Asset Acquisition in a Downturn

The following passages are highlights from the transcription of the January 26th, 2023, Experiential Webinar discussing acquisition strategies during a recession given by Adam Long, President & Fund Manager, and David Jangro, Director of Investment & Portfolio Manager at Axia Partners.

What is the current state of the CRE environment?

1. There is no national commercial real estate market.

DAVID: At the end of the day, real estate is about three things–location, location, location. So, while we can evaluate trends at the national level or any other level of granularity, it is essential to remember that real estate, especially in this environment, is hyper-local in terms of the deviations you can see between valuation, rent, growth, etc.

2. There is a base case is for a mild recession in 2023.

DAVID: We are anticipating economic contraction, however mild. If you look at the chart below, the conference board’s index of leading economic indicators is trending down. In this case, the index of leading economic indicators has never declined as much as it has in the last six months without the U.S. going into recession.

 Obviously, this is not a good sign, but there are also indicators that the U.S. manufacturing industry has already gone into a recession. If you look at some regional fed surveys and forecasts, year-over-year manufacturing activity has hit a decline, indicating a recession will reverberate through the rest of the economy.

The Fed has a mandate–to get inflation under control and to normalize the labor market, so they will pull every lever they can to push us into a contractionary environment while still achieving a soft landing. 

You saw those recessionary numbers show up in Q4 of 2022 with transaction activity of 156 billion. Typically, Q4 has the highest activity quarter for the year in commercial real estate transaction activity, but in 2022, it was the lowest quarter. It represented less than 25% of annual transaction activity, which is only the third time in the last century that has occurred.

3. This recession will be different than the 2008 global financial crisis.

DAVID: We believe that both corporations and individuals are on much stronger footing than during the last global financial crisis. If you look at these charts [below], both corporations and individuals are extremely well capitalized. We don’t see any underlying fundamental issues that could lead to a structural or systemic collapse, which was the case in the last recession.

The U.S., in comparison to other developed countries, has the lowest share of floating debt rate among mortgage holders. On top of that, this chart [below] indicates if you were to compare household income to debt ratios for other developed countries, we are in the bottom five. U.S. households are well supported by their savings and incomes, so we don’t see the likelihood of a systemic housing crash.

Also, we are seeing home builders paying down mortgage rates on their newly built homes so buyers can have affordable mortgages. This is a better option for these home builders than discounting the prices of these homes, which then reverberates through the rest of the housing market. Homeowners also now have more options to put their house out for rent as a single-family rental because of the rental supply-demand imbalance. This is another insulating factor in keeping home prices from crashing.

The last factor making us believe this recession will be softer and milder than the last one is the labor market. It has grabbed many negative headlines latley because of  tech companies making massive layoffs, but if you look at their hiring practices from 2019 to 2021, it is actually a result of them over hiring during the pandemic. They over-hired to meet the crunch they experienced the past few years and are now trimming that fat.

How does this affect the CRE environment?

1. Capitalization rates for in-demand assets are going to hit historic lows.

DAVID: Throughout the pandemic, you had a combination of record-breaking transaction activity, and valuations based on unsustainable revenue growth coupled with unprecedented rate increases by the Fed. This led to this whipsaw effect where you saw property valuations and capitalization rates across most asset types and in most markets hit historic levels. Now you have the Fed raising interest rates, and all this rental growth and investor demand have cooled off, causing cap rates to whipsaw in the other direction. That’s going to impact the acquisition environment in the future.

It was easy to get deals done in 2021 and 2022 because credit was cheap, and there were a lot of deals out there. Many sellers at that point recognized that it was a good selling environment and put their properties up [for sale]. There was also a ton of dry powder sitting on the sidelines that held off through the initial stages of the pandemic that was all being put to work. As that money gets put to work, a momentum effect can lead to an acceleration in valuations that what goes up must eventually come down. That is what you can see in this chart [below].

2. Growth created by the pandemic in Tier 2 markets is slowing.

DAVID: During the pandemic, in multifamily, we saw rapid and pronounced demographic shifts where you had a bunch of people moving away from coastal gateway markets [Tier 1 markets] into smaller markets with better affordability and better quality of life [Tier 2 markets]. In many of these markets, they were not well positioned to absorb an influx of household formation or in-migration, so developers built new products and pipelines to meet the capacity needed for everyone to live affordably in these markets.

Rent growth accelerated faster, and cap rates compressed significantly more in these smaller markets than in Tier 1 markets. There’s still a lot of potential in these markets. However, there has also been an overshoot in many of these markets where developers built more than they needed to, especially headed into a recession. This will have implications for occupancy and future rent growth.

3. The commercial real estate market is highly fragmented.

DAVID: Some markets had a drastic overshoot in supply and investment, and cap rates got aggressively compressed. There are other markets where a lot of people moved into that still have a huge demand for apartment housing and stable mid-high, single-digit rent growth forecasted for the next several years. 

 [In the chart below], the X-axis represents inventory underway as a share of existing multifamily supply, and Y-axis represents cap rates. The takeaway is the bottom right quadrant is markets where a ton of transaction activities happened, and it suppressed cap rates. There is an extensive pipeline of new development as a percentage of existing supply. Those are the markets we are going to stay away from, and we advise anyone else making acquisitions this year to stay away from as well.

