Late-Cycle Opportunities: Perspectives from the ULI/McCoy Symposium on Real Estate Finance

The clock is still ticking on real estate markets. “We are right at the end of a real estate cycle,” says Bowen H. “Buzz” McCoy, who joined the 25th annual ULI/McCoy Symposium on Real Estate Finance, held in December in New York City. Though the closed-door session is strictly confidential, some attendees shared their takeaways.

Participants said demand for real estate is still relatively strong; capital to invest is still available, and investors still find opportunities for yield. “There was not a lot of worry in the room—no sense of crisis or impending crisis,” says Ken Rosen, chairman of Rosen Consulting Group, a real estate market research firm.

Long Real Estate Cycle Gets Longer

Prices have been rising for real estate assets for more than a decade—since the worst of the financial crisis and Great Recession. “Everyone at the symposium talked about the real estate cycle,” says Rosen. “We all know it is late in the cycle.”

The same is true for the broader U.S. economy, which has been growing since 2009. Rosen forecasts a likely recession in the U.S. economy within 18 months. But other participants see no sign of recession before three years, and no one foresees a sharp disruption for real estate. “You could curl up in a fetal position looking at where we are in the cycle,” says Roy H. March, chief executive officer of Eastdil Secured. “But looking at what has caused a break in the cycle in the past . . . it has been about oversupply. We don’t have oversupply . . . overall.”

Real estate experts have also become accustomed to the idea that interest rates are rising. The yield on long-term, 10-year Treasury bonds has risen by roughly 50 basis points and now hovers around 3 percent. It is likely to rise to more than 4 percent by 2021, according to Rosen’s forecast.

Money Keeps Coming

Investment dollars from all around the world continue to flow into U.S. real estate. “Everyone said there was lots of money in both debt and equity,” says Rosen.

In the world economy, few investments can reliably provide the 6 or 7 percent yield needed by many institutions. For example, the investment yields from many sovereign bonds are much lower than that. “We call it the ‘chief investment officer conundrum,’” says March.

The flow of capital overall was strong enough to make up for reduced investment from China in 2018, with tougher capital controls from Chinese regulators. The overall volume of dollars invested in buying U.S. real estate rose in 2018 after falling in 2016 and 2017, Rosen says.

All this investment has kept capitalization rates low. Cap rates represent the annual income from a property relative to the price it sells for. “Cap rates are too low to be sustainable,” says McCoy. “There is an increased risk in the market that has not been fully priced.”

However, the experts are also not expecting a sharp change in cap rates anytime soon: a rise of 50 to 70 basis points by 2021 seems likely, according to Rosen’s forecast.

And many experts at the symposium look forward to an adjustment in prices that might make it easier to find good deals to invest in. “If there were a 10 percent price correction, people would be mostly happy,” says Rosen.

A Few Signs of Trouble

With so many investors so eager to spend money, there are a few places where they may already be taking too many risks. For example, a large number of private equity fund managers have created debt funds to issue mezzanine loans to real estate projects, adding more leverage to many construction loans—arguably the riskiest and most complicated kind of real estate investment.

“Mezzanine funds—they will probably get burned,” says McCoy. “They don’t have the trained inspectors to monitor the construction process.”

Many regional banks have also boldly increased their book of construction lending. “They don’t have the experience,” says McCoy. “They are mispricing construction risk.”

Helped along by some of these lenders, some developers have arguably built too many projects in a few niche property types like senior housing, student housing, and self-storage. Some markets now suffer from oversupply, and investing in new construction is no longer an easy success. “Too much money has flowed in,” says Rosen.

Other assets in trouble include some shopping center properties. “Last year and even more so this year, in the retail sector, B and C malls are having to close,” he says.

However, investors are finding opportunities to invest even in retail properties troubled by competition from online stores. “They are excited about experiential retail,” says Rosen. “Also, more and more online stores are wanting representation in brick-and-mortar stores—showroom space.”

In this environment, investors seem to be most interested in the income from their investments, either in core real estate with proven income or in value-added investments where the income can improve.

Uncertainties

The federal deficit is likely to become a contentious issue in Washington once again. “The biggest problem I see is the deficit, which we have stopped talking about,” says McCoy. “If it becomes an issue, it’ll become a huge issue.”

However, the federal government has also showed its value as a crucial backstop in difficult economic times. “The Federal Reserve Bank did a superb job,” says McCoy. Low interest rates created by the Fed’s extraordinary policies gave many investors time to at least attempt to work out problems.

“When things go sour, what you need more than anything else is patience,” says McCoy. “What amazes me is the depth and resilience of the U.S. economy. You do all kinds of terrible things to it and it is still the strongest in the world.”