My belief is that real estate investing – and logically all investing – can be broken down to just four words:

Being Overpaid for Risk

I know I have said this many times before in a bunch of articles; however, it is a theme I do believe in, so I will continue with it. 

I do love the above pithy statement, but of course it is a rallying cry and irrelevant without specifics.  So, here are some specifics, i.e. how I think you might be Overpaid for Risk in today’s real estate world.  You might see some surprises in my thinking.  Here goes:

GP Capital:  This is a tricky area and requires a good deal of savvy about (i) real estate transactions with a multi-level capital stack, (ii) interlocking joint ventures, (iii) legal risks, and (iv) creativity about keeping legal costs under control; however, for those who really understand the joint venture space, I believe you can be Overpaid for Risk here.  I emphasize that this is not a simple space to enter.  Also, for what it is worth if I personally were entering into the real estate investing world, this is where I would go. 

New York City Office:  It is late to the party, but I think not too late.  Office has moved from a four letter word to a viable asset class again, at least in NYC, although not necessarily other markets yet.  Note today’s Wall Street Journal article, "The New York City Office Market Is Roaring Back, and It’s Pricier Than Ever," which is now outlining an office shortage – yes a shortage!  And – humbug that I am – this is exactly as I predicted would happen.  However, my belief is that there are still places where opportunities exist to be Overpaid for Risk in NYC office.

Development:  As someone who spends a ton of time sourcing capital for clients – either through my law firm, Adler & Stachenfeld LLP, or through my placement agent business, The Useful Bruce, I am pleased to see that capital is becoming available for real estate again.  Cheers!!!  However, I still see upwards of 75% and maybe upwards of 90% of investors shying away from development.  Yet there is enormous demand for this capital from sponsors.  As I have said before to investors, you are not (actually) getting so-called equity returns in preferred equity and high yield debt right now.  Instead you are getting yesterday’s equity returns in preferred equity and high yield debt.  This is because today’s returns for investing in development are in the mid to high twenties and even the thirties.  And you aren’t getting that with preferred equity.

Providing Up-Tier Capital to Developers:  This is also not for the faint of heart, but developers are perennially short of cash and optimistic or even over-optimistic about their business prospects.  This leads some of them to be open to taking debt – usually structured as preferred equity to avoid consent requirements – at the up-tier level, i.e. at the top of the company’s capital stacks.  This is fraught with risk, and that fosters the opportunity as the returns can be quite high, and in my view, can result in the investor being Overpaid for Risk. 

Platform Investments:  I guess this is the most complicated and high-risk investment profile, but since it offers the most upside for the complexity, I think it is solidly in the Overpaid for Risk camp.  This involves investing in – or taking full ownership of – a real estate platform.  The risk is high in that the investor is essentially betting on management, but the reward is commensurate since the upside of the leverage and scaling of the business is shared with the investor.

Multi-Asset Joint Venture:  Instead of structuring a deal as a platform investment, a way to hedge the downside is to create a joint venture with the sponsor that essentially acts the same way as a platform investment.  This can be better – or worse – than a platform deal for various reasons, but is also solidly within the Overpaid for Risk ambit for the same reasons as outlined in the preceding paragraph.

Ground Leases:  I perceive this as a tectonic shift in US real estate, and even though it is going on right under our noses, I think that most real estate players still don’t realize the power of ground lease financing.  There are several spots here, including:

  • Providing the ground leases, i.e. being the ground lessor
  • Obtaining the ground leases, i.e. being the ground lessee
  • Financing the fee
  • Financing the leasehold

My sense is that the parties are Overpaid for Risk from all of the foregoing vantage points, except that financing of the fee is probably more fairly paid, than Overpaid, for the risk.  Notably, there are hassles – and increased legal and other costs – in obtaining this sort of de-facto financing, however, due to the different risk/reward profiles of investors and lenders, I believe that this industry is in its infancy and a great spot to be Overpaid for Risk. 

