Predictions (and Recommendations) for 2023Jan 23, 2023
We all know what clickbait is, and it usually (almost always) relies on a prediction of a dramatic calamity or, the opposite, a dramatic updraft of wonderfulness. In financial markets, the goal is to exacerbate fear until people get bored with that, and then switch to greed (when the bottom is reached), and then go the other way. Indeed, how many articles are titled with words like ‘record,’ ‘largest,’ ‘highest,’ ‘lowest,’ ‘biggest,’ etc?
I am going to do the opposite and, as always, say what I think is accurate rather than entice with dramatic predictions, and in a nutshell, my prediction is that for real estate in general:
There will be a lot less drama in 2023 real estate than most people think.
Here are my specifics predictions and thoughts:
- Distressed Real Estate: There is a lot of real estate that could, sort of, fall into this category, i.e., overleveraged properties. But I predict that the hundreds of billions of dollars of raised, and being-raised, capital will have a partial field day, but not as robust as anticipated. Instead, since most of the distress is now caused by raised interest rates – and not the fault or incompetence of sponsor parties – there will be every incentive of the parties involved in the actual deals to cooperate in working out win/win, or at least not lose/lose, results with parties which they expect to do repeat business. This does not mean magic will occur and overleveraging will vanish with a poof, but it does imply that a wave of distressed borrowers begging for large sums of capital at 15% interest rates will not be as prevalent as expected. Having said the foregoing, there will likely be many opportunities for investors and lenders to put dollars to work in what I have nicknamed Fulcrum Capital. However, due to market forces, the chance to put money out at super-high interest rates will probably not last that long. Instead, once the market senses things are stabilizing, there will be a good amount of competition, so pricing will settle at a still-expensive but not crazy-expensive level. Anecdotally, despite my reaching out on this email list to anyone seeking Fulcrum Capital, I have received zero requests for it so far.
- Distressed Debt: My sense is that it is unlikely that desperate banks and lenders will be dumping distressed loans at cents on the dollar in bulk. Old-timers remember this happening nearly thirty years ago, but I think the abundance of capital and the sadder and now much wiser banks and lenders will make that unlikely. The exception to the foregoing will be specific projects in trouble. For example, a busted construction loan may give rise to some desperation on the part of a lender. My belief is that those with pools of capital and deep expertise in distressed debt transactions will do very well; however, I would discourage neophytes which have never done distressed debt deals before from wading into the market. Distressed debt transactions are intricate and creative and the inexperienced hunter will likely quickly become the hunted – or at least the disappointed – without a solid background and understanding of the pitfalls.
- Stay in the Market: I hope I am not being too redundant in suggesting that taking a pause on investing, lending, etc., is really a form of market timing that I think should be avoided. Notably, Goldman Sachs predicted a 35% chance of a recession last month– sorry, but is that even a “prediction” in the first place? The bottom line is that no one has a clue about what the coming months will bring. I refer here to my most recent article on this subject. By no means do I advocate imprudence or throwing caution to the winds, and indeed I suggest solid strength in sticking to careful underwriting, but predicting that the investment environment will be better or worse over the next six months is just a guess. Taking yourself out of the game merely increases the likelihood you will miss out on opportunities, and even if you don’t find opportunities, you will not have a leg-up on opportunities from people you are now kicking tires with third parties with those opportunities.
- Recapitalizations: I predict that this is where the most action will be in 2023. In this vein, I look at a property as (sort of) a game with players that consist of first lien lenders, mezz/preferred equity/high yield players, common equity, and possible new money at any of the foregoing levels. When the debt held by players in the game matures, the property comes into play (following the game metaphor), and everyone involved is pressed to find a new or different angle. Maybe musical chairs is a better metaphor. The underlying property will still be there, but each party may end up with a different position in the property. Creativity, some brinkmanship, savvy negotiating, and solid risk/reward assessment will all come into play. Notably, as the game is played out, those players who had good careful lawyers who put together a strong place for them in the capital stack will typically have a major advantage in the game over those that were more cavalier – I hope that is an unsubtle plug for our law firm.
