Zell continuing to be negative on the economy. Is he right, or are his claims self-interested based on his holdings?
[{"id": "d9aatuu", "text": "He's right.\n\nWe're maxed out on equity growth from cap rate compression and interest rate compression. The only path to growth now is higher lease rates and absorption, which requires growth in the economy.\n\nIf you pro forma 3% rate growth in a 1.5% growth national economy, well eventually you're likely going to bump into a ceiling.  Real estate is local of course and different markets behave differently (ground breaking stuff here) - but even hot markets like Austin and SF are more likely teetering on tech equity valuations than broad based job growth.\n\nYou can see that in Houston where oil and gas is a major component of the economy (less so than 20 years ago but still a major driver) - oil tanked and that market went to 1% growth with a quickness. Hottest market for about six years straight and then poof.\n\nWe don't have a lot of growth upside. \n\nMy separate account clients are concerned with getting either a short term equity pop (18 - 36 mo execution and exit) or long term protected cash flow (from in-place credit leases). I like either of those plays still, market and location and project dependent of course.\n\nI don't know that I agree that the economy needs a cleansing before we can get more growth. I can see growth coming out of a recession of course, just to get us back to our current trajectory, but that's again cap rate expansion and then compression.\n\nI believe we're in a low growth environment because of the unique recovery from the Great Recession and the on-going turmoil in the global markets. If its not PIGS its Brexit, or its slow growth in Latin American or China.\n\nI hope that some stability out of the global markets and some stability in DC (stop with the damn budget showdowns and job killing sequestration) and we can soldier on at a relatively low growth nationally and continued pockets of growth locally.", "replies": [{"id": "d9aimtz", "text": "Helluva post man. Very insightful. Thank you.\n\nSternlicht seems to have made the right play on the apartments though, don't you think? ", "replies": [{"id": "d9ajcy6", "text": "Thank you - glad to share.\n\nYeah I'm bullish on apartments (though that's not my main asset type) just due to the demographic support and the equity hurdle for purchases (which has climbed of course as that sector has recovered). To that end, I especially like plays in higher priced housing markets where again I think you'll see a lot of people having trouble getting over the initial equity hump because of those higher purchase prices (if a condo is $500k, how long does it take a college grad to save 20% for a down payment? $100k takes time - time that the person will spend in a rental).\n\nFor me that's a long term cash flow play that when coupled with proper leverage can create some really attractive, fairly insulated returns. I mean if housing takes a dump that increases demand for rentals - there's not a lot of downside there beyond the affordability ceiling (which is real, you need rising incomes within your typical renter's cohort) and a complete bed-shitting of the economy (in which case everything is fucked and at least these are short term leases with again, sticky demand).\n\nIf I was Sternlicht/Starwood I would probably get out of the Inland Empire and South Florida assets as those low barrier to entry markets that got thumped in the last turn.", "replies": [{"id": "d9al39y", "text": "can you elaborate more on that last sentence? \n\n\"We're maxed out on equity growth from cap rate compression and interest rate compression. The only path to growth now is higher lease rates and absorption, which requires growth in the economy.\"\n\nvery, very well said and makes a lot of sense", "replies": [{"id": "d9amx1t", "text": "So the return on a CRE project owes to the cash flow, its leverage, and the difference between going in and exit cap rate (hold period and equity basis also play but they're not so much driven by macro-economics).\n\n**Cap Rates**\n\nA $1,000,000 NOI is worth $12.5M at an 8 cap and $16.6M at a 6 cap. Buyers in 2010-13 probably saw something more like that 8 cap and have been able to exit in 2014-16 at something closer to that 6 cap. That's a lot of boost in return fueled only by an appetite for commercial real estate. There's a lid on that appetite now because we can't expect cap rates below what we're currently seeing - they are the lowest risk adjusted returns that investors will tolerate for the given assets. In other words, assets are fully priced and investors cannot expect to get returns from cap rate compression (e.g. moving from a going in 6 cap to a going in 4 cap).\n\nA lot of people look like geniuses today because they bought at an 8 cap and sold at a 6.