Exclusive Research: Caution Creeps In

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High net worth individuals (HNWIs) have emerged as an avid group of commercial real estate investors in recent years. Yet even as allocations to the asset class remain strong, investors are treading carefully amid concerns about slowing growth and the near-term economic outlook.

The latest NREI research report on HNWI commercial real estate activity shows a continued healthy appetite to expand commercial real estate holdings. More than half of respondents (53 percent) said they expect HNWIs to increase allocations to real estate over the next 12 months. Specifically, 35 percent predict an increase of 5 percent or more and 19 percent predict a slight increase of less than 5 percent. One-third (34 percent) believe allocations will remain the same, while those who think allocations will decline in the coming year are in the minority at 10 percent.

Expectations for allocations show some uplift compared to last year’s survey. Over the prior three years, views on allocations had been trending lower. In 2016, 59 percent of respondents predicted a rise in allocations as compared to 55 percent in 2017 and 49 percent in 2018. Anecdotally, some sponsors are seeing an uptick in interest from HNWIs for a variety of reasons.

“The economy is booming, and a lot of these investors seem to have extra cash that they want to put to work,” says Reuben Berman, founder and partner at Entrada Partners, a commercial real estate investment firm based in Los Angeles. The performance and stability of real estate relative to the stock market has helped attract more capital. Real estate is also more of an accepted asset class compared to 20 years ago, when stocks and bonds were the primary place where high net worth individuals were putting their money, he adds.

Survey results put the mean HNWI allocation to commercial real estate at 21 percent.

According to the 2019 Capgemini World Wealth Report, allocations to real estate are averaging 15.8 percent among global HNWIs and 15.6 percent among North American-based HNWIs. But while institutions typically fall into a tight range of real estate allocations, the reality is that allocations for HNWIs can range widely from a low of about 5 percent to upwards of 50 percent with investors using real estate to serve different purposes. The NREI survey puts the mean allocation higher, at 21 percent.

“Real estate can be used in a variety of ways as a very effective tool in a portfolio, whether it is for income or appreciation or simply as a shock absorber to smooth volatility in a portfolio during uncertain times,” says Ben Adams, CEO and founder of Ten Capital Management, a real estate investment firm based in Cleveland. “I would say that every solution for every single investor that we have is a customized solution to serve an individual purpose,” he adds.

HNWI wealth contracts

HNWIs have long been a lucrative target market for the commercial real estate investment marketplace. However, the spending power of this elite group did take a hit in 2018. After seven consecutive years of growth, wealth held by HNWI’s declined by 3 percent globally or about $2 trillion, according to the Capgemini World Wealth Report. Ultra-high net worth individuals (UHNWIs) were the most affected and accounted for 75 percent of the overall HNWI wealth decline.

Specific to the U.S., the decline in wealth may not be as dire as the data suggests. The sharp drop in the stock market at the end of 2018 was likely partly to blame for the decline in net worth, and the survey did not capture the subsequent rebound in the stock market in early 2019. As the start of November, the Dow Jones Industrial Average was up about 15 percent since the start of 2019.

“We haven’t seen a dramatic shift in allocations from our investor base, but they’re definitely remaining active within portfolios,” says Zack Otte, a senior vice president in the Chicago office of Plante Moran Real Estate Investment Advisors. HNWIs have been taking advantage of opportunities to sell real estate assets and investments at higher values, rebalancing portfolios or diversifying into other properties, as well as taking advantage of low interest rates to refinance assets that are going to be longer term holds, he adds. “One of the biggest questions for a lot of our investors is, ‘if I do sell, what do I do with the proceeds?’” says Otte.

Data from research firm Real Capital Analytics (RCA) that tracks acquisitions made by HNWIs shows some choppiness in total sales volume over the past five years. Generally, annual totals have ranged from a high of $8.8 billion in transactions in 2016 to a low of $4.8 billion in 2017. Preliminary sales data for year-to-date in 2019 is at $5.2 billion, which is up about 13 percent compared to the $4.6 billion in transactions for the same period for 2018.

“We have seen some investors, not necessarily pull back, but get more selective because of the stage of the cycle,” says Berman. Even passive investors are well aware that the economy is slowing and that a potential recession could be on the radar within the next nine to 18 months, he says. Entrada Partners is fielding more questions from investors, such as “Is this the right time to buy? How are you going to protect us if and when the recession comes? Are you conservative enough on your assumptions, and are you conservative enough on your debt? And can you weather the storm in a recession?”

Risk tolerance has changed, agrees Adams. “Among our high-net-worth clientele, every single one of them is worried about a recession,” he says. Depending on what property sectors they are invested in, investors are also worried about how a downturn might impact commercial real estate, he adds.

Nearly half of survey respondents (48 percent) believe that the biggest issue that could impact HNWI investing strategies in the near term is the potential of a real estate downturn. Other top concerns include fears of a broader recession at 43 percent and negative impacts from a change in the tax code at 42 percent. On a positive note, an increase in interest rates, which was the top concern in 2018 at 46 percent, has dropped back as a concern to far fewer respondents at 32 percent in the current survey.

