10 CRE Investment Strategies for 2018

Joseph Ori, executive managing director of Paramount Capital Corp.

“We are feeling very optimistic about the CRE industry.” So says Joseph J. Ori, executive managing director of Paramount Capital Corp. In the exclusive commentary below, Ori notes that there has been tremendous growth and opportunity in the CRE industry and one of his top 10 investments strategies for 2018 is in data analytics. Check out the full commentary below for his thoughts.

The views expressed below are Ori’s own.

1. Buy depressed shopping center and mall REIT stocks

Many mall REIT stocks are selling for values substantially less than their NAV and private market valuations (as discussed in VOM’s November issue). Some of these REITs include CBL Properties (CBL), Brixmor Properties (BRX) and DDR Corp (DDR), which is analyzed and valued in the REIT Review section. All of these REITs have seen substantial drops in their stock prices and currently trade at very high dividend yields of 8%-10%+.

2. Sell core assets in core markets

Core assets, primarily hi-rise office, and apartment properties are still way overpriced and selling at 3%-4.5% cap rates. These properties should be sold, and the proceeds reinvested in secondary markets and higher cap rate properties, including much cheaper retail assets.

3. Sell net lease assets

The net lease asset sector has been very robust the last five years with billions of capital invested in this sector which have accelerated the growth of net lease REITs. According to NAREIT, the three-year average annual return for public net lease REITs was 15.95%. We believe that the new tax bill and pro-growth policies in Washington will produce higher GDP growth of 3.5%-4%+ and with it higher interest rates. Net lease assets are the most susceptible to higher interest rates and interest rate risk due to their long lease duration and flat income streams. If interest rates do increase, cap rates will follow, and the value of net lease assets will suffer large declines in value.

4. Acquire industrial assets

The industrial market has been very robust the last few years with the growth and demand coming from e-commerce distribution and fulfillment. According to NAREIT, the three-year average annual return for public industrial REITs was 23.09%. Even though cap rates are trending below 6% in many newer properties, it still makes sense to acquire these assets in select markets. Even though valuations are high, rent growth will outpace cap rate compression in many markets.

5. Invest in lodging assets

With higher GDP growth and a solid economy, hotels, motels, and resorts should outperform the four primary CRE categories. In CBRE’s lodging forecast for 2018, the sector has a positive outlook, with continued growth, albeit at a slower pace. Occupancy that currently averages 70% is projected to increase .1% and a RevPAR (average daily rate multiplied by the occupancy rate) is projected to increase by 2.4%. According to NAREIT, the average annual return through 10/2017 for lodging stocks was 17.48%.

6. Sell mortgage REITs

Mortgage REITs are trusts that either buy mortgage-backed securities on single-family homes or originate/buy commercial mortgages and CMBS. Many of these mortgage REITs finance their long-term investment portfolios with short-term repurchase agreements or bank loans. This mismatch in funding will be under pressure as interest rates rise and the cost of funding these long-term assets increases, thereby shrinking the interest rate spread and reducing the value of the real estate mortgage assets.

7. Originate participating mezzanine loans

With banks and insurance company loans typically limited to 70%-75% of value, there is tremendous demand for secondary and mezzanine loans. One type of mezzanine loan that should be considered is participating loans. These are high loan to value loans, up to 90% of a property’s value, with the lender receiving a generous interest rate of 5%-8%, a portion of which may be accrued, fees of 2%-4%+ and ownership of 20%-40% of the property, for taking some of the property equity risk. The IRR on a portfolio of participating mezzanine loans should be 15% to 18%, which is higher than a typical CRE fixed income return, due to the higher risk of the transaction and the participation interest. The mezzanine lender is taking some of the equity risk and should be compensated for such. The mezzanine lender will most likely not be able to lien the property and instead have to rely on a guarantee from the owner and a pledge of the owners’ equity interest in the property as security.

8. Perform a systematic review and analysis of the risk in a real estate portfolio

There are 15 risks inherent in investing in CRE as follows:

• Cash Flow Risk-volatility in the property’s net operating income or cash flow.
• Property Value Risk-a reduction in a property’s value.
• Tenant Risk-loss or bankruptcy of a major tenant.
• Market Risk-negative changes in the local real estate market or metropolitan statistical area.
• Economic Risk-negative changes in the macro economy.
• Interest Rate Risk-an increase in interest rates.
• Inflation Risk-an increase in inflation.
• Leasing Risk-inability to lease vacant space or a drop, in lease rates.
• Management Risk-poor management policy and operations.
• Ownership Risk-loss of critical personnel of owner or sponsor.
• Legal, Tax and Title Risk-adverse legal issues and claims on title.
• Construction Risk-development delays, cessation of construction, financial distress of general contractor or sub-contractors and payment defaults.
• Entitlement Risk-inability or delay in obtaining project entitlements.
• Liquidity Risk-inability to sell the property or convert equity value into cash.
• Refinancing Risk-inability to refinance the property.

All investors that own CRE should perform a detailed and systematic review of the above risks and their potential effect on an asset or portfolio.

9. Invest in data analytics companies

There has been tremendous growth and opportunity in data analytics in the CRE industry. Data analytics is a broad term but can be explained by four different types of analytics, Descriptive, Diagnostic, Predictive and Prescriptive.