ATLANTA — Today’s low interest rate environment is inducing many buyers to pay significantly more for properties than they should and poses the single biggest risk to the commercial real estate industry, warns Dean Adler, co-founder and CEO of Philadelphia-based Lubert Adler Partners LP, a real estate equity firm with $16 billion of assets under management.
“There are a lot of asset allocators out there that are paying way too much for real estate because of cheap interest rates, and they will get whipsawed,” predicts Adler. “It’s fine to raise money today, but they will get whipsawed in four and five years as interest rates rise. Real estate still has the same amount of [operating] risk and obstacles as it had two, three, four, five, six years ago. I could make an argument that there is greater risk.”
The insights from the outspoken Adler came Thursday morning during a commercial real estate finance and investment conference at the Westin Buckhead. The law firm of Morris, Manning & Martin LLP and France Media’s InterFace Conference Group jointly produced the daylong event, titled “What to Expect In 2013?” The event attracted more than 400 leading investors, developers, lenders and financial intermediaries from across the Southeast.
A lot of commercial real estate is trading today at cap rates in a band ranging from 5.5 percent to 7 percent, according to Adler. At the same time, borrowers typically can secure five-year debt at an interest rate of 3.5 percent. Under that scenario, property owners have positive cash flow. “That’s the most dangerous strategy in the business today because all you need is an increase of 200 basis points in the interest rate. You think you may be earning 8 to 10 percent on your money, and your capital is lost.”
Adler was one of five industry experts who participated in a lively panel session — “State of the Market: Where Are We At in the Cycle?” — moderated by keynote speaker and economist Dr. Peter Linneman, principal of consulting and research firm Linneman Associates. Other panel participants included Larry Gellerstedt, president and CEO of Cousins Properties; Mark Grinis, head of North America Real Estate for New York-based Ernst & Young; and Tom Roberts, executive vice president and head of real estate investments for Phoenix-based Cole Real Estate Investments.
The fact that so many real estate investors are willing to accept a 5 percent yield in the real estate acquisitions market today amazes Adler. “You are paying 20 times cash flow for a piece of real estate. Are you kidding me? You could go buy businesses for five, six or seven times cash flow. Why is someone paying 20 times cash flow for a piece of real estate?”
Grinis of Ernst & Young said that compared with the relatively low yields generated by other asset classes, a 5 percent yield for real estate is attractive. “Even when you look at sovereign wealth funds and other capital sources, they are fine with a 5 percent return.”
But landlords can’t ignore the operating risks in real estate, which include capital expenditures, the possibility of losing tenants, and in many submarkets the inability to raise rents significantly, Adler argued. Those risks make a 5 percent yield look less attractive than an investor might initially be led to believe.
Seizing the moment
Atlanta-based Cousins Properties (NYSE: CUZ) is taking advantage of investors' healthy appetite for acquisitions. The publicly traded real estate investment trust (REIT) is currently a net seller, said Gellerstedt, in order to take advantage of attractive pricing for quality assets in high demand. Between now and the end of the year, Cousins expects to generate approximately $250 million in cash from property sales.
Cousins sold three properties in the second quarter, generating $68.8 million in net proceeds to the company. A partnership between Cousins Properties and The Coca Cola Co. sold Ten Peachtree Place, a 20-story office building in Midtown Atlanta, to Prudential Real Estate Investors for $61 million, resulting in $5 million in net proceeds.
In another office building sale, Cousins sold Galleria 75, which consists of two office buildings in the Cumberland-Galleria submarket of Atlanta, for $9.2 million. Baker Dennard & Goetz and a private family investor acquired the properties in a 1031 tax-deferred exchange. The properties were 95 percent leased at the time of sale, according to CoStar Group.
The diversified REIT also sold The Avenue Collierville, a 732,389-square-foot retail center in suburban Memphis, Tennessee, to affiliates of Poag Lifestyle Centers and New York-based DRA Advisors. The $55 million sale generated $54.6 million in net proceeds to Cousins.
Gellerstedt sees a bifurcation in the marketplace when it comes to pricing. Institutional investors are aggressively bidding on stabilized Class A real estate, he pointed out, but they are less interested in value-add properties because of the inherent risks.
“Where we can find opportunities to harvest because of what we think is very attractive pricing, and then redeploy [that capital] where we can take advantage of where the institutions classically won’t go, that’s the opportunity,” said Gellerstedt. He emphasized that Cousins is not generating the cash because of any leverage challenges. Indeed, the company’s overall leverage is quite conservative, about 35 percent.
An example of Cousins’ opportunistic strategy is its recent acquisition of 2100 Ross Avenue, an 844,000-square-foot, Class A office building located in the Arts District submarket of Dallas. The company announced in early August that it had purchased the office tower at a foreclosure auction for a net purchase price of $59.2 million.
“2100 Ross Avenue is an outstanding fit with our ongoing strategy to acquire quality urban office assets in the best submarkets [in the South] at valuations below replacement cost,” said Gellerstedt at the time of the sale. “This investment also provides a rare combination of significant value creation potential and an attractive in-place yield.”
While much of the discussion focused on what the big institutional players are up to these days, the panel also addressed the needs of the small investor.
Cole, a sponsor of commercial real estate products designed for the individual investor, including non-traded REITs, has adopted a conservative investment strategy, explained Roberts. The company invests in single-tenant and multi-tenant retail and has an office and industrial platform. Cole-related entities own and manage more than 1,925 properties in 47 states with a combined acquisition cost of approximately $11.6 billion.
Cole’s latest fund is 99 percent leased and the average lease term is 13.5 years, said Roberts. The financing is quite conservative. Cole typically has a 45 percent loan-to-value on the properties in its portfolio, said Roberts. “We match up long-term, seven- to 10-year interest only debt with our 13.5-year average lease term.”
— Matt Valley