- Fulcrum Capital: Fulcrum Capital, as I have defined it, is capital needed to rescue properties facing a refinancing shortfall, usually due to higher interest rates lowering the loan to value. There is a great deal of eagerness among the parties that have enormous amounts of Fulcrum Capital available. My sense is that there will be a lot of use for Fulcrum Capital; however, its pricing will drop pretty quickly. Probably as quickly as this first quarter, the bell will be rung that it is time to step back in the water, and there will be a repricing of Fulcrum Capital dropping from roughly 15% to 18% (where it informally is now) down to more normalized I would guess around 10 to 12%.
- Creating Deals Will Become Critical: I wrote several years ago an article that was entitled You Will Never Find a Good Deal Again. My point being that you have to create deals as opposed to find them. As the twenty-year decline in interest rates is likely at an end, finding deals will now become even more difficult and close to impossible, at least for sizeable transactions. Instead, now it will be even more critical to actually create value since financial engineering will not do it.
- Office: I maintain my view that this is the biggest chance to buy office you will probably ever get. Yes, I am mindful of office negatives in big cities like NYC and the statements of investors that “Office is Four Letter Word,” and pension funds and other investors bailing out of the asset class, not to mention public office REIT’s focusing on residential, Vornado cutting its dividend and being booted out of the S&P, etc. Worse yet, most organizations would penalize, or laugh at, a contrarian colleague who dares to recommend investing in office. I won’t delve into all the reasons I am thinking office investment is where the most dramatic upside is, as I have written on it before, but I will say that: WFH is gradually morphing into hybrid working, meaning a business still needs an office, albeit possibly somewhat smaller. Note that unless hybrid is three or fewer days a week, then footprint shrinking is awfully hard to do. In that regard, the chart I wrote out two years ago is looking more and more accurate; however, the portion of the chart During-COVID below is now being lengthened to encompass a possible recession or fear of a recession:
- The articles saying that, say, 40% of office users are trying to shrink their footprint are not that germane because (i) office users are always trying to shrink their footprint and (ii) the other 60% might be trying to grow their footprint. We saw articles like this about retail two years ago when they predicted how many retail stores would close without predicting how many would open and, sure enough, in the end more opened than closed.
- Recession fears allow employers to be stronger in getting their employees back as everyone has figured out that the remote guy/gal will likely be the first to be let go if business shrinks
- So far class A office is overall doing great, so the concern is class B and C office, which many say some buildings are functionally obsolete. That is a good point; however, real estate obsolescence is nothing new and it is no doubt true that some buildings might indeed be obsolete. However, when that happens it shrinks the office supply, which of course raises demand for what remains.
- I can’t believe I am the only business owner in NYC that is (greedily – I hope I am not greedy!) rubbing his hands with the amazing deal I will get this year to lease space in a Class B building. Soon they will ring the bell at the bottom for these kinds of deals and then those deals will go away.
- The biggest countervail to what I am proposing is the commute. Cities with big, pain-in-the-neck commutes are having trouble filling their offices as the employees have a good point that one, one and one half, and even two hours of commuting is a tough sell. This article from The Real Deal says it quite well. It is a major issue in cities with terrible commutes, with NYC being a poster child for this. I admit this is a possible Achilles Heel for my thesis, but I believe the other factors override these concerns. And I believe that over time people will find workarounds. Notably, people do come to the city for sporting events and concerts.
To conclude, my prediction is that prices will no doubt adjust for class B and C office buildings, but probably not as dramatically as some think. And yes, office investment is going to be fraught with severe pitfalls, but I think it is likely going to be the best place to outperform.
