in 2024 has a “scarcity” premium attached to it. It’s simple supply and demand - not enough deal flow for too much capital.

As of 1Q24, the sunbelt market is squarely ± 5.00% cap rate on true T3 income / proforma market expenses. Trades range from the mid-to-upper-4% cap for core/core+ product in major markets to upper-5% to low-6% on class B/C suburban garden-style deals.

These 5% cap deals equate to a 4.5% yield on cost (YOC) for stabilized assets in markets with ample supply. Remarkably, this is below the yield of risk-free Treasury bills.

Buyer’s of this deal profile are not focusing on yields. They are looking at projected IRRs. To achieve mid-to-low teen IRRs on a 5% cap purchase over a 5 to 10-year period, the exit assumptions have to be aggressive. You'd need above-average rent growth of over 5% year-over-year and/or flat to compressed cap rates (5% and under), which are below current borrowing rates.

What we do know is that the active institutional limited partners (LPs) and allocators aren't overly concerned with yields. Their primary focus is on deploying capital on the right deals.

For clarities sake, here is what I am seeing across active sunbelt markets:

On a positive note, nearly all deals in sunbelt major markets are trading well below replacement costs. This includes the 2010’s 5-story wrap-construction in Uptown Dallas trading for $230k/unit and the 1980’s garden-style construction suburban-Charlotte deal trading at $145k/unit. Nothing can be built anywhere close to these sales prices.

Today’s buyers see this phenomenon and understand they can own prime physical real estate for significantly below what it would cost to build, limiting the future pipeline.

They are willing to take the risk on lower yields today with the upside chance that rents start to pop once market deliveries extinguish and pricing power returns.

Specifically, the Core and Core+ deal profile is a much larger total capitalization (+$60m range), which limits the potential buyer pool. It fizzles down to your Family Offices, Equity Funds, Insurance Companies, Fund-of-Funds, and larger REPE institutions that can deploy the cheapest cost of capital into vehicles with discretionary spending power. These buyer groups believe in the long-term fundamentals (population growth, job growth, quality of life) of the respective market + buy into basis story. These deals make it through Investment Committee.

The other side of the market today is heavy(ier) value-add deals. The buyers for these deals are highly concerned with yield, more notably, distributable cash flow, as their investor pool is HNWIs who expect earnings on their investments along the way.

The 1980s-2000s garden-style value-add assets in B locations within major markets of the sunbelt are trading in the low-to-upper 5% cap rate range on the premises of upside in the rents from renovations.

Operators are buying deals at 5.50% cap rate, which generally works to a low-4% Yield on Cost (YOC) after renovation capital. The underwrites show growth to ±6.25% YOC by stabilization year 3.

Sponsors are taking out 65% LTC variable debt at 3.25% spread over SOFR (~5%), making their interest rate +8%. A loan like this would weigh down distributable cash where retail investors would be unsatisfied. So the sponsors solve this issue in two ways:

One way to execute is through floating rate debt and deep ITM rate cap purchases where they can synthetically decrease the debt rate below the YOC to produce positive leverage.

The other way is through over-raising equity for cash flow reserves where investors receive x% from the pool of reserves until one day in the future, yield catches up to cover expected distributions.

Both are very costly. Millions of dollars. Intrinsically, the bet is lower rates at a point in the future.

This becomes even more complex when you add a pref equity check. Pref providers are charging 12% for better/repeat clients. They charge 4-6% current rates, and the remainder accrual. However, most of the deals can’t cover current rates, so again, the only way to satisfy cash flow requirements is by raising more reserves.

Groups have to believe in rent premiums in order to get yields above the borrowing rates. The truth is renovation premiums aren’t achieving the rent pop anywhere near what they used to (if they ever did… its not easy to discern between organic and created rent lifts), so underwriting a blanket renovation program makes no sense. But the most active buyers continue to underwrite this way.

What happens if yields are never achieved? If the growth stops? If the value-add strategy isn’t executed? Or if rates remain high and cap rates expand slightly?

There is no room to mess up. If you have to structure a deal this way to win, you should not be buying it (or investing in it).

I’m not saying this is the only active money or deal type right now. In fact, that’s far from the truth. There are incredibly unique deals being taken down off-market with strong yields on quality assets. You’re just not going to see or hear about them. The sponsors running these types of deals have the operational chops and equity relationships.

They see everything (or close to). They know exactly where deals are trading, and more importantly, where they are not. They are looking for well-located deals at below-market basis and finding unique stories from motivated sellers. They are not buying to buy. Or because “it’s time”. No, the savvy groups are doing what they always do. They are sifting through 10 levels shit to find the diamond. And that is exactly what it takes right now.

So be the guy/gal/group that finds them. Or someone else will.

If you made it this far, thank you. I would love your feedback, comments, questions, pushback, etc.

Peace,

M.F.Man