The Year of the Rabbit
In our Fall Investment Outlook, we applied the metaphor of a quarterback ‘going through the progressions’ to express how RanchHarbor was approaching its investment decisions and asset management. In this edition of our investment outlook, we are going to discuss the Rabbit. For those of you that follow the Chinese Zodiac, 2023 is the year of the Rabbit which, according to the Chinese Zodiac, is summarized as follows:
“2023 is the Year of Rabbit, indicating a year characterized by many fluctuations in luck, when your highs are very high, but lows can be quite devastating as well. Even so, it’s up to the Rabbit to keep an upbeat attitude to life and work, which will help them sail through difficult patches with patience and resolution, while in the good times, their positivity will attract the attention of those in positions of power to extend a hand that could prove decisive for Rabbit’s fame and fortune for the next 12 years. In any case, this should be a year full of excitement, prosperity and surprises that run in both directions – anything but boring for dear Rabbits!”
Here at RanchHarbor, we certainly hope all of you (ourselves included) have a 12-year run of fame and fortune. However, we will focus on the here and now and provide our insights and expectations for the year ahead.
Going back to the Chinese Zodiac, 2022 was the Year of the Tiger. We believe 2022 should have been the ‘Year of the Blowout’ given the sharp increase in interest rates throughout the year – resulting in the sharpest increase in rates in decades.
The onslaught of Fed rate hikes pounded the real estate markets through the end of 2022 and will likely continue in the first half of 2023. Below is data and charts from Green Street providing perspective on the severity of the change in pricing and cap rates.
Throughout 2022, the investment team at RanchHarbor reviewed hundreds of value-add deals. We seriously debated the merits of 106 investment opportunities in the multifamily, industrial and storage sectors.
The majority of deals we screened exhibited a risk profile and underwriting metrics that did not meet our standards. In particular, the combination of negative leverage and the aggressive underwriting assumptions (i.e., rent growth well above historical averages) required to overcome negative leverage produced an unattractive risk profile. As the Fed continued increasing rates in 2022, these assumptions proved overly optimistic – rapid rent growth, occupancy, and cap rate compression were not sustainable. 2022 turned out to be a good year to test drive the car, but not buy it.
We closed on one investment in 2022 – a JV investment in a multi-tenant industrial property in LA County. We are very bullish on multi-tenant industrial (especially in Southern California) and despite the headwinds in the market, we have been pleased with the leasing activity in this investment. As for all the other deals, the consistent theme was slowly shifting seller expectations and optimistic valuation assumptions. Overall, the second half of 2022 was just too difficult to ascribe any reasonable value to assets given the volatility in the debt markets.
We congratulate all investors that were able to sell performing assets in the first half of 2022 and those that were able to complete refinancings with long term fixed-rate debt. Here at RanchHarbor, we were pleased to accomplish both.
RanchHarbor 2023 Investment Outlook and Strategy
Assessing The 2023 Landscape – Where are We Today?
- The traditional value-add, 3-year business plan with a floating rate bridge loan doesn’t work.
- Uncertainty in the current environment (interest rates, macroeconomic concerns, softening fundamentals) over the next 12-24 months creates a mismatch between the ability to execute a traditional value-add business plan and the term of the debt.
- Focus on deals where debt is assumable or source new, fixed-rate debt for value-add deals.
- Capital markets are adapting.
- Emergence of preferred equity funds and mezzanine lenders becoming more active in the market.
- This will continue and these capital solutions will be in high demand in 2023 for asset owners that have to solve the ‘gap’ in equity to either successfully refinance a loan maturing this year or cover the cost of a new rate cap.
- The obvious alternative will be to ‘call-in’ new capital from investors which is not the worst outcome for assets with strong underlying fundamentals.
- Long-term fundamentals remain positive.
- New supply is a short-term issue; we believe there are structural long-term supply constraints in the multifamily, industrial and storage sectors.
- The increase in interest rates will continue to lower home ownership rates and drive more demand for apartments.
- Affordability has been and will continue to drive the demand for apartments – specifically workforce housing.