- Retail: I put this next since – thanks to a media-fueled overreaction – almost everyone gave retail up for complete dead about two years ago, except this Real Estate Philosopher, who said the exact same thing I am now saying about office; namely, two years ago was the time to peer into the broken retail wreckage for opportunities. And now – viola! – retail is (mostly) quite hot, other than Class B malls and some other disaster locations. An article I read today said there was actually not enough retail availability. Sorry to be humbuggish here. Going forward, I would stick with my recommendation from two years ago; namely, to look carefully at retail investments to be as sure as possible that the retail tenants have a true reason to exist as, if they don’t, they will end up like Bed Bath & Beyond, Kmart and many others. Going forward, I predict retail will continue to do even better as time goes on since the downturn wiped out a large number of walking dead former retailers, so that ones in place today have a much stronger profile.
- Multifamily: I think this is still a good area to invest. Pricing for core assets will be affected by interest rates, but otherwise, the asset class should continue strongly. I am guessing it is not a great area for outperformance; however, it is probably one of the best areas for avoiding underperformance. However, I would be very careful assessing political risk in states or municipalities where rent control, or similar curbs on upside, are on the table. It is a shame if your investment thesis is spot-on, but due to the political climate you lose the upside of your investment. Unfortunately for investors this type of concern is growing in quite a large number of places and it is a major headwind for multifamily investment. Indeed today’s headline in the WSJ scared me that some in Congress are proposing nationwide rent control - I do hope that that proposal goes nowhere, but investors should be vigilant.
- Industrial: I have the same sense here as for multifamily; however, the rent control risk does not yet exist there that I can see.
- Places to Invest if You Want to Outperform: in prior articles, I have noted that trying to outperform leads to the risk of underperforming, and that risk not a logical one to take if the downside for underperforming is too great – either for you personally or for your organization. If, however, you are set up to try for the upside and can live with the downside risks, here are some areas where I think you have a solid chance of outperformance:
- Small Sized Deals: These are a pain in neck and most sources of significant capital avoid them. My thesis is that the lack of competition gives rise to a good chance of outperformance opportunities; however, there are devils in the details in terms of how to do these deals with solid risk/reward evaluation.
- Niches: Niches can be fantastic if you hit the right niche at the right time. Consider that self-storage was hardly an investment class 15 years ago but has now done spectacularly well for long periods of time. Investment in niches can lead to outperformance if the investor develops a solid knowledge of the underlying business as well as the real estate. This effectively becomes a Power Niche – see my book on Power Niches for a deeper dive here.
- Operating Businesses and Real Estate: This is both dangerous and exhilarating. You are no longer a pure real estate player if you do this kind of thing; instead, you have to have a real understanding and expertise in the underlying operating business itself. The reason I like this so much for outperformance is that most real estate players are not comfortable with operating businesses, and most parties that invest in operating businesses don’t have the real estate expertise. Investors that can do both have a major advantage.
- Slicing and Dicing: I have been advocating this for over 20 years, and it is still a solid way to think about real estate investing. The simplest thing imaginable is buying ten acres in bulk, getting the needed approvals, and selling off each acre separately for upside. No one needs my thought process on something that obvious of course, but how about chopping out a ground lease position from real estate, or creating office condos targeting different users, different investors, and different lenders, or bifurcating the financing to bring in PACE financing or other favored investment vehicles. There is no limit to creativity that can be applied here to create economic upside.
- Interest Rates: As per my last article, I am trying hard not to make a prediction about interest rates, so I am sticking to my suggestion that one should assume the worst (that rates go up a lot more than expected) and be prepared for that. This is because not doing so could be so destructive as to cause you to lose all of your capital and be out of the game. So, my non-prediction is to assume rates are going up more than you expect or want.
To Conclude: 2023 is looming ahead of us all right now. There is always excitement – and sometimes fear – in a new year. I conclude with these thoughts:
Don’t get down – keep your spirits up – bad markets give rise to more opportunities to get great deals than strong markets
Don’t jump into new businesses you know nothing about, i.e. buying distressed debt for the first time
Assume the worst to protect yourself, but as noted, I suspect that things probably won’t be that bad
Don’t pause activities– stay in the market
Only try to outperform if you can stand the risk of underperforming
Keep your reputation at all costs – it is never worth sacrificing your reputation for a few dollars – never
Try to have some fun
Good luck to everyone