Transwestern’s Capital Markets Symposium: Institutional Capital Reevaluates Commercial Real Estate

A great deal in the capital markets changed between late April, when Transwestern’s Steve Pumper began assembling the panel for the firm’s 15th Annual Capital Markets Symposium, and mid-June when the symposium was held in Chicago. Coming off a rebound year in 2021 and anticipating more of the same in 2022, the seasoned investment pros Pumper brought together for the 90-minute discussion found themselves recalibrating their strategies as the debt and equity markets encountered serious turbulence. 

In the edited conversation below, you’ll hear from Pumper, executive managing partner of Transwestern’s Capital Markets and Asset Strategies Group; Tuba Malinowski, COO at Stockbridge Capital Group; Craig Tagen, managing director, separate accounts at Clarion Partners; Tim Ellsworth, managing director at DWS Group; Gio Cordoves, regional president, western U.S. at KBS, and Jim Halliwell, managing director, Principal Global Investors. 

Pumper: Let’s compare 2021. How does that compare versus 2020 coming through the pandemic? 2021, as we all know, was a spectacular year: over $800 billion of transactional buying in the U.S. in all asset classes. Jim, do you want to lead us on that?  

Ellsworth: Sure. In 2021, we executed $3.3 billion of equity and debt investments. $1.9 billion of multifamily, $1.3 billion of industrial and the remainder in retail.   

Pumper: Talk year to date in ‘22. Where have you been spending your your money? What are you underwriting? What do you like?  

Halliwell: We invest across the risk spectrum from core all the way to development. We were at a client conference a couple of weeks ago and we recommended that clients stay in high conviction sectors and markets. When markets become less settled like we are starting to witness, it is more important to avoid any style drift in investment strategy. 

Tagen: 2021 was a $5-billion year for us of new capital invested and we also had a couple billion dollars worth of dispositions. So on a $7-billion year, here we are sitting at the midway point and we’re not half as good as last year. And it will be very interesting to see as we go into the second half of the year. I see a potential disconnect between buyers’ and sellers’ expectations and pricing. 

Cordoves: We’re primarily a class-A office owner. We own some industrial and some multifamily, but really the lion’s share of our portfolio is office. Because of that, it’s been an interesting couple of years for obvious reasons. That said, ‘21, echoing your comments, felt like a really successful year. We had some fund lives that caused us to be sellers and I’d say 95% of those we were successful in exiting last year. Almost all of them exceeded pricing expectations, some marginally, some by a lot. 

Halliwell: We did five and a half billion in 2021 and a little over two of that was acquisitions and the rest development. We have been very long in development with high-quality development partners and the market has rewarded groups for taking development risk in sectors such as industrial and multifamily. On our acquisitions, much of what we’re doing in 2022 is alternatives: manufactured housing, self-storage, single-family rental, medical office, data centers, and life science. I’d say probably 50-60% of our acquisition volume is in some alternative property type. These have been tailwind sectors and we expect this theme to continue in the near term. 

Malinowski: A big portion of our outperformance has been exactly that: niche sectors. In L.A., we executed a partnership for what we refer to as niche industrial properties, which include truck terminals, truck yards and outdoor storage units, because they have been such strong performers. We were seeing quarter-over-quarter rent growth of 50%. 

2021 was a great year. We bought a lot, and frankly, I think that looking back on it, we’re all going to wish we’d sold more. Our 2022 numbers are going to look really good, but much of that will be a result of assets mostly closed in January, left over from 2021.

Pumper: Let’s talk about development. Given what’s going on in the run-up in interest rates, are you  rethinking how you’re going to deploy your capital for development or are you reallocating it into those sectors for acquisition to minimize some of that development risk?  

Malinowski: As a core fund, we are only doing some development. We’re comfortable with the development we are doing, but it’s been interesting to see that lenders have been more forgiving on construction loans than they have on other debt. I think our clients have done really well with the development they’ve done on separate accounts, so I don’t see them getting too shaken about that potential risk.  

Pumper: Quite frankly, I feel good about it. But people are looking to minimize risk now because the world has changed a lot in the past four to six weeks. Jim, what are you seeing?  

Halliwell: If you look at the preceding five years, the build-versus-buy in multifamily favored the build. We still think there will be attractive development opportunities in many markets, but the build-versus-buy proposition may be less one sided as it had been in the past. Costs are going up and values may adjust downwards based on interest rate advances. So, we think the market may present some more attractive buying opportunities in the future as well 

Pumper: Craig, you’ve got Lion Industrial Trust and Gables Residential, so you’re very active in both sectors. How are they viewing things these days?  

