Rule No. 1: Invest in properties suffused with resiliency
How does a commercial real estate investor weather the current storm of rising rates fueled by inflation? Think resiliency.
That’s the assessment of Doug McKnight (pictured), president and chief investment officer of Dallas-based RREAF Holdings, who’s weathered his share of past economic storms over the course of a career spanning more than 30 years. McKnight’s focus is on investment banking and structured debt/equity at the privately held commercial real estate firm.
In a telephone interview with Mortgage Professional America, he offered glimpses into the investment strategy at RREAF Holdings as it navigated the uncharted waters that emerged last year – yielding something of a blueprint to those just entering the commercial real estate space.
Inflation has left its mark
He summarized the impact last year had on business as inflation took hold, forcing the Fed to tinker with rates in attempts to tamp it down. “As the year progressed, we saw the starting of some pretty severe hikes in interest rates,” he said. “Today we’re at 4.5% on Fed funds, and we started out at 25 basis points,” he said in an interview earlier this week. “We’re up 325 basis points since this started.”
That’s left a mark: “So those are sharp rises in rates, and it has had resulting impact on commercial real estate – whether it is what debt costs today to create your leverage and deals, or whether or not those hikes in rates have impacted existing assets, existing portfolios, that are tied to floating rate debt.”
The current environment has been a spoiler, he suggested: “It’s been really hard for folks to not make money in real estate for the past 10, 12 years,” he said “Coming out of the financial crisis, we had a lot of free money, a very accommodative Fed, a very robust environment, so a lot of people made a lot of money. A lot of people who are newer into the industry really have not gone through cycles like we have,” he added. “We’ve been through a lot of cycles, and we understand it. But certainly, going into 2023 it is going to be more of a challenge.”
Tailoring tactics to go with the flow
McKnight detailed how RREAF Holdings navigated around the changing economic landscape: “As we wrapped up ‘22 and moved into ‘23, looking back and taking some assessments, probably the past 18 months leading up to the end of ‘22 we were able to take advantage of very strong pricing in the market to exit certain deals,” he said. “Gosh, I think we exited $700 million or more in assets over the past 18 months – very favorable execution for ourselves and our investors. You have a lot of capital out there chasing yield and chasing deals so there is somewhat of an imbalance – maybe where assets should’ve been priced versus what they were priced at. We definitely took advantage of that. However, over those same 18 months, we were still net buyers of assets because we had the capabilities, we had the capital available to us to be able to execute when there were opportunities.”
Learning from the past
He advised those who are newcomers to the CRE space to educate themselves on the past. “I would say read a lot, learn a lot, and try best to understand what history tells us,” McKnight said. “Everything that goes up comes down at some point. Right now, we’re in a transitional environment where there’s going to be a lot of opportunities. There are going to continue to be disconnects and sometimes those disconnects will move to the investor’s favor. Right now, we have some disconnects that are not necessarily in the investor’s favor given where leverage is costing versus where cap rates are currently on certain types of assets,” he said.
In the meantime, think resiliency
“But I would also say to those who are going to be venturing into real estate in the current environment to look for types of real estate that are somewhat recession-resilient,” McKnight said. “Not all real estate is recession-resilient; obviously nothing is recession-proof. But there are certain examples of resiliency in real estate. For example, as you look at the multifamily sector, you can’t necessarily say that as a whole it’s resilient. But there are types of multifamily that are more resilient – whether that be suburban, more garden style type properties or properties that are in secondary types of markets where there are higher barriers to entry for new product."
McKnight noted RREAF Holdings has some 12,000 multifamily in its portfolio. “As I mentioned, we had a number of successful exits,” he noted. “I believe that number used to be 16,000, 17,000. But we’re very high on that space because it’s quite resilient.”
Another type of resilient asset: Drive-to leisure. “What do I mean by that? Well, if you look at COVID, no-one wanted to fly, everyone wanted to have space and at the same time wanted to go to the beach or somewhere and they wanted to be with their family. So there was a big spotlight that was put on drive-to destinations, whether it be hotels, or beaches, or rental houses, on lakes or resorts that could be affordable for families. That space has always been there, and it’s always been a driver - but COVID put a spotlight on it, and we have a lot of that product. We have a lot of resorts and hotels that are on beaches in iconic locations along the South.”
At the end of the day, it’s the people factor: “But really the overriding theme to resiliency is what types of growth they serve,” McKnight said. “The majority or America, which is middle America. Whether it is affordable housing, whether it is affordable leisure, whether it’s lifestyle experiences. All of that is going to be more resilient because people are still wanting to live their lives; still going to want a roof over their heads that’s safe and clean; they still want to get in the cars with their kids and go somewhere on a vacation and spend time together. And that is what we focus on.”
The word of the day, then, is resiliency: “For investors looking at the current environment and where to place their capital, they ought to look at areas where there is resiliency,” McKnight said.