Yes, We're Still Investing in Mid-2023 - But Not in the Way You May Think
As I write this article in July 2023, we’re seeing a lot of negative headlines about commercial real estate. For example, here's a July 7th, 2023 article from Business Insider:
Commercial Real Estate Values Set to Crater as Much as 40% by 2025 in These 6 Cities (link)
Here are a few more…
Commercial Real Estate Crash Still Looming Over US Economy - Fox Business, June 7th, 2023 (link)
Why a Crisis Is Looming in Commercial Real Estate - The Washington Post, June 21st, 2023 (link)
Morgan Stanley Says Commercial Real Estate Will Crash Harder Than During the Great Financial Crisis - Fortune, June 26th, 2023 (link)
Commercial Real Estate Crash Sparks Bank Collapse Fears - Newsweek, July 10th, 2023 (link)
Right now, the headlines do not reflect the facts, nor do they tell the whole story of what's happening.
In this article, I'll discuss the contrast between the dire headlines and what we’re seeing in the commercial real estate space. I will also discuss our “edge” for investing in commercial real estate right now.
Why You Can’t Trust the Headlines
I don't want to focus this article on clickbait headlines, like the ones above. But I’ll address this one (mentioned above) as an example: Commercial Real Estate Values Set to Crater as Much as 40% by 2025 in These 6 Cities
My friend David is a nationally renowned copywriter. He says there is a thin thread of truth between headlines and facts, especially in tabloids. This is how they avoid lawsuits.
We believe this is one of those cases.
The content in the article following that shocking headline is entirely about the values of commercial office space! In fact, it quotes a few other sources that are wholly focused on plummeting office values.
The author doesn’t consider (or even hint at) the values of self-storage, manufactured housing communities, or any other CRE asset type. And there are other embellishments as well, like "up to 40%," which could mean anywhere from 1-40%.
The problem is that many of us form opinions based on headlines without actually reading the article and checking the sources. I’ve certainly done this, and I’m guessing you have done this at least a few times as well.
The Truth About Commercial Real Estate Right Now
The truth is that there is a lot of carnage in the commercial real estate sector right now, but it is not widespread across the board. Rate hikes and reduced lending by regional banks have historically taken 4-6 quarters before the full effects are seen. We anticipate seeing more of the effects near the end of 2023.
The main issues right now stem from:
Office properties. According to data company Commercial Edge, the US office vacancy rate was 17.1% as of June 30, 2023. Many expect the vacancy rate to trend upwards in the coming months, which is a horrible trajectory for this asset type. Many office buildings in large cities have already been lost to the bank. However, single-story suburban office properties in Miami are faring differently than multi-story office properties in downtown San Francisco. There are many nuances in how office properties are performing across the country.
Properties with uncapped/unhedged floating rate debt. Will every property with uncapped/unhedged floating rate debt be lost to the bank? Absolutely not. Many operators have reserves budgeted or set aside to cover increased borrowing costs, and they are increasing income. But, many operators don’t have reserves and are having trouble boosting property income fast enough to cover their increasing debt payments.
Properties with debt that is maturing or interest rate caps that are expiring in the next 12-24 months. According to Bloomberg, almost $1.5 trillion of US commercial real estate debt comes due for repayment before the end of 2025. Will every property with a looming maturity or rate cap expiration be in trouble? No. Many properties across asset types are performing well and will easily obtain new loans. However, some properties are not performing well and will struggle to get refinanced. In addition, interest rate cap costs have skyrocketed due to rising interest rates and uncertainty about how long rates will stay high. Many operators will struggle to afford new caps, and when their caps expire, there is the possibility for distress.
I'm not a journalist (and I don't play one on TV), but I’ve been accused of purveying bad news…or at least predicting it…since 2018 (here’s one example). That's when I started warning everyone who would listen about the disastrous situation many multifamily sponsors face today due to overpaying, lack of operational excellence, and poor debt decisions.
And I'm sad to report that many of these predictions are playing out before our eyes right now. We have an internal document called “Operators in Trouble” that we update whenever we hear about an operator that has issues. There are currently 29 groups on our list who have stopped distributions, reduced distributions, or done a capital call for at least one of their properties.