Tagen: The big challenge right now if you’re building multi is really getting a good understanding of price. We’ve just seen such tremendous labor increases and material increases in pricing and it’s really hard to get anyone to commit to a price until you’re really further along in the process. Industrial, on the other hand, is 12 months to go to market. The supply chain still has some challenges and that is going to put some strain on our ability to control our costs.  

Pumper: Tim, you’re in charge of acquisitions at DWS. What are your top two or three favorites?   

Ellsworth: Industrial and multifamily continue to be of strong interest to us. Due to the uncertainty related to work from home and corresponding tenant demand, our interest in office continues to be limited. Alternative investments including life science, student housing and medical office, are of interest to us. However, the investable universe for those product types is relatively small and won’t offset the decline in office investment activity. 

Pumper: The amount of capital that’s been raised for our industry since March of 2020 to date is astronomical. I was looking at the numbers through April. Year to date, office is second in volume at $40.4 billion, and that’s a 33% increase year over year because capital has to find a place in there. The leader in the clubhouse is multifamily at $83.4 billion, and then industrial is right there with office, pretty much head to head.  

Halliwell: Which it never had been in the past. It’s always been much lower.  

Pumper: Absolutely. With all this capital being raised, it seems like European investors during the pandemic weren’t able to come over here and look at properties. And now, the Russia/Ukraine war is negatively impacting Europe more so than it is here. And so we’ve seen a lot of Europeans coming over here looking to place capital. They’re viewing the U.S. as a safe haven. Are you doing anything with European investors?  

Malinowski: Given the turmoil due to the war in Europe and interest rate movement in the U.S., we think our European investors are being a lot more cautious in terms of making big movements within their portfolios right now. We have, however, seen a lot more interest from our Asian client base. 

Halliwell: We have an enhanced fund called Principal Enhanced Property Fund. Most of the European capital comes in through our funds. And I would say it’s been a fairly steady flow; we have not seen an immense pick-up from Europe. Korea is a country that we’ve seen more capital come from. 

Malinowski: Definitely. We’ve also seen an uptick in capital from Korea. In general, we’ve noticed Canada has been more receptive to separate accounts, rather than funds, lately.  

Pumper: And you’ll see the Koreans– 

Malinowski: Are receptive to both. 

Pumper: Exactly. So if you’re looking at the top foreign investors from last year, Canada is always number one, and then South Korea and Singapore were high on the list as well. And you’re always going to see the UK participate to some extent. Gio, on your transactions, whether you’re buying or selling, are you running into international investors?  

Cordoves: We are seeing many international investors remain bullish on U.S. real estate which historically remains one of the safest asset classes in all economic climates. For example, one of our largest dispositions in 2021 was a well-located single-tenant office property in Austin, TX occupied by a credit tenant with significant lease term left. While we ultimately went in a different direction and the result was extremely successful the property garnered substantial interest from overseas and Korean investors in particular. 

It may not feel it to everyone in this room right now, but when you compare anyplace else to the U.S. to invest, this is the safest place to put your dollars. 

Craig Tagen, Clarion Partners

Pumper: Craig, what are you seeing at Clarion? 

Tagen: It may not feel it to everyone in this room right now, but when you compare anyplace else to the U.S. to invest, this is the safest place to put your dollars. It’s also the largest markets where you have many, many more opportunities. So I think you’re still going to continue to see foreign capital interested in investing in the U.S. markets. Our dollar is still relatively very strong and interest rates have been extremely low for a long period of time. All of us that have funds, for the most part, we’re not putting individual property debt. We’re doing different types of debt structures to have some flexibility within our portfolios. So we’re paying a lot less than today’s spot market pricing for debt. And that still makes it attractive for foreign capital to come over and invest here.  

Pumper: Tim, the debt markets have had to be crazy as of late. Are you seeing any new conversations that you’re having with your lending relationships?  

Ellsworth: I’m not sure we’re having conversations with our lenders as much as we’re having conversations with our clients about what we’re paying for properties as a result of what lenders are charging us.  

Pumper: Did you see leverage starting to come down a little bit?  

Ellsworth: Our core fund, RREEF America REIT 2,  is moderately leveraged, somewhere in the neighborhood of 20% percent loan to value. For the remainder of our portfolios, our leverage strategy is generally in the 50% to 60% range. Leverage levels have come down slightly for core but have been more impacted on value add and development.  

