“Never waste a crisis, they all have opportunity.”
It is a common occurrence during difficult times, and there is something very human about perceiving the current situation and lamenting that it is the worst or most extreme crisis in history. Although most of the time this can be chalked up to theatrics or over reaction after hearing Mr. Andy Deckas, President of Founders Properties,
speak about what happened in commercial real estate (CRE) over the past seven years, one can only hope that he is correct in his analysis that, at least for CRE, the market is moving forward and recovering from the difficulties of the last few years. Mr. Deckas gave a superb analysis of the root causes of CRE bubble, using a combination of personal narrative and hard data to support his claim, while being very specific in the way he defined the crisis in the context of the greater economy, and the world in general. His labeling of the fluctuations in CRE market, as the worst in history, based on the criteria of loss of equity, disruption of the industry, and systemic implications on the greater economy quantifies his claim, and despite the pitfalls of making such sweeping assertions, seems to be reasonable. Despite Mr. Deckas’s sober analysis of the recent state of the CRE market, his presentation had a positive tone that included optimism about current opportunities, as well as providing a recap of his fascinating career in the industry.
Resume | Mr. Deckas’s credentials as a commercial investor date back to beginning of the industry, when financial professionals were just realizing the value of securitizing CRE. Mr. Deckas earned his BA from Northwestern University, and planned on continuing his education by earning an MBA until he received an offer that he could not refuse. A personal connection encouraged Mr. Deckas to contact Tom Crawley, who was an executive at Heitman Financial. Mr. Crawley’s pitch was simple, come work for me, and in two years I promise you will learn more than you ever could about CRE in academia. Mr. Deckas agreed, and part of his initial responsibilities included working on raising the capital needed to construct the Mall of America. After nine years moving up through the ranks at Heitman, Mr. Deckas left the firm and moved to OPUS, which at the time was one of the nations largest real estate developers. His first role at OPUS was creating and growing OPUS financing operation. At OPUS, Mr. Deckas moved the focus of there customer targeting from institutional investors, which were flush with capital but also with a highly bureaucratic structure that impeded flexibility, to high net worth, private equity. It was here that Mr. Deckas found an untapped niche of the market, linking investors eager to increase returns, with securities that offered high upside, with (at the time) minimal risk. Mr. Deckas’s final move brought him to Founders Properties, were he serves as the President of Operations.
The resume that Mr. Deckas possesses, especially the quick ascension to the c-suite in every firm he worked for, provides credibility for his opinions and the analysis of the situation on a macro level. Raising capital for funds in the $100M-$200M dollar range places Mr. Deckas in a unique echelon of individuals who were present in the board rooms and at the job sites of developments that represented the center of the looming decline of the industry
The CRE Industry Structure & Financing
Structure | Mr. Deckas gave a detailed overview of the current CRE industry including the challenges, opportunities, and the players involved. He distinguished three tranches (investment grades) of CRE investment properties. The top tranche, includes the highest cost grade A commercial space, that attracts and retains AAA credit rated tenants for long lease periods (10+ years). Due to the high costs of acquiring and maintaining this space the return on investment is traditionally lower, along with the risk. According to Mr. Deckas, there has been such a high demand for this tier of investment, that the prices of units have recovered and now match the pre-bubble, which Mr. Deckas believes is still extremely inflated. The premium and competition for these top tier investment properties have driven rates available to investors down significantly, to the point where they are only marginally more productive than the standard risk free investment (10 year nominal T-Bill’s are being offered at 3.22% as of 3/16/11, see chart below) The middle tranche represents investment grade properties, that are often distressed or have minor impairments, and may or may not have tenants locked into a lease. This is the area the Mr. Deckas looks in when searching for investment opportunities. In this tranche, Mr. Deckas is projecting annual returns on this type of investment to be 10-11% unleveraged and 13-14% leveraged. The bottom tranche consists of high risk, high yield investments that usually have major impairments, and cannot attract credit worthy firms to sign leases easily. To entice tenants into these properties, the investors must make major concessions (reductions in standards) including accepting poor credit, short-term leases or investing in less desirable markets.
Financing | According to Mr. Deckas, there are two major components, and competitors in the CRE market that vie for the opportunity to finance projects. The first, and the one Mr. Deckas and his company engage in, is private equity. For the last few years, these players have sat on the sidelines, as opportunities to invest in securities posed to great a risk for most investors appetite. Instead, they have been hoarding liquid assets, meaning that a lot of equity is floating out there, waiting for appropriate projects to invest in. There are several challenges for fund managers today revolving around investors expectations, most importantly, managers must convince investors that the returns being generated during the peak of the market were unsustainable and unrealistic. For an investor to earn an IRR% of 30%+ today requires an amount of risk that is comparable to the odds at a vegas roulette table. Unfortunately, a lot of investors still believe that these returns are still realistic for investment grade assets, which Mr. Deckas predicts, will not happen anytime soon, or ever again. Also, investors who are more realistic about what constitutes an acceptable IRR% still hesitate when it comes to real estate, something that Mr. Deckas admits is understandable, considering the massive losses investors had to bear over the last few years. However, this causes many investors to seek a risk premium that is inflated well above the actual risk these investors are taking. Mr. Deckas, who is in the stages of organizing a new fund (more on that below) believes that his fund will generate a predictable IRR% between 9%-10%, which as he is quick to point out, is significantly higher than the risk free rate. Part of the new reality that managers and investors are facing is a dramatic increase in the required equity to secure long-term debt from the bank. This lowers the leverage a fund is able to operate with, thereby lowering returns. Right before the bubble burst, banks were lending out low interest fixed loans at a loan to value ratio of 90-95%, in other words, the fund could secure $9 in debt financing for every $1 of equity invested in the project. Today, the loan to value ratio is much closer to 50%, meaning the returns are less leveraged, the funds must raise more capital, and they are limited in the amount of projects they can finance. These factors combine to reduce expected returns to the figures currently being offered by PE funds. Furthermore, banks have stopped the practice of interest only loans in favor of the more conservative approach of loans that begin amortizing immediately, requiring the fund to begin paying down the principal immediately, instead of waiting until the maturity day to repay the total balance.
