With the events of 2008 and 2009, the industry's outlook seemed bleak. Sponsors, broker-dealers, and registered representatives spent most that time wrestling with problems and asset management. The obstacles to doing new transactions evident last year — the lack of investors (particularly like-kind exchange investors), the reluctance of sellers to adjust price expectations, and the very tight debt market — still persist. While there is light at the end of the tunnel for some aspects of the economy, notably the stock market and the stabilization of oil and gas prices, the commercial real estate and debt markets remain depressed and could get even worse before they get better.
So what to expect in 2010? Here are a few thoughts.
Real Estate Opportunity Funds
Although sales of direct investment interests in commercial real estate to like-kind exchange investors will remain slow, there are reasons to be optimistic about other segments of the industry. Sponsors and investors are increasingly sensing the bottom of the commercial real estate market — maybe not quite yet, but not far off. This means that would-be opportunistic buyers, whether existing sponsors or newly formed companies, are anxiously seeking capital to take advantage of what they view as a unique buying opportunity.
Generally, these sponsors are not looking at doing one-off direct participation or tenant-in-common (TIC) transactions. They are trying to raise pools of capital, either through fund or REIT structures. To date, their efforts have met with mixed success. Institutional sources of capital, even for opportunistic investing, are still very limited, with capital flowing only to top-tier sponsors. The retail market also is still slow, so sponsors raising capital have to have a simple, compelling message. The ones most likely to succeed have these characteristics:
- Modest fees, costs, and mark-ups
- A focus on properties that have current income that can be improved, as opposed to no-income properties that may require additional capital contributions
- At least some designated assets, not completely blind pools
- A reasonable goal for the first offering: $10 – $15 million in equity
- A good preferred return (10 percent or more) and fair sharing of residual
- An established source of debt on reasonable terms
Oil and Gas
After a wild ride in 2008, oil prices have bounced back nicely to $70/barrel — not too high, not too low. This allows royalty sponsors to acquire royalties at an acceptable spread and still deliver diversified portfolios that yield double-digit unleveraged current returns. Natural gas prices remain low, clouding the outlook somewhat, but there is enough upward pressure to bring working interest sponsors back into the market. As with real estate funds, the model most likely to succeed for working interest sponsors is improving the performance of wells with existing production.
While fund formation and subsequent acquisition and financing, will actively give sponsors positive, revenue-generating opportunities, the problems in the commercial real estate market have not gone away. Tenants will continue to fail, landlords with leases up for renewal will be facing much more competition at lower market rates, and sources of additional or refinanced debt will remain very tight. On top of this, if we have learned anything from the last 18 months, it is that the work-out of TIC transactions is uniquely complicated, requiring reasonable parties in interest and a lot of patience.
Can We Adapt?
The opening of the TIC industry to a wide variety of real estate and oil and gas sponsors, symbolized by the transition of the Tenant-in-Common Association (TICA) to the Real Estate Investment Securities Association, is a critical part of the industry's future. The growth of TICA mirrored the strong growth of the commercial real estate market from 2003 – 2007, with consistent appreciation and many like-kind investors entering the market specifically searching for cash-flowing commercial real estate opportunities managed by reliable sponsors. That wave of like-kind investors is unlikely to reappear soon. On the other hand, real estate and oil and gas investments remain significantly under-allocated in many investors' portfolios. The purchase of such investments through the private placement market allows for a much more targeted investment strategy with more accountability and transparency than in investing in large publicly traded vehicles. There is a place for this industry, but it will require sponsors, broker-dealers, registered representatives, and ultimately investors to be open to change and quick to adapt.
Even in a best-case scenario, 2010 will remain a struggle, but often in this type of unsettled market, the successful market participants of the future are established. The opportunities are there. It should be a challenging year, but one filled with opportunities for creative, committed industry participants.