The biggest surprise to me, frankly, has been the fact that there are so many fewer buyers on our sell side. There are also a lot fewer buyers on the multifamily side.

Tuba Malinowski, Stockbridge Capital Group 

Pumper: As a result of leverage decreasing, in the core space when you’re all-cash buyers, that provides you with a benefit. But then there’s some offsets with the drop in the stock market and the denominator effect.  

Malinowski: Ultimately, yes, we are all-cash buyers and when we do our buyer interviews, that’s a big part of it. However, as an example, let’s say you had an Amazon-leased industrial asset, and the price had a cap rate of 3.2%. It doesn’t mean we still want to buy it at a 3.2% if the market is pricing it at a 4.2% because the debt markets have traded. Keep in mind, our vehicle is a core, open-end fund and is valued quarterly. We would not want to buy an asset and a few months later think we freaked out about Amazon and now the asset is pricing at a 4.5%. It hurts us just as much as it hurts a leveraged buyer. Our fund can’t use leverage as an excuse for changes in pricing. Ultimately, prudently, we all had to go in and adjust our exit cap rates. 

Pumper: Right. And the benefit may be that as pricing will be going down, cap rates will be going up, and they’ve gone up 25 to 50 bps on the best of the best, For some others, maybe it’s 50 to 100 bips at this point, and that’s just over the past couple of months. But what it may do is eliminate some of the competition, so you can move up in the cap rate but benefit from being able to acquire all-cash. 

Malinowski: The biggest surprise to me, frankly, has been the fact that there are so many fewer buyers on our sell side. There are also a lot fewer buyers on the multifamily side. We recently put a great multifamily asset on the market in Atlanta, and we were surprised by how few buyers there really were at the end of the day. I think that’s a big change. 

Pumper: The most important question on that is, how did your pricing turn out? 

Malinowski: We’re refinancing. But there are properties that you will sell at the market pricing and properties that you’d rather hold. This is a rather-hold property.  

Tagen: I would agree. If we saw 10 buyers in the first round in the beginning of the year, you’re seeing three at the moment.  

Pumper: Given the transactional volume that this group represents, have you seen some deals that you’ve had under contract on the acquisition side or on the sale side go away, due to the recent events?  

Tagen: We’ve had the same thing; we’ve decided to hold in a few cases. In 2021, if you took anything to the market, you received a broker BOV, you priced it at the midpoint. And then it was how much above that: “am I going to get 10% above the broker midpoint? Am I going to get 15% above that?” If you took that same mindset into March or April of this year, you were walloped on the side of the head because you’re nowhere near the broker midpoints that you received at the end of the year.  

Cordoves: Speaking to value-add office, transacting in 2021 was generally doable. There were operators and underlying equity hungry for those types of deals as well as available financing and good pricing. Fast forward to 2022, and we still have hungry operators but lessened interest by their equity partners and far and away the biggest challenge is the debt side of the equation. They may not even get a quote from a lender, not to mention all-in borrowing costs that went from five and a half, maybe five and a quarter in 2021 to something that starts with an eight today—incredible movement in a relatively short period of time. 

Pumper: Jim, what are your debt guys saying down in Des Moines? You’re very engaged in a lot of asset classes throughout the U.S. in the debt markets. How are they feeling today versus maybe a month ago?  

Halliwell: If you’re a provider of debt, you’ve had rates rise and you’ve also had spreads rise. This positive correlation is less common: if you look at the past when rates have risen, spreads compressed. So, the challenge is really production, the all-in cost challenge, and the debt coverage with new, higher loan constants. The relative value proposition is starting to look appealing in the private debt quadrant, particularly in the subordinate debt side, but qualifying transactions and willing borrowers may pose the greater hurdle. There are other obstacles such as volatile and widening corporate spreads, which have a bearing on private commercial mortgage spreads. So, while the relative value may seem appealing, the volatile landscape may hinder execution from both the borrower and capital provider side 

Pumper: We talked about all the capital that’s been raised. And then we saw Duke turn down $24 billion from Prologis and accept $26 billion. You’ve got to think more M&A is going to be happening moving forward. What are your teams’ thoughts on that within the industry?  

Ellsworth: We have a securities group that buys and sells public company stock. One of the challenges they face is the limited number of participants in each sector. In the industrial space, there really are not that many players left. That may be an opportunity down the road for asset aggregators.