\n\n**Interest Rates / Liquidity**\n\nA lot of the money chasing commercial real estate is available due to the ease of money coming out of the Fed. And that's two fold. Low interest rates have contributed to an equity bubble in assets (most glaringly stocks), with the increases in equity allowing those gaining to put that equity to work chasing other equities... which further inflates the bubble. That's pretty generally accepted, I think, though no one likes to say \"equity bubble\" too loudly (partly because we currently have no alternative to loose money... the US doesn't have the growth to allow for increasing interest rates that would act as a drag on inflation and GDP growth - especially given that we've seemingly been the only stable market in the world post-recession, can't afford to rock that boat).\n\nAnyways, that liquidity and those low interest rates have allowed for higher leverage in the commercial real estate sector - which leads to higher prices (if you can afford to pay more due to positive leverage, so can the other bidders). There was also a time where you could forecast low interest rates over a fairly long term (2 years at least) as a sort of bet on the Fed Funds rate. That would allow you to hit your levered return target at higher prices (or find additional returns at your existing price due to lower than pro forma interest rates). My team probably snagged some deals off the table due to our ability to pay more based on our early anticipation of mid-term low interest rates, modeling floating rate debt and taking a flyer on the Fed holding near zero. I think everyone already has that in mind when they're buying now, plus there's more uncertainty about the future of the Fed rates now that we're so far out from the recession and we're at our employment target. \n\nFWIW I think we (the Fed that is) still hold rates near zero until we see consistent inflation above 2%, which looks unlikely to be soon given growth. If the global markets get their shit together all of a sudden that could take off quickly. Again though: this is priced in. Rates cannot be forecast lower than they've been over the last couple of years and we've already traded about every property in America at values supported by at near zero interest rates. The next round of asset trades will likely be at higher rates which means lower pricing. Not a recipe for equity growth.\n\n**Cash Flow**\n\nWhich leaves us with the actual business of commercial real estate: cash flow from leases. These are (in the macro sense) driven by job growth and income growth. This is the hard part of real estate: the part that isn't reliant on greed (cap rates) or a proclamation from Janet Yellen.\n\nSince we won't see further cap rate compression and lower cost of capital is already priced in on most assets (you will not see rates below recent and you will instead likely see more expensive debt over your next hold, reducing returns)... we have to do it the hard way.  Now we look to markets like Seattle and SF and Austin that are seeing excellent job growth.  Houston had this down too until oil hit the skids and now it's a dog. And that's indicative of the issue: these hot markets rely on a single growth driver and when it's taken away all we have are the fundamentals of a slow growing national economy.\n\nSo either you take the ticket and ride the tech train (and feel your balls tighten as you waive to the wreckage of the oil train) or you recognize that the slow growth economy means relatively slow growing rental rates and absorption. That's why I think we've gotten all the lift we can out of cap rates and leverage and what we're left with is slow growth mirroring slow macro-economic growth.\n\nOf course this is all in the general sense and individual projects will vary. You can still find deals with meat on the bone out there - it just takes work or a move to a more tertiary market or most simply put: more risk.\n\nMaybe that's more than anyone wanted to hear out of me but that's my expanded opinion on that referenced sentence.", "replies": [{"id": "d9b28cs", "text": "This was amazing to read and I really appreciate your thoughts. What do you do? I'm an underwriter for a bridge lender and it's gotten so tough to find good deals. It's clear we are at peak pricing. We are starting a fund so I'm really trying to learn about all of the forces that affect debt pricing. Thank you again!", "replies": [{"id": "d9b2yyr", "text": "Acq and AM for a fund manager (REIT and separate account). Was a PM previously, AM analyst, and acq associate.\n\nThanks for the kind words and glad you appreciate them. It's nice when this forum is buzzing with good chatter - thank you for adding to it!