Despite headwinds from higher interest rates, we believe the fundamentals remain strong for self-storage, mobile home parks, multifamily, RV parks, light industrial, open-air shopping centers, and single-family rentals.
How is Wellings Capital Investing in Mid-2023?
2023 Investment Strategy #1 *
We continue to invest in common equity deals with a select group of operators we have worked with in the past. For example, our Wellings Real Estate Income Fund is about to invest in a multifamily deal built in 2008:
Equity required: ~$26 million
Purchase price: ~$80 million
Lender appraisal: ~$113 million
Estimated increase in equity on day one: ~$33 million or 126% of equity invested
How is this possible? A partnership with the local housing authority to make 50% of the units at the property income and rent restricted in exchange for receiving a 100% property tax abatement (!). This both serves as a built-in value-add for investors at purchase and also helps to provide downside padding in the event of an adjustment in cap rates and/or values in the future. These deals are very complicated to structure, but the results can be very worth it.
2023 Investment Strategy #2 *
We found an edge.
We didn’t invent it. But we’re taking advantage of it. And our investors are benefitting.
The edge is Preferred Equity in the $1-5 million check size range into quality deals/operators.
As Warren Buffett stared down the Great Financial Crisis in 2008, he invested $5 billion in Goldman Sachs as their stock plummeted. But he invested in preferred rather than common equity. He made billions in the process.
Likewise, we are investing heavily in preferred equity. Like debt, it has a predetermined cash flow from day one. But unlike debt, it provides projected upside at the time of refinance or sale. Preferred equity occupies a theoretically safer position in the capital stack than common equity.
For $1-5 million check sizes (limited competition for these check sizes), we are seeing preferred equity investment opportunities with quality operators that provide annual cash flow of 7-10% and total annual returns of 15-20%. Not only are these projected returns higher than most common equity deals are penciling now, but the risk is also lower, and the payments are far more reliable. As mentioned above, returns to preferred equity are prioritized ahead of common equity investors.
Though we don’t believe another 2008 is in progress, we believe it is prudent to add preferred equity investments to our portfolio to hedge against a potential decrease in valuations while maintaining solid projected returns.
See this article for a glossary on preferred equity terms. See this email for more detail on what preferred equity is. See this email for more detail on why right now is a limited window for preferred equity.
Two Brief Preferred Equity Deal Examples
We highlighted these two deals in a video here.
Example #1 *
Our Wellings Real Estate Income Fund made its first preferred equity investment in Spring 2023 in a commercial-grade single-family rental portfolio with approximately 1,000 units. Our investment is ahead of the common equity, which is 20% of the capital stack. In theory, 20% of the value of the portfolio could go down and our investment would lose nothing.
Our Fund is receiving 10% “current pay” cash flow out of the gate. Our Fund is also accruing 5% annually, which we will receive upon a recapitalization or sale. We also negotiated a 2.5% (of our preferred equity investment) common equity kicker. *
This investment is projected to benefit our fund investors by providing current cash flow as well as appreciation. The targeted total annual return on this investment, including the common equity kicker, is ~16%*. This is considerable in light of the priority position in the capital stack.
Example #2 *
More recently, our Wellings Real Estate Income Fund invested preferred equity in a multifamily deal with an experienced operator. The operator assumed a fixed-rate Fannie Mae loan at 3.7% that matures in 2031 with interest-only four more years.
This project is paying our Fund 9% annually, reserved in advance for the first year. Our Fund is also accruing 8% upside, payable at refinance or sale*. We also structured a minimum MOIC (Multiple on Invested Capital) of 1.3x if the operator refinances our preferred equity out of the deal early.
There is 25% common equity behind us in the capital stack, which shields us from losses if the property is sold at a 25% or less loss. We negotiated cash flow sweep and forced-sale provisions to provide additional protection.*
We are evaluating several other preferred equity opportunities with similar metrics right now. One of them pays 15% current pay with a 2.5% fee up front. There is no guarantee that we will close on these deals, so these results may not be achievable.