Pumper: They’re going to carve out one market, then they’ll consolidate and get rid of the duplicative roles. With the energy prices the way they are within your industrial strategy, have you considered looking at rail-served parks as a differentiator?  

Tagen: We’ve always looked at rail, but we look at rail as just one component. And actually, when you look at a large portfolio, it’s not a big factor. There’s not a long list of tenants that are asking for rail as a part of it. Tenants are interested in close proximity to a major highway for their trucking, and making sure that they’re in a neighborhood that’s friendly and they don’t don’t have to worry about driving their trucks through the streets.   

Pumper: With gas prices moving up so quickly, you’ve got this work-from-home fight that’s going back and forth that looked like the people who wanted people back in the office were winning for a while. But all of a sudden on the coasts, in California it’s $7-plus for gas. It’s probably that way in the Northeast and it’s headed that way in the Midwest and in the South, at $5 and then moving up to $6 shortly. Gio, with employees maybe utilizing the increased energy cost to allow them to continue to work from home, are you taking that into account when you’re looking at your office portfolio and absorption?  

Cordoves: Yes, we are hearing that specific comment from a few of our tenants—the context being they were going to push more of their people back to the office but now they’re taking a pause because of the costs to get to work. So that’s a very real thing. That said, we continue to believe that the vast majority of employers want their people back together, in person, to continue to drive peak performance and results via enhanced collaboration, culture building, and mentoring that transpires most effectively in an office environment. 

Ellsworth: We’re supposed to be in the office three days a week and its been a challenge to achieve that attendance rate. It’s been a slow and steady increase, but I think we ultimately end up with attendance somewhere between 3 and 4 days a week. I see that happening sometime next year.  

Pumper: How about you, Craig? 

Tagen: This is one of the big challenges that real estate companies, private equity companies, investment companies are facing today. For our company, we just announced a 3-2 policy. We’re going to ask our employees all to come back into the office three days a week. They will have two days as flex days, whereas the three days are mandatory days by group and by department. And we’re doing that across the country. I think the market will bring us and many others back to a 4-1 over time, especially if you’re in a performance-driven culture. 

Pumper: On the medical office/life sciences, I know some of you play in that. Jim and Craig, I know you do. Anybody else who plays in the space, I’d love to have you guys weigh in. It looks like you’ve got a $2.5-billion portfolio, Craig, and you’re looking to grow it. Is that safe to say? 

Tagen: It is. That’s really helped fill our alternatives bucket. We look at life sciences outside of our office allocation and we’ve been fortunate. We picked a few really strong partners in the markets that we like and stuck to those markets and a few really strong partners.  

Pumper: I know you bought a big portfolio in Seattle about a year ago. What kind of percentages would you say? Is it 10% development and 90% acquisition, or how would you handicap that?  

Tagen: I would bet our life sciences is probably 50% development.  

Pumper: And you like the infill locations in the major markets.  

Tagen: Major markets: right outside of San Francisco, Cambridge, Boston, San Diego, Seattle. Those key markets are really helping drive venture capital in those markets.  

Pumper: Moving forward, do you still have the appetite and what space are you playing in? Is it is it a core space that you’re playing in for the life sciences?  

Tagen: I think the the life sciences is more core plus or even development. And we see interest in life sciences across both the value-add bucket of a core fund or within a separate account that can look out a little bit to the future and has a value-add allocation to capital as well.  

People will come back to well-located, well-amenitized office buildings in the CBDs and other areas. And once that happens, there will be a ripple effect for the retail sector in those markets. 

Gio Cordoves, KBS

Pumper: Jim, you’re closing on a deal in Austin in the medical office space. I think it’s one of two deals you’re doing with your operating partner there. You’ve got some life sciences product out in the Bay Area. Talk about Principal’s viewpoint with your clients in life sciences and medical office. 

Halliwell: The short run outlook for the life science is sector is rather compelling. Demand right now is excellent and if you have a first mover advantage, you should be rewarded. There are similarities to the hedge fund business in the Plaza District in Manhattan years ago. Notably, rent tends to be a less material factor in the tenant decision making matrix so landlords have strong pricing power in well located and functional buildings. Like Craig, we’ve been sticking to California, Boston, the Maryland 270 corridor, and Raleigh, so pure markets. On a longer-term perspective, the national supply landscape needs to be monitored. Sources vary, but some estimate another 150 million in supply between new development and conversions. Not all of it is going to happen, but when this pipeline starts to deliver in earnest, the pendulum may adjust towards the tenant.  

Pumper: Can I say one thing about Boston? Every office building in Boston is a potential life science building.  

