The Current State of Commercial Real Estate and What Wellings Capital is Doing About It
Are you nervous about your real estate investments right now?
As I write this in mid-January 2023, the economy is shaky, and some real estate investments are headed for trouble. There’s already public reporting about a few large portfolios facing problems, and we’re sure there are many smaller properties and portfolios across the country with similar situations.
Chetrit Struggles With $481M Loan, Looks to Sell 43 Buildings - January 12, 2023
Veritas in Default on $450M Commercial Loan - January 11, 2023
Please note that if you are a Wellings Capital investor, you received a version of this article in your Q3 2022 investment update. Since some time has passed since the update, there will be a few additional details in this article that were not in the investor update.
I’d like to share some reflections on the economy and commercial real estate in general, and how we are adjusting our strategy in 2023. As you can imagine, we’ve been getting a number of questions from current and prospective investors.
Investors have been primarily asking about the impacts of:
rising interest rates on our current funds, new acquisitions in the Wellings Real Estate Income Fund, and our strategy for 2023
the expansion of cap rates (lowering asset prices)
a potential U.S. and worldwide recession
We’ve learned all we need to know about making economic predictions from Warren Buffett, Howard Marks, and other successful investors. The wide array and interplay of economic, sociological, legislative, and psychological factors among over 330 million Americans (not to mention black swan events) render accurate predictions impossible.
For example, one of our experienced operating partners shared the following chart from Chatam Financial, which shows experts’ many predictions on forward-looking interest rates compared to what actually happened. Do we really believe we can trust their current predictions about where interest rates are going?
We are guided by billionaire hedge fund manager Howard Marks, in his excellent book Mastering the Market Cycle – Getting the Odds on Your Side. Marks counsels us to stop trying to predict the future but rather to focus on acting prudently at whatever point in the cycle we find ourselves today. He says that the worst of deals are made in the best of times, and the best of deals are made in the worst of times.
While I certainly don’t believe we are in the worst of times, I’m afraid some in our space may feel they are heading into the worst of times for their investments. We’re hearing more than a few stories about multifamily (and other CRE) operators begging their banks to renegotiate their loan terms and some that are already in default.
One of our industry contacts reports on an operator whose entire portfolio is financed with personally guaranteed floating rate debt. The guy had no idea of the massive risk he caused for himself and his investors.
A November 2022 Fitch report on maturing CMBS conduit loans predicts that 23% of loans that mature in 2023 are in trouble and will not be able to be refinanced without 50% growth in net operating income or a significant equity infusion from investors.
While we wish the very best for every other syndicator and their investors, we have regularly predicted the likely pain that would result from their risky bets over these past several years. This past decade has been overrun with Newru commercial real estate operators (my term for New Gurus) who have never experienced a downturn before. Their investors have been saddled with the potential effects of:
the acquisition of overpriced assets with high sponsor fees
aggressive underwriting that assumed trees always grow to the sky (they never do)
the promise of exaggerated IRRs due to short holding times
and perhaps worst of all, floating rate, unhedged, and/or short-term debt
For example, an experienced operator told me about his worst deal ever. He had never made an investor distribution and struggled to keep the property afloat. A Newru syndicator swooped in earlier this year with low-cost floating-rate debt and acquired it for 50% more than this experienced operator had paid. The buyer’s debt costs have approximately doubled this year, and he may already be in default.
Wellings Capital Was Built for a Time Like This
On behalf of our investors, we have sought out recession-resilient asset types. We seek to provide diversification across operators, asset types, geographies, properties, and strategies. We have gone to great lengths to partner with operators who seek to conservatively underwrite their deals and employ the prudent use of fixed-rate and/or hedged debt. Our 10-year projected hold times are designed to give operators a lengthy window to hold assets through a downward cycle that rights itself in time.
Because these operators often acquire underperforming assets from mom-and-pop operators, they have a track record of extracting significant intrinsic value to the benefit of investors. Of course, these facts do not mean Wellings Capital is immune to the impact of a recession (we could certainly be impacted), however we believe our funds are well-positioned to weather a recession.
Our Strategy the Next Six Months
Since Wellings Growth Fund I, Wellings Income Fund I, Wellings Income Fund II, Wellings Income Fund III, and Wellings Income Fund IV are closed to new investors and since capital was deployed in previous years, the current interest rate environment has had minimal impact on operations. We have not suspended or reduced distributions for any of our funds since inception, and as of right now we don’t have any plans to suspend or reduce distributions for any of our funds.
Though these funds are closed to new investments, it’s likely that a few properties will be added to some of these funds this year. How? Because several of the funds’ investments were into other funds, and these portfolios are still making acquisitions.
Many of you have asked about our operators’ ability to acquire assets during this time of sharply rising interest rates. Though our answer is not universal across all situations, we have been quite encouraged by the reports of a few of the operators we have conferred with.
One mobile home park operator we work with reports that he is seeing an increase in the deal flow for seller-financed opportunities. He often competes for deals with institutional investors. Many of these institutional investors are “pencils down” and not competing to buy assets like they were in previous years.
Many smaller owners in the market to sell are returning calls now, ready to make a deal since soaring rates make it impossible to get their original asking price. We understand our operating partner is negotiating seller-financing at a 4%(!) interest rate on two upcoming deals as a result.
Another operator we invest with recently negotiated a $4 million reduction off a seller’s original asking price based on interest rate increases. This decrease is expected to provide a meaningful increase in projected cash flow and IRR to the benefit of investors.
One operator reports that COVID has accelerated the desire of some of his mom-and-pop sellers to move forward sooner than later. The aging patriarchs/matriarchs are ready to move on (or are being forced to for health reasons), and their kids don’t have the desire or ability to take over.
These older owners often call the potential buyer who has stayed in touch most consistently. That buyer is often our operating partner, and with some competitors currently scrambling, they can negotiate a better deal and terms, such as owner financing at below-market interest rates.
wellings real estate income fund and Preferred Equity
The Wellings Real Estate Income Fund has made nine commercial real estate investments since launching in June 2022. Eight of those investments were our traditional “common equity” investments. One of the investments was into a unique real estate debt fund. If you’re a prospective investor and curious about what is in the Fund, feel free to reach out to us.
We believe there is a unique window the next 3-6 months or so for “preferred equity” investments in the $1-$5 million range. Due to the lending environment right now, it is not uncommon for preferred equity investments in this range to yield 7-9% annually with another 7-8% annually upon sale or refinance. The immediate cash flow, back-end appreciation, and protected position in the capital stack are a few reasons we are pursuing preferred equity opportunities for the Wellings Real Estate Income Fund right now.
Though we are always considering common equity opportunities from our approved operators, over the next few months we are focusing the majority of our due diligence efforts on sourcing these preferred equity opportunities. We feel that we need to narrow our focus to capitalize on what may be a limited window of opportunity.
The preferred equity deals, operators, and terms we have examined at so far have been extremely encouraging. As always, we continue to follow our rigorous due diligence process for these preferred equity operators and deals.
Conclusion
We’ve been quoting Warren Buffett for years. The tide is now going out. Skinny dippers will be exposed. I’m thankful to many of you who have entrusted us with your hard-earned capital, and we look forward to continuing to serve your investment goals in the coming years. If you have any questions, please email us at invest@wellingscapital.com or use this link to set up a call.
This article is for educational purposes only and is not to be relied upon as the basis for entering into any transaction or advisory relationship or making any investment decision. All investments involve the risk of loss, including the loss of principal. Past performance and any performance results reflected in this article are not an indication of future results.