‘When Will This Market Run End?’ Isn’t Really the Question
Since 2018 began, I’ve been speaking at various real estate events where I provide market color by speaking about deals on which I’m currently working, or trends I’m seeing in the capital markets, both in debt and equity. Inevitably, I get the crystal ball question, “When will this market run end?”
My answer? “That’s not what you’re really asking me.” I’ll expand on that shortly. First, let’s go to the data.
At a corporate level, the macroeconomic fundamentals continue to point to growth. There can be no denying that generally, companies are expanding their capital investments into their operational infrastructure, and into new and additional locations. The development and adoption of new technology is advancing, and strong job growth continues. The Amazon HQ2 story is the quintessential example of all of the above. The company’s site selection story has also surpassed headlines surrounding LeBron’s “Decision” to sign with the Miami Heat a few years back, but I digress.
All of this translates into the acquisition, development and lease up of most asset classes of real estate. Pick an asset class, any asset class (don’t pick Class B malls), and there is a fundamental driver supporting its momentum forward.
We also began the year with a new tax plan that has serious impact to the corporate bottom line and delivers more profits to shareholders. Smart investors like Warren Buffet contend that this increased profit hasn’t even been factored into equity values yet. Stated differently, when you’re invested in a deal and the senior investor in that deal (the government) reduces their cut of profits from 35 percent to 21 percent, your equity is inherently more valuable.
A little noticed component of the new tax plan that specifically impacts real estate investing is the change to carried interest. In order for investment managers to take advantage of long-term capital gains treatment on their profits, they now must hold investments for over three years, rather than over one year. While real estate isn’t necessarily a quick in and out asset, and taxes aren’t the primary driver of an investment manager’s business plan, it does factor into the investment equation and inject some stability into speculative deal making. Stating the impact in numbers, it’s the difference between paying your favorite senior investor 23 percent of your profits, or 40 percent of your profits.
Now to speak to the maturity of this market cycle.
The lifeblood of this industry is capital. Right now the sources of capital directed at this asset class are diverse and abundant—REITs, private equity, individuals, both foreign and domestic, all seeking to participate somewhere in the capital stack of a real estate deal. There have been no indications that any of these groups are turning off the capital spigot either, as we continue to see new investment vehicles formed everyday.
In contrast, when you look back at real estate values during the last recession, the severe lack of capital had the most impact. The CMBS/CDO markets completely shut down, balance sheet lenders were extremely selective if they were lending on real estate at all, and pensions and endowments were avoiding equity commitments to the space. The only groups that were in business were opportunistic individuals with access to private capital, or private equity funds seeking out distressed plays. Those investments played out pretty well for those groups.
And therein lies the implication of the question—“When will this market run end?”
If you are running a closed ended fund, whether debt or equity, there is a defined exit period and it’s important to track the trends for when it’s time to harvest fund assets. It’s why we’re seeing some debt funds move from three-year loan terms and two one-year extensions to two-year loan terms and three one-year extensions.
However, for most individual investors, the question really means, “When can I get in at a better price than today?” because they are reflecting back on the last downturn and how it played out pretty well for anyone that got in at that bottom. That thought process highlights the key take away: As long as people consider real estate an attractive investment and have abundant capital to invest in it, that “discount” won’t materialize anytime soon and there’s still runway left.
David Blatt is chief executive officer of CapStack Partners. Connect with him on LinkedIn or on Twitter @capstackceo.