\n\nI've never worked the debt side directly so I don't have any particular insights there... I think an eye on basis is probably the smart play today, that's the feedback that we've been getting.", "replies": [{"id": "d9b4j7u", "text": "Are REITS buying anything in the $8MM-$10MM range? Or is that too small? ", "replies": [{"id": "d9b4omu", "text": "Mine doesn't ($25M+) but there are probably some. Private REITs (non-publicly traded) would be more likely given their lower cost of capital and management.", "replies": [], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}, {"id": "d9am2in", "text": "Would you consider a 5 year lease with credit tenants, in a top 10 growth market, with lots of new supply coming on a, \"long-term protected cash flow\"?", "replies": [{"id": "d9an9k3", "text": "5 years isn't enough time for me to consider it long-term protected, though it's close. 8 years would feel a heck of a lot better.\n\nIf we get hit with a downturn in two years, I'd be worried that the market won't have fully recovered by the end of that 5 year lease. I'd be worried about the tenant's appetite for renewal in a recovering economy and I'd be worried about the rate that I could get for that renewal (or replacement tenant) and the effect of a lower NOI and potentially a higher cap rate on my potential sale price.\n\nFWIW the capital markets and debt guys that I work with generally agree (almost uniformly agree) that 5 years of remaining lease term is not quite enough to consider it a long term protected cash flow in what we all feel like is an economy at the end of it's cycle. Whether we're approaching the crest or already looking over the edge is anyone's guess, but we're certainly late cycle.\n\nYou could sell a 5yr term today. I wouldn't be excited about buying it and holding it though.", "replies": [{"id": "d9b2b0h", "text": "From my experience most leases in multi-tenant office buildings, even class A, are 3-5 years at most. Seems to be the new normal unless it's an HQ or SLB. ", "replies": [{"id": "d9b2uzp", "text": "That's probably true and definitely true in slower growing markets... I've seen a pullback in tenants' appetite for long term leases (especially for less credit worthy tenants).\n\nThat's part of my point: to get the long term protected cash flow you've got to hunt or scrap together a rare long term credit deal. It's all unicorn hunting these days - or at least that's how it feels compared to the last three years.", "replies": [], "depth": 7}, {"id": "d9b4e5k", "text": "Yeah, these 5 year options periods don't mean shit to investors.  But they're not getting any longer than that. ", "replies": [], "depth": 7}], "depth": 6}, {"id": "d9b4fha", "text": "Preemptive apology for the crassness, but I'd give my left nut for a fucking 8 year lease these days. ", "replies": [{"id": "d9b4mgk", "text": "Oh no doubt. We're sneaking one in right now with a major tech company (thanks Austin) and I'm on edge until it actually gets signed.\n\nOur leasing agents in Houston are on semi-permanent vacation.", "replies": [], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "d9be739", "text": "You seem very knowledgeable on this matter - I would be interested in getting your insight on a few questions:\n\n1) Interest Rate vs Cap Rate. Average spreads between the 10 year and cap rats are upwards of 300 bps. Even when interest rates rise, there will still be a cushion. What is the spread 'minimum' you foresee?\n\n2) \n\n&gt; We're maxed out on equity growth from cap rate compression and interest rate compression. The only path to growth now is higher lease rates and absorption, which requires growth in the economy.\n\nI work in multifamily development, so I cannot speak for office/retail/industrial. I am always surprised at how high rents have come. When you compare average income growth to rental growth - the numbers are unsustainable. My only hope is your point on absorption. I truly believe that urbanization, the \u2018millennial desire to be in cities\u2019, demand to rent, is still high and alive. What are your thoughts?", "replies": [], "depth": 2}, {"id": "d9bisna", "text": "The curve ball.  Trump comes in and immediately slashes regulations everywhere and implements his 100 day plan and the economy responds with 3-4% growth.", "replies": [], "depth": 2}, {"id": "d9d34oj", "text": "Hey man,\n\nWould you say that a glut of construction in a particular market would be indicative of further cap rate compression to come in that same market (assuming there's some room on cap rates)? In other words, could existing investment properties benefit from Class A construction just by virtue of being in the same market?  \n\nCan increased economic activity in downtown area help all surrounding markets, e.g. a rising tide lifts all boats?\n\nJust looking for an expert opinion. Thank you! ", "replies": [{"id": "d9d9bbe", "text": "That's a really good question (or set of questions).\n\n&gt;Does construction indicate further cap rate compression? \n\nMaybe, but usually not much more. Once we've gotten to the point in the cycle where new construction makes sense (from a return perspective), that market has already experienced cap rate compression. It's the last segment of the cycle, so early builds would be a strong indicator of a maturing market and by the time you get to \"a glut\" I think that's largely a fully baked market. Usually I'd buy the former and hope to sell by the time I saw the latter.