Halliwell: The differential in rents between office and lab in suburban Boston justifies this conversion dynamic. Say suburban office rents in outer areas are between $15-$20 psf, net. If you have quality suburban lab space, you may get $50-$60, net. Accordingly, if you buy a suburban office building between $200-$250 per square foot, put in $400-$500 for conversion, tenant improvements, and carry, you have a workable 8% or so yield on cost. In many markets like Boston and suburban Maryland, if this office to lab rent differential remains wide and office buildings can be acquired on a cheap enough basis, this trend will continue. 

Pumper: Two things within office. On CBD versus suburbs, it seems to me suburbs have been winning, number one. And number two is underwriting: underwriting buildings where tenants have tended to fall back on three- to five-year terms. How are you thinking through that?  

Cordoves: Obviously, CBDs anywhere in the country are still more challenged than non-CBD locations given the transportation infrastructures of many downtowns. But as people in these areas resume activities like attending sporting events and concerts, taking public transportation is slowly becoming more normal again, ridership levels are picking up, etc. While it may be a slower process than many would like, we believe office workers will once again embrace the use of public transportation for all of the reasons they did pre-COVID. 

Pumper: If you’re going to live in Chicago, if you’re going to live in in New York, if you’re going to live in a Boston or Seattle or San Francisco, you want to benefit from what those cities offer. And so once we can stabilize that and people feel safe again, we’ll get people coming back into the office space and that hopefully will revitalize things. Is that what you think?  

Cordoves: Yes, we do. And that’s a “when” not “if” question. It’s going to happen. People will come back to well-located, well-amenitized office buildings in the CBDs and other areas. And once that happens, there will be a ripple effect for the retail sector in those markets. 

Pumper: Strength in numbers.  

Cordoves: And honestly, the COVID issue seems like that went away a little while ago and the conversation went to safety. That’s been the big issue in a lot of metros, especially, some of the Western big metros. It’s still pretty bad, between the homeless situation that hasn’t gotten any better and people just not feeling safe. 

Pumper: In the industrial sector, with Amazon talking about giving back 10 million square feet, that’s about 4% of their space in the U.S. And then I’ve also heard that in addition to that, they’re going back to some of the landlords trying to renegotiate some of the rent. Is this the beginning of what we’re going to see going forward?  

Ellsworth: From our perspective, the amount of space being given back by Amazon is relatively small relative to their footprint and the overall market. I think it’s more headline news. We do recognize the potential for a flattening or decline in e-commerce sales and the impact that may have on industrial demand. However, we continue to see strong tenant demand and assuming we don’t slip into an extended recession, we remain bullish on the sector.  

Tagen: I would agree. I think this is just a pause for Amazon, but the 3PLs are extremely busy. We all have a ton of boxes still arriving at our house every day. And although the retail numbers that just came out show that the consumer’s taking a little bit of pause because the headlines are horrible and everybody’s sort of holding on to cash for a little while, retailers learned during this past cycle that you can’t just be e-commerce. So this year, we’re seeing more new store openings than we have.  

The past two years have been horrible for malls. If you’re marking to market your malls, you’ve taken huge double-digit write downs the last couple of years. But that stabilized and occupancies are back up in malls. There’s no real trading occurring in that market. But you’re starting to see it in other pockets of retail. Grocery has done extremely well. Neighborhood retail is really benefiting from the work at home. So investors are starting to look at retail.  

Pumper: We’ve got the election coming up. We got interest rates bumping up. Now they’re talking about potential food shortages on the horizon. You’ve got the talent issue, which I think is I think it’s finally starting to head back our way. I think we’ll see that in six to 12 months in a positive way. What keeps you up at night?  

Malinowski: We all get the headlines and all the negativity. The denominator effect does worry me a little bit, but when other asset classes start losing value, our clients do have real estate as a percentage of their portfolio, which worries me a lot. However, I mostly think about what the opportunities are going to be and want to make sure we’re in a good space to be able to take advantage of those because frankly, we all saw how long the GFC actually lasted for real estate. It wasn’t a terribly long down cycle for us, so we want to be able to have capital to invest when things turn around. 

Transwestern’s 15th Annual Capital Markets Symposium panel. From left: Gio Cordoves, KBS; Steve Pumper, Transwestern; Craig Tagen, Clarion Partners; Tim Ellsworth, DWS Group; Jim Halliwell, Principal Real Estate Investors; Tuba Malinowski, Stockbridge Capital Group.