West Coast: Where Capital Wants to Be in 2019

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Deal volume for commercial real estate in the U.S. fell off in the first quarter of 2019, mainly due to a bumpy interest rate environment that had a chilling effect on investors. Still, there was room for optimism across the West Coast, where some of the hottest markets continue to exhibit strong fundamentals and are attracting robust demand.

Real Capital Analytics reported that investment volume was higher in 2018 than any recent year, save for 2015, though it also noted Q4 2018 exhibited a pronounced slowdown. Whether the deal flow picks up the pace for the balance of 2019 remains to be seen. Some commercial real estate economists believe there’s still plenty of runway left in the current cycle. Real Capital Analytics’ Jim Costello points out the size of deals in the current pipeline suggest an improvement later this year.

An overview of the key West Coast Markets, primarily Seattle, the Bay Area, and Southern California, reveals where capital wants to be, where it is coming from and the types of assets it seeks. We’ll take a quick tour through some of the drivers influencing investment decisions, and the best strategies to navigate the challenges toward capturing the best opportunities.

Capital sources today are more diversified than ever before. Traditional sources, such as pension funds and REITs, are active players, but now Wall Street funds and major private groups are crowding out those traditional sources, pricing-wise. Foreign capital – primarily Canadian – is also prevalent for large core deals and mega-projects. Family offices have also become market-movers, as they seek capital preservation in strong locations despite low yields.

Rick Putnam, senior vice president at Kidder Mathews, says, “Allocations are up in 2019 for industrial and multifamily, but are steady or down for office and retail.” The primary drivers influencing decisions today certainly key off past returns or performance.  And, while Putnam agrees those are “big influencers,” he notes, “investors especially want to be on the right side of any disruptive technology trends.”

That is leading CRE investors to seek out properties where they can add value. Frequently, today, that is drawing investors toward industrial and multifamily assets, which remain the darlings, but any property with a strong value-add story gets strong attention. Putnam says, “This is because investors want to show that they are uniquely able to create value and generate extra returns, and don’t just ride the market’s tide “like everyone else.” Another asset type experiencing high demand these days are those with long-term, high credit leases. That is because they are viewed as valued income generators in a low-yield environment.

The markets expected to be in demand this year include secondary markets, which should continue rising in favor. San Diego, Las Vegas, Reno, California’s Central Valley, and Portland are all benefitting from sky-high prices in the primary markets, where capital is getting crowded out. Putnam predicts, “As pricing moves, capital finds the relatively more attractive markets, and those markets adjust … and recently, that has been all upward.”

The biggest investment opportunities on the horizon are benefitting from the abundance of cheap debt capital. This presents an opportunity to finance new investments attractively, but it also gives some savvy sellers a smart option of re-financing, to wait for a better day to divest an asset.

Investors are also considering getting in front of tech trends as a way to carve out a competitive leasing advantage for an asset. That may deliver a market differentiator that attracts a significant e-commerce tenant and generates higher rents. Liquidity itself is an opportunity, given the highly-diversified pool of capital today notes Putnam.

There are a host of challenges for investors to consider today, as well. Among the primary factors to weigh include pricing, low cap rates, and high per-square-foot values. The costs of dollar hedging is a hurdle for foreign players, because Putnam says, “it has gotten expensive.” On the development side, developers are facing more regulatory, neighborhood, and cost pressures on their projects.

To be sure, the opportunities outweigh the challenges for most investors today. So, who will have capital in 2019, and what is the best strategy to secure it for a deal? Most investor participants are flush with capital but are remaining very disciplined, and they are very attuned to each potential risk. Putnam advises sponsors must find the right capital for each deal. “Those that can find similar-risk deals on a programmatic basis, are having the most success,” he concludes.

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