The Mechanics of Investing in Preferred Equity
Other investors may be able to access some of the common equity deals we invest in. However, we usually get better terms due to our check sizes, and some deals have minimums that are impractically high for most individual investors (like a self-storage firm with a $5 million minimum).
But preferred equity is entirely different. Individual investors have virtually zero access to these opportunities. Even large family offices would be hard-pressed to replicate the deals we’re doing. Here’s why:
You would need to source a quality operator with a quality deal, and you would need to know what “quality” looks like.
You’d have to negotiate terms and know how to ensure you don’t get screwed in the deal.
You’d have to know how to work with transactional attorneys in order to draft lengthy legal agreements.
You’d want to go through a rigorous due diligence process on the operator and property, and know what questions to ask.
You’d need to invest at least a million dollars or much more.
And you may have a hard time finding the best deals. We’ve all seen “preferred share class” opportunities from well-known multifamily sponsors. The issue is that these investments typically cap you at 8-10% total return with no chance of upside.
We’re seeing preferred equity deals every week with projected total returns between 15-20%. We seek additional upside through points, MOIC floors, equity kickers, promote participation, and conversion rights.
Still Focused on the Basics
Though we’ve added preferred equity as an investment strategy, we’re still highly focused on the basic tenets of what has made us successful to date as we invest in both common equity and preferred equity. And we’re still committed not to invest just for the sake of deploying capital, making fees, or growing our fund.
Our five income funds are performing at or ahead of schedule, and as of July 2023, none have missed a distribution or decreased distributions since inception. We’re especially proud of that given the environment we’re operating in and the chaos unfolding around us.
Here are some cornerstones of our philosophy and practice:
Historically recession-resistant asset types: Note that I didn’t say recession-proof. No such thing.
Due diligence: The non-negotiable in everything we invest in.
High margin of safety: Buffett said this is the key to investing success. We agree.
Selecting investments with moderate leverage: Besides sponsor risk, debt is the #1 risk in most deals.
Fixed interest rate or all-cash acquisitions: Describes 89% of our properties in our Wellings Real Estate Income Fund as of 6/30/23.
Working with operators who source off-market acquisitions: Brokered deals are typically overpriced.
Working with operators who acquire assets from mom-and-pop owners: A key in acquiring undervalued assets.
Conclusion
I'm encouraging you to take the time to dig a little deeper the next time you see an alarming headline. Consider what the article really says and realize that the devil is in the details. There is so much nuance in the commercial real estate space, and not all asset types, states, cities, and neighborhoods are equal. And within a specific asset type, there is a significant difference between investing in common equity vs. preferred equity.
If you're a current or prospective Wellings Capital investor, I invite you to schedule a time to speak with us about how we're navigating this economic environment and why we're as bullish as ever on commercial real estate.
I'll leave you with this oft-repeated quote from billionaire investment manager Howard Marks:
"The worst of deals are done during the best of times. And the best of deals are done during the worst of times."
* There is no guarantee that these results will be achieved. Past performance is no guarantee of future results. These results may not continue. There is also no guarantee that future opportunities will have similar characteristics.
DISCLAIMER: Investors should consider the investment objectives, risks, charges, and expenses before investing. For a prospectus or a summary prospectus with this and other information about any Wellings Capital fund, please call us at 800-844-2188 or contact us at invest@wellingscapital.com. Read the prospectus carefully before investing.
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 A more detailed explanation of the various assumptions and risks associated with hypothetical information in this email is set forth in the Private Placement Memorandum ("PPM") for Wellings Real Estate Income Fund ("WREIF"). Please read the PPM before making any investment decisions. All terms of this section are subject to the terms of the PPM. All investing involves the risk of loss, including a loss of principal. We do not provide tax, accounting, or legal advice, and all investors are advised to consult with their tax, accounting, or legal advisers before investing. Information and any opinions contained in this article have been obtained from sources that we consider reliable, but we do not represent that such information and opinions are accurate or complete, and thus should not be relied upon as such.