 [On the other hand] it’s more complex than going to the top left quadrant too, which are markets that do not have a high supply pipeline as a percentage of current multifamily supply and have yet to see cap rates get suppressed as much. This could be due to several factors, including people moving out of these cities causing shrinking demand. So, it’s more work than just looking at one of these quadrants and picking a good acquisition target; you must roll your sleeves, look at the fundamentals in these markets and evaluate deals on a case-by-case basis.

4. People may want to trade down to Class B and Class C housing. 

DAVID: Now that we’re headed into a recession, anybody who’s stretched to live in a Class A property will come back to Class B and C, and anyone already in Class B or C will stay there to achieve more affordability. The percentage of Americans spending more than 30% of their monthly income on rent breached a new level not seen in a decade. People are spending a lot of money, and inflation is affecting everyone. That is why we see Class B and C properties as resilient and potentially will overperform in this recession environment.

5. In Q4 of 2022, about 275 million square feet of industrial space was leased, which is only 8% off the high watermark set in Q4 of 2021, indicating strong demand.

DAVID: Also, of new industrial product brought online in 2022, only 26% remains unleased, pointing to quick lease-up timelines.

[Despite the statistics] There have been a lot of negative headlines around industrial as it relates to Amazon cutting back on its footprint. That is the case of bias and gravitation toward negative headlines because Amazon is shifting their strategy away from an experimental footprint they tested throughout the pandemic of smaller footprint stores or warehouses. Amazon still has robust leasing and building activity.

1. You must identify the most resilient and opportunistic sectors.

ADAM: The recession that we’re entering is driven mainly by inflation, which positions different property types in different ways in terms of how they will perform and where the opportunity lies. This chart [below] illustrates a possible way to think about the real estate market. The Y-axis is how essential salaries and other operationally intensive components are to this property which translates to how cash flows are negatively impacted by inflation. The X-axis is pricing power or the ability of this property to utilize greater demand than supply to push these cost increases along to the tenants or consumers.

1. 1. • The top left quadrant are assets that have a high labor load, high costs, and low pricing power. This is where you do not want to be–hospitality and senior living.
      • [ In the bottom left quadrant] you have stagnation where you don’t want to be because your pricing power is so low, but you don’t have this labor load problem. For example, in net lease retail, you won’t see your return grow at all other than a fixed rent growth, and that is not the best situation as we approach an inflationary dynamic.
      • On the right-hand side, you have the inflation winners. We’ve talked about large self-storage, mobile home parks, and industrial warehouses, where the is pricing power is  demand is excellent. You can do dynamic pricing and shift things on to tenants, but everybody knows these opportunities exist because they are the super big winners making them competitive.
      • The top right-hand quadrant is where things get most interesting because they’re asset classes that people start to lean away from because the labor load is so high. You have R.V. parks, small to medium self-storage facilities, and multifamily. You have this high labor load, but they have those same dynamics of that bottom quadrant where your pricing power is also extreme and where the opportunity comes with the right group that’s able to bring operational expertise to focus on different ways to enable the labor load to be decreased. You can turn these into great opportunities.

2. Avoid underwriting based on a static cap rate assumption.

ADAM: When you’re underwriting a deal, think about it in terms of here’s my entry cap rate, here’s what’s going to happen with cash flows, and here is what I plan on being able to sell these cash flows for later at this cap rate. The lazy approach that many people have taken for the past decade is to assume that you can always sell a property for the same cap rate you’re buying it for. That is a very dangerous assumption.

3. Beware of LIPO.

ADAM: LIPO is last in, first out, and you see this when we have market cycles, and we go further and further out into the periphery of deals that make sense, and capital starts chasing potential yield as you go further out from the core. That last in-market opportunity also typically ends up being the first out, and liquidity for those markets dries up very quickly in a downturn. You end up with values dropping as there isn’t demand to equal the supply in those markets. This is important as you approach acquisitions right now in the market. You must be very careful of going into periphery deals that can translate both in terms of geography and what you see in asset classes and opportunities. The big key for us at Axia is to look for that growth path. Instead of last in, first out, we’re looking for relatively first in, and then there will be a lot of opportunity for an out later.

4. Focus on demand.

ADAM: Something significant to know from this graph [below] is how much a shift in demand translates to rent or the value and income from a property. If you look at that top graph, right, in 21, we saw a 4.2% demand increase. That demand increase, which exceeded what we had in terms of supply, translated to an 11% rent increase.

Likewise, when we see a drop in demand, you can see how quickly rent growth adjusts with a small percentage move in demand. You need to think about it on a market-by-market level. As we pick locations to focus on, we understand that a little supply and demand imbalance can translate to great opportunities. We pay a lot of attention to mapping out factors like:

• What are the employment opportunities?
• Why do people live there?
• What are the drivers for other projects being built there?
• What is going to happen to demand in the short term?

5. Lean into the affordability crunch to reduce vacancy risk.

ADAM: When you consider new Class A apartment rents and how high construction costs have reached, we question who can afford those rates. That sliver of the market that can afford these property types makes these projects have a higher risk profile.

If we’re looking at a project and seeing the asset is at the very top of the market, and we don’t see this as a high growth, high employment opportunity market, that’s where we would be concerned about taking on too much risk.

6. As so many players are pulling back and pulling out, it opens the door for many opportunities. 

ADAM: We can fill market needs and create value, not only by focusing on market appreciation but also by creating greater income and building value within recession-resilient properties in new growing markets.