The Principals of Cresset Real Estate Partners have been investing in institutional-quality real estate projects for more than 40 years. In that time, they have managed through many challenging markets—such as the one we are currently experiencing.
While volatile markets carry risks, they also create opportunities for investors. Below, Executive Managing Director of Cresset Real Estate Partners Michael L. Miller discusses the current market environment, its challenges, and future opportunities for private real estate investing.
At the 30,000-foot level, how are you feeling about the real estate space currently? Is this a good time for investors to get in or increase their exposure?
Over the past four decades, we have seen several treacherous investment periods, marked by severe bouts of illiquidity, sharp decreases in real estate values, and frozen capital markets. Each time, we have seen lower-leveraged core properties withstand these downturns quite well. In addition, we’ve seen these properties recover their values faster than lower-quality real estate and rise significantly above previous peak valuations once liquidity and credit are restored in full.
Our current portfolio appears well positioned for what is shaping up to be an unusual economic period, where rents are rising faster than costs (which, anecdotally, have flattened out or are falling slightly), while the economy slows down. The Fed is doing what it can to reduce demand by raising interest rates to try and curb inflation, with a stated willingness to continue doing so until inflation returns to 2 percent annually. It is not apparent yet how high interest rates will have to rise to slow demand enough for that result. We take the conservative stance that interest rates will rise higher and stay higher longer than the market currently expects.
With that background, at Cresset we design our investment strategy so that our portfolio provides our investors with what we believe to be the best chance of long-term profitability, with the recognition that there will be short-term swings in cash flow and valuations. Cresset continues to focus almost exclusively on core assets, which we define as the newest, institutional-quality buildings in high-growth major markets—including primary markets in Arizona, Texas, Colorado, Washington, and Florida. In addition, Cresset is dedicated to maintaining lower leverage, often with long-term fixed interest rates. This limits our portfolios’ exposure to short-term volatility in the capital markets and keeps breakeven occupancy and rental rates low enough that the investments should be well protected if there is a protracted and/or deep recession.
Inflation is at a 40-year high and interest rates are climbing. What does that mean for real estate investors?
Inflation has often been favorable for real estate investors. While interest rate increases during inflationary periods may put upward pressure on cap rates, as long as rental rates rise faster than inflation, real estate will have increasing cash flows and remain an attractive investment. In addition, the stability and mitigation against potential losses in real estate assets becomes more attractive as inflation causes volatility and repricing of risk in the markets.
Talk about investing in supply chain logistics. What opportunities do you see the new logistics paradigm presenting?
At Cresset, we are maintaining our focus on the development of core quality logistics assets. Again, that means delivering the highest-grade institutional properties in high-growth major markets across the United States. We capitalize our investments with lower leverage and underwrite significant contingencies and interest carry. This capitalization allows us to hold projects for 5-7 years in the event the capital markets are illiquid when the projects first become stabilized and ready to be sold.
The demand for new logistics space in most markets in the United States is still well ahead of supply, as evidenced by space currently being 97 percent occupied nationally. As a comparison, for the logistics market to function normally, the market would typically be only about 90-92 percent occupied. In other words, at 90 percent occupancy, the rental market would be at equilibrium, and rental rates would stabilize. At the 97 percent occupancy rate, rental rates are rising over 12 percent nationally and show no sign of flattening out.
For the logistics market to fall to 90 percent occupancy, there would have to be approximately 2x the amount of space under development nationally than there is currently. There is a tremendous amount of functional obsolescence in the existing industrial space, and the current demand is almost all desiring new construction with modern amenities. Regardless of the economic situation in the United States, we do not think it is likely that demand slows enough in the next several years to move the vacancy in the market back to the 90 percent equilibrium rate.
The various drivers of the high demand for newly constructed, fully amenitized logistics space are generally not dependent on the overall state of the U.S. economy. Manufacturers and suppliers have changed their views of the cost savings of globalization and “just-in-time” inventory methods, which is causing a massive shift back to regional trade zones and “just-in-case” warehousing. In addition, logistics providers continue to demand more efficient logistics buildings, with higher ceilings, expanded parking and trailer parking, larger floor plates, COVID-induced air circulation upgrades, etc., which they need to remain competitive. While e-commerce is likely to slow from its pandemic fueled expansion, there will still be growth in the category, as well as an ongoing need for more efficient e-commerce facilities. This will also continue to drive the change from a logistics industry designed to service larger retail store networks to buildings geared to serve consumers directly. Eventually, the logistics market will develop enough new product for the vacancy rate to rise back to about 10 percent, but we are seeing no evidence that we will come close to that any time soon.
What is your outlook for Qualified Opportunity Zones (QOZs)?
While the Cresset QOZ Funds currently have more than $4 billion in properties being completed, we look at these investments as no different than our other real estate properties. Our QOZ properties are all located in rapidly growing urban markets, with increasing tenant demand.
We feel the best protection for investors is to be adequately capitalized at lower leverage, with enough reserves and contingencies to handle a down market until the property achieves stabilized occupancy.
Therefore, we believe QOZ investments are well protected on the downside and will capture significant long-term upside over the holding period as markets work through this period of volatility. In addition, the substantial tax benefits make these funds very attractive long-term investments.
Clearly a lot is in flux. How should real estate investors adapt to this changing capital markets environment?
It is highly likely that we are going to see a repricing of risk throughout the investment markets. When this happens, it is typically expressed in the real estate markets in the following ways:
- There will likely be a bifurcation of the markets into the higher-quality real estate that will still be desired, but with a different price for the risk. Lower-quality real estate will find it more difficult to transact because there will likely be a wide valuation spread between a buyer’s and seller’s perception of risk. There may be little ability to sell lower-quality assets for a long period of time.
- Equity capital will likely become scarcer, as it will have to provide returns that compete with lower-risk investments that will once again have positive income returns.
- Equity returns demanded by investors will increase, and equity structures will become more conservative, with more attention to covenants, credit quality, leasing risk, etc.
- Good investment opportunities will arise for those with equity, solid credit, strong track records, and proven strategies.
Periods of market volatility often create situations with significant opportunities. We remain committed to providing quick, flexible equity capital, which puts us in a strong position on behalf of our investors. We favor strategies that take advantage of a scarcity of institutional capital, and we believe this market will offer these types of opportunities over the next several years.