PACE Financing:  I think that obtaining twenty-five-ish year fixed rate financing in the current world is a wonderful thing.  However, as we know, it is still very difficult to get first mortgage lenders to subordinate to PACE financing.  Accordingly, I would say that in a typical deal the sponsor is not Overpaid for Risk by taking PACE financing, but this dramatically reverses in a workout situation.  This is where PACE financing can provide rescue capital at very advantageous rates, as compared to the alternatives of preferred equity and mezzanine debt.  So, a sponsor taking PACE financing where possible is an avenue for the sponsor being Overpaid for Risk. 

Stretch Seniors/High Leverage Mezzanine Debt:  Sponsors are always debt-hogs if they can feed on it.  Sorry if that didn’t sound right – my wife and I collect pigs so this is not meant negatively – but you get my point.  Since sponsors often think more about upside they are candidates to overpay for this kind of financing, by which I mean leverage going up to 90-ish percent loan-to-value.  Of course, there are the optics that it looks bad to provide too much leverage.  But if you are rewarded/paid for this risk – I mean Over-Rewarded – then it turns into a negative into a positive.  The rewards/payment for the risk can be any or all of a partial personal guaranty, additional collateral, a higher interest rate and a bunch more.  This can create a win/win for everyone and result in the debt provider being solidly Overpaid for Risk.  

Niches:  You know what I will say here if you have been reading my articles for the past bunch of years, and you are right – Power Niches are a place to be Overpaid for Risk.  And my warnings here from prior articles – i.e. You Will Never “Find” a Good Deal Again – and You Will (Definitely) Never “Find” A “Good” Deal Again - Redux – are even more current.  AI is eliminating competitive advantage and equalizing risk factors in most typical real estate transactions.  Accordingly, the best place to be Overpaid for Risk is creating a Power Niche that you have ownership of.

Operating Businesses Mixed With Real Estate:  I love this as a place to be Overpaid for Risk.  This is because most real estate players simply refuse to be in these types of deals, which shrinks the competition.  Also, it is terribly difficult for AI to disintermediate these types of transactions.  This is because AI’s weakness is uniqueness, and coupling real estate with an operating business is always unique. 

Data Centers:  This is a feeding frenzy right now.  It is easy for me to say it is a bubble and everyone will eventually get burned, but the fuel for real estate is tenants that pay rent and the AI frenzy that has gripped the world leads me to believe we (definitely, positively, surely, might, possibly) be at the beginning of the next industrial revolution, and that the real estate component of that revolution could be in the data center space.  So, it feels foolish to turn up my nose at it as a bubble – however, it feels equally foolish to rush in.  Synthesizing my trepidation and eagerness, I lean modestly in favor of the data center space as a place to be Overpaid for Risk.  However, I temper this by predicting that savvy players will end up being rewarded, but tyros who jump in without really knowing what they are doing will be humbled. 

Preferred Equity:  This is a wonderful space on its face.  I love the idea of essentially locking in a solid return and giving up some upside.  As savvy investors know, it is more important to avoid losing than to try to win.  However, unlike some of the other items above, I don’t think you are usually being Overpaid for Risk here, because there is just so much competition in the space – plus those taking the preferred equity really hate it and don’t want it, and will avoid it if they can.  Accordingly, I think pricing is fair but not a bargain.  Having said that, if you can find a nice preferred equity deal that pencils out well, I would still advocate doing it. 

….

So, there you have it.  The Real Estate Philosopher’s thoughts about where to be Overpaid for Risk.  Am I right?  As Dr. Seuss said in his famous book, Oh, The Places You’ll Go:  “Ninety eight and three quarters percent guaranteed.”

…

Finally:

On behalf of my law firm, Adler & Stachenfeld LLP – www.adstach.com – I cannot help adding, that every single one of the above investment profiles is deep within our law firm’s expertise. We have partners with in-depth experience on all of these matters and do these deals every single day. 

On behalf of my fund-raising placement agent business, The Useful Bruce, I cannot help adding that the fulcrum of all potential investments that I promulgate to investors is my good faith belief that the investor will in fact be Overpaid for the Risk of the investment.

I wish everyone in my beloved real estate industry the greatest success.

Bruce Stachenfeld, aka The Real Estate Philosopher™