Residential is the Capitol of Capital

08/02/2016

In June 2016, Meyers Research completed an extensive survey of the real estate capital markets that indicates that for the first time in years, the residential sector is poised for sizable gains relative to the more traditional income-producing asset classes. In fact, we expect the market for real estate capital over the next 12-24 months will change significantly. Led by our Managing Director of Advisory Steve LaTerra, we surveyed both debt and equity sources and compared the responses to past Meyers Research surveys to extrapolate financing trends and patterns. We then analyzed our survey within the context of institutional capital flows and fundraising over the last few years and considered the performance of private equity investments since 2010. The paragraphs below provide additional detail from our research.

For starters, the amount of foreign capital coming to the US is currently spiking, stemming from a confluence of Chinese economic uncertainty and FIRPTA incentives to BREXIT-caused uncertainty in the European markets. These are temporary conditions but have caused a spike in flight capital that seeks security in the face of elevated domestic market risks. Likely, foreign capital has under-priced the risk of real estate investments in the U.S., resulting in irrationally low cap rates. This has made it difficult for U.S.-based funds to compete for high profile income-producing assets in gateway cities.

In response, U.S.-based funds have temporarily broadened their scopes and are looking where foreign funds are not. Scopes have expanded both geographically and by asset class, but all are seeking yield. Opportunistic fundraising has been increasing at the expense of Core funds within the U.S. The most overlooked of all asset classes is land and residential, mostly because current returns aren’t typically available and a “mid-to-high teens” return was not enough of an incentive over the last few years. Today, we find ourselves in a fundamentally under-supplied residential market, with the capital markets deserving much of the blame. The mortgage industry is broken at the consumer level, BASEL III has disincented commercial banks from lending to developers and home builders, and private equity has ignored residential in favor of the mid-teen returns offered by the multi-family and commercial sectors.

Over the next several quarters, experts expect a sharp fall off in the returns experienced in commercial real estate as the flow of unusually motivated international money slows and more “normal” conditions return. To gain truly opportunistic returns, funds must accept more risk and expand their investment profile. Multi-family has some runway left, but will eventually succumb to its own success by becoming overpriced, while distressed funds will struggle to find acceptable opportunities. Residential will likely stand alone as the most attractive opportunistic real estate play, as prices have proven to be sticky and the lack of supply has made a downside bet tough to accept.

The message is that residential is finally taking its appropriate position as an attractive alternative asset investment that can be proven by long term fundamentals rather than institutional capital flows. While the capital markets will take some time to capitulate, they will eventually get there. It may be more difficult than ever to secure capital, but capital market conditions are becoming supportive and funds will eventually find a home in residential (pun intended). If your investment opportunity has struggled to obtain financing, don’t lose faith. Now is the time to redouble your efforts.

Contact us to discuss how we can help with your understanding of the capital markets.

Steve LaTerra, Managing Director – Advisory Phoenix
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