A Note From the CEO Part II: What We Are Seeing in CRE
This content was originally sent by email to RealtyMogul registered users on March 24th, 2020.
For starters, we hope you and yours remain safe and healthy. This is truly a historic time in our world. We remain concerned about the status of our public health systems and support our leaders around the country who have established Shelter in Place orders to contain this pandemic.
In the world of real estate, a lot has changed in just a matter of days. While 5-10 days ago aggressive terms were still the norm in major markets to win real estate deals, this week things have come to a standstill. The biggest issue is due diligence. Without the ability to walk properties, enter apartment units, enter office buildings, etc., real estate companies cannot do proper due diligence. Many third-party vendors, including appraisal companies, contractors and physical inspectors, are either prohibited or unwilling to put themselves in harm’s way to perform due diligence.
We have seen a range of reactions – some deals are dying all together. Other transactions are being extended 60 to 90 days in the hope this will all end soon. And still other transactions are seeing a significant re-trading of terms – distressed pricing 15-20% below where the price would have been just two weeks ago.
As of this writing Fannie Mae, Freddie Mac and many banks are still lending. Other debt sources have dried up. Due to the volatility in the public markets, there is zero demand for securitizations right now and the CMBS and CLO markets are nearly shut down. As an aside, CMBS stands for commercial mortgage-backed securities. A CMBS loan is a commercial real estate loan that is backed by a first-position commercial mortgage. The loan is then separated into bonds – known as tranches – and those tranches are sold with different risk tranches typically being sold to different investors with different risk tolerances. When the securitization market seizes up, these investors don’t want to buy these bonds and lenders refuse to give firm quotes on new CMBS deals, because they don’t know what price they can sell the bonds for and they don’t want to take the risk that they make an unprofitable loan for 10 years. While there may be some “best efforts” pricing available from lenders, most borrowers do not want to take that risk.
We see a few scenarios that could play out. In one case, real estate We are also hearing that insurance companies who lend against commercial real estate are pulling back. Some have moved completely to the sidelines to wait out the volatility while others have been increasing interest rates on new loans. The increase in interest rates is due to alternative investments available to these insurance companies, namely corporate bonds. The recent widening of corporate bond spreads has made them more attractive compared to lower yielding commercial mortgages.
We believe most of the deals being financed today are transactions that were already in the system, where due diligence was conducted prior to various state orders to stay home. In the coming weeks we expect the volume of sales transactions in commercial real estate to slow even further.
Another interesting consequence of this epidemic is title. Due to government closures, specifically in counties that do not offer electronic recording, there is an inability to record deeds and deeds of trusts. For anybody acquiring a property right now, it is critical to work with a title company that offers gap coverage. Gap coverage is when the title insurance company provides insurance for the gap between close and recording.
As far as on-the-ground responses, we are investors in over 15,000 apartment units, and across the board resident functions have been postponed, non-essential maintenance calls are being delayed, and residents are being asked to stay home. Most leasing offices are now closed and while there are some virtual tours happening, we think the likelihood of new leasing during this time is slim. Our main priority has been keeping tenants in place. In many of our properties we are also partnering with various non-profits and government agencies to assist folks who have lost their jobs and may be unable able to pay rent come April 1st. The first week of April will be very telling for real estate when April collections come in – will people be able to and choose to pay their rent considering widespread restrictions on evictions?
It is true that where there is turmoil, there is opportunity. So where are we seeing opportunity today?
For starters, we believe there is opportunity in the public markets in REIT stocks. As a result of Coronavirus, public REITs have lost tremendous value. There are certain REITs that are trading well below asset value despite having capital that we believe will allow them to weather the storm until the economy comes back. There also appears to be an opportunity in certain REIT preferred stocks that are trading well below contracted redemption value.
Unsurprisingly, cash is king. In addition to the public markets, we’re seeing opportunities to buy assets where the seller has taken a beating in the stock market and needs to sell, fast. We are currently working on underwriting a few transactions that check this box and another transaction that was under contract with full due diligence completed where the Lender decided to reduce proceeds. As a result, the buyer is re-trading pricing on the Seller and needs cash to close quickly to take advantage of a significantly reduced price.
We are also seeing opportunities in properties with government guaranteed rents. We recently acquired an asset in Virginia Beach, VA in one of our public, non-traded REITs, MogulREIT 1. That property has government vouchers where the government guarantees and pays a meaningful portion of rent. Given the current climate in our country, we believe the risk of the government defaulting on these rents to be low and we are interested in increasing our exposure to government guaranteed rents.
And lastly, credit tenants offer an opportunity. While the definition of a credit tenant may change as certain corporations face extended turmoil in this downtown, we still believe there are opportunities to acquire assets with long term leases to strong companies that are well poised to weather this crisis. We believe these organizations are better poised than small companies that may struggle to weather and or survive this crisis. Although pricing for these assets may increase on a relative, risk-adjusted basis compared to other asset classes, they still look more attractive, all else equal.
We do not know where things will end up – whether or not a U-shaped recovery from this recession is possible is yet to be determined. What we do know is times of uncertainty may offer an attractive entry point for investing in real estate. There is typically less competition as investors are driven by fear more than greed. As certain sellers have a need for cash, they may be forced to liquidate assets they otherwise would not sell. We rarely see this level of dislocation in the markets, so we are actively pursuing investments we think make sense while simultaneously pursuing risk-mitigation strategies. We are re-underwriting every asset in our pipeline with new assumptions, and we are going through our entire portfolio and evaluating market risk, geographic specific risk and financing risk. We are diligently exploring new ideas and innovation in the wake of this dislocation.
We continue to believe that real estate is a key asset class in a well-diversified investment portfolio. While we don’t know if we are at a market bottom yet--- nobody does --- we do believe that real estate is an asset class that requires a long-term perspective. If we underwrite well, finance well, operate well and have a long-term view, we believe that many opportunities will come our way. We look forward to sharing the best of those with you.
Jilliene Helman, CEO
All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.
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