\n\nWhat you'd especially want to be mindful of is the amount of net absorption and the barriers to entry in the market (especially the submarket but also in consideration of any potential competitive submarkets). \n\nAs long as new construction doesn't eat up too much potential absorption, you're likely to continue to see compression. If new construction looks like it may eat up too much absorption you'll see cap rates rise back up. That's in recognition of the risk that the new supply might let some steam out of the market.\n\nEven with ongoing positive absorption above deliveries there's still a cap rate floor largely owing to the market ranking (gateway, primary, secondary, tertiary) and the barrier to entry. Regarding barrier to entry that's a recognition of the risk of further new construction coming on quickly.\n\n&gt;Can exist properties benefit from Class A construction just by virtue of being in the same market?\n\nAbsolutely, though more by way of rental rate gains and a higher price per pound ceiling. \n\nNew construction will call for the highest rental rates in the submarket (assuming its well located). Class AA buildings have more competition on their hands, but the Class A and below can draft off the increased rental rates to offer a more affordable but still Class A environment. Too much new construction though and of course vacancy would rise, rates would stagnate or fall. \n\nNew construction typically results in the sale of the building from a developer to an institutional owner. That sale comp allows an existing asset to point to a price ceiling above their asking price or their proposed value - so they can refinance at higher proceeds, report equity gains to investors, or sell the asset at a higher price (or likely all three).\n\n&gt; Can increased economic activity in downtown area help all surrounding markets\n\nLargely yes.\n\nSome aging suburban submarkets may see a hit if downtown gentrifies to become the new preferred location - especially suburban assets that aren't part of a suburban node (a cluster of activity centered on a transportation point, preferably light rail). If the downtown was already preferred and is simply improving then I think you will see a rising tide lift all boats. There are usually some submarkets that you can clearly forecast to improve as the CBD grows and prices out some tenants.\n\nSan Diego's CBD sends cost conscious tenants to Mission Valley when it expands. Austin to the SW and NW submarkets. SF to the East and South Bay. Chicago to River North and the West Loop (until those got preferred, now it may be back to the loop).\n\nThat's my experience - hope it's helpful.", "replies": [{"id": "d9dajik", "text": "Damn, that's some really good analysis. Thanks so much.\n\nI'm having a tough time extrapolating value from a hot, downtown market and applying that to a local, close, suburban sub-market with a lack of comps.  I also don't know local dynamics having not lived in the area of where the deal is.  The building is magnificent and the tenants can't get any stronger, but it's just not in goddamn downtown and so it's hard to start throwing $/SF numbers and cap rates around as comps. \n\nCan a 6% cap deal in a very close to downtown but ultimately suburban part of an upper-tier secondary market, ever hope to see a 5% cap compression, or **DARE** I say 4%?   As you smartly forecasted, seller wants to sell at a 6% - but will there be goddamn buyers?  \n\nStable yield play, yes.  Value or opportunity? no. \n\nEdit: Also, any idea how to get local market intel/expertise without being local (outside of brokers)?  Thanks so much man, it's been an education and a lotta fun rapping with you!", "replies": [{"id": "d9fgsyn", "text": "&gt; with a lack of comps. \n\nIs that a result of you lacking access or truly a lack of activity in comparable buildings?\n\nA suburban six cap is very very rare outside of gateway markets.  Below that is almost unheard of unless you're selling Apple or GM or similar long term credit and brand appeal (I've seen 5.5 caps).  \n\nSight unseen I'd say even below a seven cap may be tough, especially if rents are anywhere near market.  If rents are well below market, leases roll in the very near term, and there is strong absorption / low vacancy in the submarket I could see a low cap rate on a good building in recognition of that near term upside.\n\n\nYeah I think you're on the money identifying the low cap rate as a difficult sell because the next buyer will be limited in their upside. \n\nTo get more intel:\n\n* CoStar (take comps with a grain of salt, but it's a good place to start)\n* Meet with local brokers. If you can't get there in person then try to get connected through some kind of mutual business or acquaintance and chat them up on the phone.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "d9b0mwl", "text": "Very insightful. ", "replies": [], "depth": 1}]