10 Feb 15 By Cole Flanagan, CPA, MBA No Comments

Capital Flows Continue, But Shift Direction

NEW YORK CITY—Even as CohnReznick’s David Kessler notes in the firm’s 2015 commercial real estate forecast that “the land rush of the last two years has evolved into an environment where we can begin to see the emergence of supply-demand constraints,” capital continues pouring into the sector. And, Kessler tells GlobeSt.com, it will continue to do so.

The direction the capital flow is moving toward has shifted, though. Earlier in the recovery, “there was an enormous flood to the gateway markets where it was a little safer and unemployment wasn’t as high,” says Kessler, partner and national commercial real estate practice director at CohnReznick. “Now we’re seeing more of a laser focus on deploying capital to secondary cities that have strong fundamental dynamics with job growth and a concentration in healthcare, service industries, hospitality, energy and so forth. We’re seeing institutional capital directing investments there, whereas a year ago and earlier they wanted to stay primarily in the gateway markets.”

What the firm is also seeing is “a migration to debt funds,” says Kessler. The risk spectrum is a major factor: “you can invest in real estate in a gateway market at a 4% or sub-4% cap, but you still have some element of real estate risk—leasing risk, retention risk and capital improvement risk. That’s not so much farther ahead of T-bills, where there’s no risk.”

Accordingly, he says, “a lot of investors are going to secondary markets where they believe in the operator, believe in the market and believe in the strategy of redevelopment of 18-hour cities in secondary urban markets.” Going into these markets via debt funds,  “they can achieve returns in the low to mid teens and not have equity risk.”

CohnReznick’s Momentum 2015 report, which examines the state of the market as well as many factors shaping it, also gives concrete illustrations of just how much capital is coming into the sector. “According to industry research firm PEI, private equity real estate funds raised $116.03 billion in 2014, just below the post-downturn high of $117.85 billion raised in 2013,” the report states.

On the one hand, the report notes, “this supports a continuing enthusiastic view of commercial real estate—capital continues to flow into the industry. On the other hand, 2014 represents a plateau that ends three years of steady growth, and does so far below the 2008 figure of $161.37 billion. These statistics are probably the best encapsulation of the spirit of cautious optimism that we see ahead.”

Additionally, the report notes that “a number of institutional investors, including California Public Employees’ Retirement System and the Illinois Teachers’ Retirement System, have all increased their real estate investment allocations.” As for the pace of those increases, Kessler tells GlobeSt.com that “over the past few years, it’s been a little steeper than steady.”

He cites two main factors for this hastened pace. “One, they pulled back when the downturn hit, and two, their allocations became out of whack when the stock market climbed so fiercely. They found themselves under-allocated in alternative investments. Then in 2010, 2011, 2012, the returns began to climb, and so their allocations to alternative investments, and real estate in particular, began to accelerate.”

Kessler additionally sees the movement among pension funds and private equity firms as motivating a wave of smaller-scale investment among baby boomers and millennials. “They’re exposed to all this information, and they see two things,” he says. One, they see that their personal savings earn 1% or less. Two, they’re reading about crowdfunding, and how certain funds have created platforms for the regular investor to invest. Also, they’re reading about how foreign capital is coming into US real estate because it’s such a stable economy compared to the rest of the world.”

All of these factors are piquing interest among individual investors of different generations; “I think crowdfunding might be the biggest thing that’s creating interest,” says Kessler. “They have the opportunity to invest in something that’s cash-flowing and income-producing; it has a steady return and they can touch it, feel it and drive by it.”

By Paul Bubny

February 10, 2015