Late-Cycle Real Estate Investing Has Done A 180

The global economy is widely predicted to be approaching its first downturn since the Great Recession over the next two years, but the commercial real estate investment environment looks completely different than it did at the end of the last cycle.

In a cycle's late stages, real estate investors are targeting industrial and multifamily as the asset classes to have when the music finally stops, multiple industry experts have told Bisnow. That stands in stark contrast to the years leading up to the Great Recession, when office and retail were in vogue.

When the smoke was still clearing from the recession, Congress passed the Dodd-Frank Act to prevent banks from the hyperaggressive lending practices that characterized the late aughts. But even as a Republican Senate and White House have softened some of those restrictions, lenders don't seem to have the same appetite for leverage and risk as they did over a decade ago.

“From a financing perspective and a debt perspective, overall leverage is more conservative," Wells Fargo Managing Director Michael Petrizzi said. "We’re seeing that pretty much across the board ... [L]oan metrics are much healthier today versus pre-recession at the top of the market. With leverage being down, debt service coverage is higher, debt yield is higher; from a credit perspective, it feels better right now compared to what was being done pre-recession.”

Although banks' increased caution has opened the door for a host of private capital to become competitive commercial lenders, the Federal Reserve has kept more strict control on construction loans, CBRE Global Chief Economist Richard Barkham told Bisnow. That has prevented the overdevelopment that often characterizes recessions, and gives hope that the upcoming downturn will be relatively gentle.

“I think it’s a good thing to have some controls in place," Petrizzi said. "Markets work best when they’re as independent as they can be, but relative to what happened [with the recession, regulation] is a good thing. We definitely don’t want to see a crater anytime soon, so we don’t see regulation as a bad thing.”

Conservative financing has also prevented real estate investors from funding a purchase almost entirely with debt, as Kushner Cos. did with 666 Fifth Ave. in New York. Now, deals are less aspirational and more rooted in what a firm's balance sheet can handle.

“I think the cycle up to the Great Recession was a relatively short one, and it was pretty powerful," Barkham said. "As investors went into the financial crisis, they were much more highly leveraged and much less cautious.”

The recession didn't just end an economic cycle; it caused or coincided with fundamental changes to global and American society that don't look to be reversing anytime soon. 

While the housing market crumbled after the subprime mortgage crisis and drove Americans to apartments at historic rates, the emergence of e-commerce sent the retail industry reeling and started a mad rush to industrial properties that shows no signs of stopping. Both of those sea changes have given investors and lenders confidence, even in the face of the cycle's end.

“The sector that would be the most countercyclical would be multifamily, especially now due to the shift from homeownership to renting as a lifestyle choice and a financial imperative," Colliers International Chief Economist for the U.S. Andrew Nelson said. “Industrial is also on a different plane from everyone else right now, due to the change in how goods are moved to households. It favors new construction and new ways of doing business in the industrial sector, so I’d say that it would be [relatively] unaffected by a downturn.”

Industrial and multifamily may be reliable assets, but they are far from ideal places to place money and hunker down for the cycle to turn again.

Logistics is an industry in flux, responding to cutthroat competition from all sorts of retailers looking to find an efficiency edge. Apartment leases are by nature shorter and less certain income streams than 10-year commercial lease agreements.

“The risk would be that retail and offices traditionally had long-term leases, and in the cases of both industrial and multifamily, you’re buying into less certain income streams," Barkham said. "That’s well understood by investors, that rather than contractual income streams, you’re buying into the long-term growth of the economy, because contractual income streams are less certain then they previously were.”

As more investors turn to multifamily and industrial properties, they are forced to confront with the more intensive day-to-day process of keeping their investments desirable. Logistics' rapid changes and renters' short leases mean that absentee landlords will find no safe harbor there.

“You don’t take on that asset without being willing to get your hands dirty and either employ seasoned asset managers or do it yourself,” Barkham said.

The beginning of the age of coworking was only in 2010, but it has already caused a paradigm shift in the overall office landscape. Many coworking operators (and the startups they helped foster) have chosen to redevelop older buildings in non-core submarkets, increasing the amount of desirable office stock in lieu of new ground-up development, according to Barkham.

“The tech demand has been a little bit off-center, so it has brought existing stock back into the market,” Barkham said.

In their creative renovations, coworking operators have become massively influential in terms of design. Seemingly everyone planning an office must now incorporate flexible components that encourage collaboration and allow for different working environments to suit individuals' needs.

"Coworking has reinvented the interior of offices, which has released some latent demand from the gig economy and made a more exciting, long-term prospect for investors,” Barkham said. “But they could be wrong on this, and it could turn out that coworking is a high-risk industry. It isn’t cyclically tested, but you can’t argue that it isn’t doing something exciting and different, and perhaps reinventing the office sector. And that’s what investors are buying into.”

Coworking's influence on how offices are occupied goes beyond aesthetics. The month-to-month structure has also pressured landlords to shorten lease terms in order to compete, undercutting what made such assets so reliable in previous cycles.

The changing risk-reward equation at work in office — in every sector of real estate — is affecting the very makeup of capital markets. As asset classes rise and fall in relative value, investors are chasing those changes at an unprecedented rate.

“We’ve seen more of [investors changing asset classes] this cycle than in any previous cycle," Barkham said.