There has been a tremendous amount written about how slow the real estate transaction market is right now. I am certain that Holiday Season 2023 is going to be the slowest year end most of us have ever experienced. We all know the story. Institutional investors are largely on the sidelines, generally having raised capital around a strategy that is murky at best in the current market. Many private investors are quite content on the sidelines as well, especially when they can put any available cash into a certificate of deposit that can yield over 5% risk free. To make matters worse, many investors who are willing to commit capital struggle to find a lender that will make a loan. The results are abundantly clear, by all measures transaction velocity is way down.
Despite the well documented factors mentioned above, it feels to me like in the past 60 days there has been an increase in activity that has yet to be reflected in the statistics. Though this statement may largely be anecdotal, as I am looking at my own whiteboard and relying on conversations with others who are seeing the same thing, I stand by it. To be clear, we are far from an orderly market and are squarely in what I call an event driven transaction market. There are many factors that can drive a sale or recaptalization: A debt maturity, fund life issue, a need for capital elsewhere in the portfolio, a partnership issue and so on. Sellers have generally been putting off doing ANYTHING if possible and it stands to reason that in some cases they can't wait any longer. Ultimately, I believe these transactions will systematically increase in number and provide us with some directional market pricing. For the time being, the numbers are not great enough that you identify market trends with true accuracy, but from where I sit you can certainly see some of the market psychology evolving.
As a lifelong sailor, I enjoy reading about and looking at all kinds of boats. I am fortunate enough to be able to spend some time on the Eastern shore of Maryland, which has a rich and deep history of boat building. Some of the best and most experienced boat builders that build the iconic workboats of Chesapeake still build their boats by hand. They don't use detailed computer-generated plans, molds that have come from a factory or any other technology that has become standard. Instead, they use their experience building other boats, their knowledge of the local marine environment, and an understanding of how the boat will be used to build it. They know what they need to build, adjust along the way based on what they see and the finished product rivals the quality of any modern boatbuilders. They use what they call "Rack of Eye". They don't need plans or analytics to build what they know will work, they know instinctively. To me, this is almost precisely how many investors who have the conviction to act in today's market are looking at deals. It may be a combination of price per SF, cash yield, and locational attributes that individually may not strike a chord but together give the investor a gut feel that they are getting a good deal and have the confidence to proceed.
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This concept certainly holds true in virtually all the deals I have seen in process as of late. The most important underwriting is the buyer's gut feel. Examples of this include: The sale of an office building that is practically functionally obsolete, but in the near term produces enough cash flow to return almost all of the equity to the new investor and with some creativity, the underlying land can provide a couple opportunities for tremendous upside over time; A reasonably recently delivered apartment building in a market that has been proven but now a little soft but selling at 60% of replacement cost with enough cash flow to mitigate near term risk (but not enough to carry the deal over the hold period); or a fund life issue combined with a need for capital at the asset level causing an institutional equity source to walk from a property allowing another partner to buy in at a really attractive basis for a small amount of money. I could go on, but the common denominators are that deal timing is driven by something not at the property level and a buyer (or fresh capital) understands the market deeply and has a clear gut feel driven by their long-term experience. Generally, these deals will have some combination of cash flow, discount to replacement costs and if an office building – the potential of an alternative use. Those are all important, but right now that's not enough. Somehow, the property attributes need to get someone that has a deep understanding of the asset and/or the market emotionally attached. They become convinced that whether or not we are at the absolute bottom of the market, the pricing represents an opportunity to make significant money in the long-term and their gut tells them they can manage the downside. There are no comparables or analytics that can provide total comfort, they are essentially using "Rack of Eye".
Eventually, we will return to a market where true analytics provide the basis for go/no-go decisions and investors are able to understand the trends and make investments that reflect clearly identified fundamentals. In the meantime those with deep experience and the conviction to act on that experience may well be the ones that make the best deals.
John Kevill is managing principal of the boutique brokerage and investment firm Solitude Cove Capital and a senior advisor to consulting firm Arcturus.
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