People are very well aware that commercial real estate is a cyclical market and it has been a very long-running cycle, notes John Carrick, co-founder of Integrated Capital Management, a Los Angeles-based investment management firm. Having said that, interest rates are very low, the unemployment rate is very low, and banks have more liquidity reserves than they have ever had. In addition, people have very good memories of what happened in 2008 and are not going to make some of those same mistakes, he adds. “Of course there is going to be a correction at some point in time, but we don’t see a train right in front of us,” he says. So, if you buy good real estate, don’t over-leverage and can be flexible on the exit, investors are going to be in a good position to weather a recession.

Preserving wealth remains top objective

Commericial real estate pros have consistently noted wealth preservation as the top objective for HNWIs for each of the past four years. On a scale of 5, wealth preservation scored 4.5 in the current survey. Other options were close behind, including income production and asset value growth, both at 4.1; tax purposes at 3.8, and estate planning at 3.6.

Anecdotally, many sponsors see preservation of wealth and current income as a bigger part of the discussion when courting HNWIs. “They are not necessarily looking for a homerun on every property. They are more concerned about the location, the preservation of capital and how solid and risk-averse is the deal,” says Gidi Cohen, CEO and founder of CGI Strategies, a real estate investment firm based in Los Angeles. As such, CGI Strategies focuses on buying assets with a long-term hold strategy and modest leverage of about 65 percent.

“Since we are long-term investors, we are more concerned with the 10-year horizon versus the next two or three years,” says Cohen. That being said, Cohen believes that the market has peaked and is underwriting deals with less appreciation and rent growth.

The focus on wealth preservation is another reason that HNWIs tend to favor the safety of gateway markets. A majority of respondents (62 percent) believe HNWIs prefer primary markets, although that is followed closely by secondary markets at 55 percent. Respondents believe that tertiary markets are a tougher sell, with only 15 percent who see HNWIs interested in opportunities in those smaller cities.

Generally speaking, HNWIs are focused on investment opportunities in the top 50 MSAs and they are taking a hard look at the economic drivers within those individual markets, barriers to entry and liquidity for a potential exit strategy. “We tend to avoid the central business districts and gateway cities, because we saw capital flows over the last five to seven years really being directed into those places, and in our view, pricing things up artificially,” says Adams. Ten Capital Management focuses on top tier secondary cities, as well as the more affluent suburbs that have higher degrees of household formations, income and education levels.

Multifamily, industrial are favored sectors

Across the board, commercial real estate professionals estimate that HNWIs continue to favor multifamily and industrial assets. Similar to the 2018 results, three-fourths of respondents (76 percent) believe HNWIs favor multifamily, while nearly half (48 percent) like industrial. Other top property types trailing more distantly included medical office and office at 30 percent and 25 percent respectively, as well as self-storage and seniors housing, each scoring 21 percent.

People see the e-commerce story driving demand for industrial, and they also like the strong fundamentals for multifamily, agrees Otte. In addition, the demand for multifamily has spilled over to include other segments of the residential market, such as seniors housing and student housing properties, as well as self-storage and RV parks, he adds. 

As a group, HNWIs tend to be fairly open to investing across different platforms. Their vehicle of choice is often a function of portfolio diversification, risk tolerance and their desire to have control in investment decisions versus a more passive role. As was the case with the prior three surveys, respondents pointed to private equity funds as the most popular choice for HNWIs, with 52 percent who see allocations flowing to those kinds of funds over the next year. Direct investment in multi-tenant commercial real estate is a close second at 49 percent, followed by net-lease assets at 37 percent.

Each vehicle has its own pros and cons. If money were no object, people would want to diversify their real estate holdings much like they diversify their broader investment portfolio, with different vehicles and product types, notes Robert Lindner, co-founder at Integrated Capital Management. However, even HNWIs don’t have unlimited funds. “As much as it would be smart for people to be fully diversified in real estate as they are in their other asset classes, most people have to pick and choose the benefits offered by each specific style of real estate,” he says.

Challenges and opportunities ahead

When asked about the biggest challenges and opportunities in working with HNWIs, some of the common challenges cited include overcoming uncertainty related to the economy that is making investors more cautious, as well as the challenge of escalating property values and the ability to identify good investment opportunities. In addition, for those investors who want to sell assets and redeploy capital, it is hard to find a replacement asset that can generate the same or better return on their investment. “HNW investors at this stage of the market are starting to sit on the sidelines to wait for the downturn so that value-add opportunities can be purchased,” wrote one respondent.

Education, trust and patience are a few of the key factors in establishing long-term relationships with HNWIs. “The biggest challenge is having them react quickly to a time-sensitive market, while the biggest opportunity is once you have them, they will continue to invest with you,” wrote another respondent.

The investment landscape for HNWIs did change after investors lost millions with Bernie Madoff. HNWIs are looking to invest with people they trust. “We focus on building relationships with our investors and we think investors should be getting to know the sponsor of their deals and should be looking for transparency, good reporting and making sure the sponsor has a good amount of co-investment capital in a deal to make sure that interests are aligned,” says Berman.

One thing on the radar for sponsors and advisors is the shift in demographics ahead as wealth held by baby boomers begins to transition to children and grandchildren, namely Gen X, Y and even Z. Wealth coming into those younger generations may result in different investing strategies and different levels of risk tolerance that could influence HNWI capital flows into commercial real estate.

Survey methodology: The NREI research report on high net-worth investment in commercial real estate was conducted via an online survey distributed to NREI readers in October. The survey results are based on responses from 375 participants. More than half (53 percent) described their role in the commercial real estate industry as an owner/partner/president/chairman/CEO or CFO-level executive.

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