The second major type of investment fund, one that is relatively new in the CRE industry, compared to private or institutional equity, is private REIT’s. Brokers who manage these funds target a much different class of investor, opting to enlist hundreds, if not thousands, of small investors who by into the fund in $2,000-$5,000 intervals. These funds are raising millions of dollars a day, promising investors a standard 7% return. Again, this IRR% is more than double the risk free rate, giving brokers a strong selling point when calling on potential investors. While there is nothing inherently wrong with organizing small amounts of capital into large funds, the growth strategy for these funds appears unsustainable, and will eventually suffer losses due to inherent diseconomies of scale in the market. As the competition for CRE backed securities increases, the returns diminish and REIT managers begin buying riskier properties. To hedge the risk of a REIT, the fund needs to operate like an insurance company, with a majority of the investments earning positive returns, and having the diversification to absorb some poor performing projects. However, many of these funds have not achieved the scale necessary, due to the aforementioned market forces, and therefore are highly susceptible to uncontrollable forces.
Unlike a PE fund, where the managers are held accountable by their investors, who are few in number and demand personal accountability for their investments. Furthermore, RE managers earn most of their income in equity that they include into the funds, where REIT managers earn commissions based on the sale of the security to investors. These managers are separated by many layers of structure and do not have to0, as Mr. Deckas pronounced, look them in the face and explain their decisions. Regardless of Mr. Deckas’s opinion of REIT’s, he conceded that as long as people are making money off the investments, they will undoubtably continue, requiring PE funds to compete with REIT’s for CRE projects.
Recent Success | Despite the difficult situation that Mr. Deckas found himself in, his belief that there is always opportunity in the market paid off with a calculated gamble in the CRE market. Last year, Mr. Deckas flew to Denver to examine a potential opportunity to invest in a large, brand new, commercial building. Denver was a market that was overdeveloped and the vacancy across the CRE market was extremely high, suggesting that investing in a building with on 25% of the space leased was not a fiscally sound move. However, due to Mr. Deckas’s experience and analysis of the market he was able to parse the vacancy data to realize that the vast majority of available space was between 5,000-10,000 sq/ft, relatively small for CRE standards. On the other hand, the market demand for larger space, 5o,000 sq/ft+, was still very high, as there were only a handful of properties this size vacant and tenant ready. The combination of thorough research, experience, and optimism convinced Mr. Deckas that this was a viable investment. Despite the high pressure of needing to secure tenants quickly to make the investment profitable, Mr. Deckas executed the deal, and secured long-term leases for the space. This story is a perfect example of the idea that no matter what the trends or the initial data suggests, a combination of smart risk taking and expertise in understanding the demands of customers can lead to success in any market.
Mr. Deckas’s Plan | Throughout the lecture, Mr. Deckas insisted that investors and managers need to shake of the cobwebs, pick themselves up off the turf and get back on the offensive. He is in the process of securing projects to begin the process of raising capital for a new fund. He admits that there are many lessons to be learned from the past few years, and he insists that he is incorporating this new wisdom into this fund. He plans on presenting approximately 30% of the projects necessary to give investors a preview of the makeup of the securities. His plan calls for 70% safe and predictable investments, CRE from the upper end of the middle tranche. These are buildings that are grade A real estate, with credit worthy tenants, who already occupy a large percentage of the space with long-term leases. This reliable income will be the basis for his predicted IRR% delivering approximately 6.5%-8%. The other 30%, which will add the remaining 3%-4% of returns, will carry slightly higher risk, and could include a mix of land, buildings with low occupancy, or buildings that have tenants who do not meet all of the requirements of the top tranche. Mr. Deckas was very explicit that he is not interested in development, or any sort of speculative property explaining that it was these investments that caused the majority of the losses his remaining funds have sustained.
Mr. Deckas’s experience over the past few years has been very difficult, knocking the air out of his ego, and forcing him to report losses to his investors for the first time in his career. As he puts it, “the last few years have served me a very large slice of humble pie, I think just about everyone has gotten a piece.” While difficult in the near-term, Mr. Deckas appears to be committed to returning to the field and continuing to seek out opportunities to earn money for his clients. Being mindful of the lessons learned during this crisis is vital to ensure that we don’t leverage ourselves right back into the same situation, and hopefully there are more managers like Mr. Deckas, who has insisted on being more reflective and skeptical about propositions that seem to good to be true, because they usually are.