Enoch Lawrence, Senior Vice President at CBRE Capital Markets, has written an article Deconstructing the Downturn in the Commercial Real Estate Capital Markets. While the title led me to believe it would be an analysis of how we got here, I was surprised to find a commentary on where commercial real estate investing is headed.
The new world order in commercial real estate will be governed by patient, well-capitalized investors. Many new names and faces will appear and many old ones will re-surface again to cherry pick the market for quality assets ―the players are changing daily. The acquisition decision process is driven by equity, not debt, in this alternate universe. Investors must match their equity profile with the appropriate mode of lending, while at the same time monitoring the state of flux of the commercial real estate capital markets where respective sources of capital become more or less available. Government supported programs will significantly impact the availability of capital in the short run, but investor confidence must return to the market to help stabilize the lending environment. For this to happen, all market participants must realize that capital is available. The world has changed, and to access this capital, a healthier balance between risk and return must be achieved.
The market will be characterized by investors that have capital and are willing to earn a reasonable return equal to their risk. Mr. Lawrence questions whether 20% Internal Rates of Return (IRR) are realistic in the model going forward:
One may inquire about the vast sums of money raised to deploy into opportunistic investment strategies. In an environment where valuation remains challenging, you may ask how a 20% Internal Rate of Return over a 3-5 year holding period is being modeled and presented as a sustainable investment model en masse. This may be possible with small pools of capital deployed in niche markets, but the large scale deployment of this capital in search of distressed opportunistic returns has not materialized and is further exacerbated by more conservative underwriting from available debt sources.
Prior to the Lehman Brothers collapse in September of 2008 real estate markets were awash with inexpensive leverage. The market for debt that existed allowed real estate investors to leverage deals over 90%, in some cases, at historically low rates. The leverage boosted returns and allowed investors to have Internal Rates of Return of 20% or greater on paper.
Going forward investors must adjust their expectations to a lesser return. The important factors are going to cash on cash return and a stable long-term investment.