As 2023 begins, we are encouraged by the increase in both deal flow and deal quality compared to Q4 2022. Not only is our pipeline bigger, but the opportunities are more attractive. Starting in Q3 2022, seller value expectations were far slower to adjust than buyer price levels, resulting in the largest bid-ask spread in years. With the start of the new year, that spread is starting to narrow as sellers accept that 2022 pricing is not coming back in the short-term.
The current real estate market is best characterized by uncertainty regarding the short to medium-term outlook driven by the following factors:
- Bid / Ask Spreads: In the early stages of a rapidly evolving market, a large bid / ask spread between buyers and sellers always emerges – this market is not different. Sellers are always last to accept changes in valuation. As we move into 2023, this spread is decreasing which will lead to more transaction volume.
- Interest Rates: The 2022 spike in interest rates combined with projected additional rate increases in 2023 has created substantial uncertainty and volatility. All traditional underwriting assumptions (i.e. rent growth, expenses, exit caps, hedging costs, refinance metrics) are very difficult to assess in this market.
- Fundamentals: Fundamentals, while softening, are still strong compared to historical benchmarks with positive outlooks for assets that can be capitalized properly to weather any near-term headwinds.
- Demographics: Long-term population shifts to more affordable, lower tax states continues as does the engine of job creation associated with it.
- New Supply: While there are many headlines about significant new supply, especially in many Sunbelt markets, the increased cost of capital is causing many planned development projects to be put on hold. Furthermore, even with elevated supply, housing in the US still remains supply constrained.
Investment Opportunities in 2023
While real estate values are likely to adjust further downward in the near-term due to the confluence of the factors described above, RanchHarbor is optimistic that 2023 will present significant investment opportunities.
Key to our investment success will be utilizing the proper capital structure to acquire deals.
- We are adapting to the current environment by utilizing a more conservative capital structure:
- Lower Leverage: 60% or lower LTC.
- Longer-Term Fixed-Rate Debt: Minimum 5 years of term at a fixed-rate.
- The impacts / benefits of a more conservative capital structure are:
- Reduced concerns regarding short-term fundamentals and new supply.
- Elimination of hedging cost risk and reduced refinance risk.
- Positioning our investments to benefit from long-term positive demographic trends in our target markets.
- Slightly reduced return profile but significantly reduced risk profile.
Putting all this together, we are adjusting our focus toward lighter value-add deals that can be acquired at cap rates that are neutral or slightly above current fixed-rate debt (either traditional bank or agency debt). This will allow us to ‘trade up’ in asset vintage and quality which reduces execution / CAPEX risk. This also means we will require a longer runway for each investment (i.e., +5 years).
The longer hold period will enable us to provide our investors with stronger stabilized cash-on-cash yields and generate more capital appreciation. The total return for each investment will be greater.
We summarize our 2023 investment strategy with a ‘Risk / Mitigant’ framework below:
Back to our theme: The ‘Year of the Rabbit’ indicates that 2023 will be characterized by fluctuations in luck. There will be some hard luck with downward pressure on real estate values, serious issues with loans maturing in 2023, ongoing hedging costs (i.e., rate cap extensions) and cash-in refinancing (i.e. capital calls).
However, we also recognize that good luck occurs when preparation meets opportunity. And we believe there will be many opportunities in 2023 to acquire quality real estate assets with a sound capital structure in place to generate solid returns on investments.
The RanchHarbor Investment Team
RanchHarbor is a real estate investment firm based in Newport Beach, Calif., focused on investing in small-cap, value-add opportunities in the multifamily, industrial and storage sectors. RanchHarbor provides joint venture equity, general partner co-invest equity and invests directly in real estate. Target equity investments range between $2 million and $10 million in select U.S. markets. The firm also provides sophisticated asset management services to its institutional and private investors and operating partners. Since its founding in 2012, RanchHarbor (formerly Isles Ranch Partners) has closed on 50 investments, managing over $650 million of equity capital. In 2020, the firm shifted its focus to investing in value-add real estate. For more information, visit ranchharbor.com. Follow the company on LinkedIn.
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