The US commercial real estate outlook for investors
CIARAN RYAN: With interest rates rising in the US there’s been a lot of talk of the property market softening. Where will it go from here? Has the interest-rate cycle in the US peaked?
Well, there are pockets of real estate that appear relatively immune to this market cycle, one of them being the medical commercial real estate sector. Joining us to discuss this is Justin Clarke, who is chief operating officer at OrbVest. Hi, Justin, good to have you on. What is the real estate market doing in general in the USA, given that intro that I just went over about rising interest rates? How is the medical commercial real estate market surviving under these conditions?
JUSTIN CLARKE: Yes. Great to be online again. I think following our last conversation it’s been pretty interesting. Inflation in the US is really crazy, it’s the highest it’s been since the eighties, and of course the Fed [US Federal Reserve] is reacting, and interest rates are obviously increasing, in order to try and control these inflationary courses. There are a couple of things that I see in the news quite recently, specifically an article on Bloomberg [on Saturday], [which is] very strong evidence that inflation will normalise pretty quickly – and by the end of the year, which I think is quite interesting. We certainly have been planning for it to be a high-inflation environment, certainly for the next 24 months or so. But it seems like measures being taken by the Fed are certainly already biting.
Interesting[ly], in the construction sector one of the real indicators is the cost of lumber – as they call it over there – or timber for us, and that price is plummeting. Obviously after Covid there were a lot of people doing activity, building on, doing alterations to their homes, etc, and the prices rocketed obviously with the additional supply-side pressures. So I think that’s a good indication of the fact that these Fed measures are clearly biting very, very hard and very quickly.
At the same time, it’s quite interesting that we are also seeing large capital inflows – into the commercial real estate sector specifically. I can touch on residential for a second. There is an interesting scenario in the States that there is actually not a lot of supply of second-hand real estate on the market. So we are not having much of an impact on real estate prices at this point although, if you look the indicators, you can see that new home loans to certainly the sector below $600 000 to $700 000, those type of home loans are very clearly dropping off quite dramatically, so people are not applying for new debt.
But a lot of refinancing happened in the good days when interest rates were low, especially just after Covid, so I think again that we must understand that in context.
So, especially in our sector, in the medical sector and there are others – industrial I think we talked a little bit about last time – there is an enormous amount of interest and cap rates have remained super firm. That means that buildings really haven’t followed the interest rates and reduced in value. If anything, they’re still increasing in value, especially in the medical environment. We find that certainly when it comes to the big Reits [real estate investment trusts] etc, they are still aggressively acquiring the attractive assets. They are going for any building that’s got nice long leases and has good escalation, etc.
So there is absolutely ongoing demand for these types of commercial industrial properties, and of course [they are] considered by the smart money to be an inflationary hedge. So all this money moving out of markets, effectively, and moving into commercial real estate, is having a kind of double whammy on us, if you want to call it that. Interest rates [increasing], so costs are going up, taxes and remedial work that you do in the building costs are going up, and at the same time the price of new building costs are going up. It’s a very interesting scenario for the commercial real estate space.
CIARAN RYAN: If I can just circle back to what OrbVest itself is offering, it does raise a question. You’ve been giving us this background about the real estate market in the US – why not invest in publicly traded Reits or real estate investment trusts in the USA? What’s fundamentally different about what you are doing, what OrbVest is doing?
Register for the upcoming OrbVest webinar: Commercial real estate trends in the USA
JUSTIN CLARKE: I think there are two main differences. First of all, it’s volatility. When you are investing in US Reits, you are very susceptible to ‘Mr Market’, the ebb and flow of the market. I like to quote one of the largest trading Reits in the US, American Tower Corporation, which I was actually looking at [on Saturday]; it’s trading at US$223/share, which is exactly where it was at a peak in 2019. So it has kind of recovered quite strongly. But it consistency pays a dividend of around 2.2%. That’s considered an okay return for people looking for stable returns, but if you want to sell, make sure that you sell at the top of the market and not when the market sentiment turns against that particular Reit.
The difference is of course [that] our products are normally limited to a small portfolio or a single building where we have long-term leases that almost guarantee the income of that particular property.
So it’s kind of ring-fenced to a much smaller sample of property and our cash-on-cash dividend.
Just to give you an idea, across all our portfolio over the last six years – and that’s up to the end of last year – it was 7.3%, including some of the older opportunistic buildings that we acquired right at the beginning that have obviously not performed as well, partly as a result of the big Covid hangover.
So I think to nail it to two things: one, your return is going be considerably lower, your cash on cash. And, especially for South African investors, we kind of are in a higher return frame of mind because our interest rates are higher. So we are kind of comparing it against returns that we would get in rand.
Think about it: 7.3% in US dollar terms is actually a really, really good return. And that’s for cash on cash. There is obviously the additional benefit that we have a limited investment period, normally five years, and at the end of the five-year period, when we sell the building, any capital growth we obviously share with investors. So that pushes that 7.3% up to our target range of above 10%. So 10% in US dollars as opposed to your Reit, where you are speculating with the market and at the same time earning a very low dividend.
CIARAN RYAN: That sounds very good in US terms. Now, if you invest in a single building like you are offering, and that building doesn’t perform the way that you expect it to, do you have the benefit of a blended return across a broad portfolio?
JUSTIN CLARKE: Yes. That’s absolutely true. It comes down to our early days when we started to acquire these buildings. I think I’ve told the story before, but originally any good South African, who has a huge portfolio that [they] can build in South Africa, started to acquire these buildings. Initially it was just with a couple of large, very astute property investors who were ultimately looking at big returns. So we sought out buildings where there was repurposing required.
Let’s say that it is a building with a large amount of vacancy, or it’s got some old commercial tenants on low leases and a core of medical tenants. You get rid of the commercial tenants, you put the medical tenants in it, [and] it automatically adds value to the building.
It creates a synergistic relationship between those doctors, and it becomes a very, very strong asset. So obviously there is risk there, because you’ve got all commercial tenants that have been affected, for example by Covid. But at the same time with risk comes reward.
I must be very clear here, Ciaran, we have learned that we actually have no appetite for risk and certainly our investors don’t have. Predominantly people from the third world, South Africa, want to make sure their money is kind of safe and ticking over. So now we only do what’s called in the US ‘core’, ‘core plus’ and ‘value add’. Core is really just a building [where] you are buying the income stream. There is a solid credit tenant who’s paying the lease over a long period of time. We call it the Walt, ‘weighted average lease term’. This is generally a slightly lower return because these are more expensive, but you know you are going to reach a dividend over the period of the investment and a bit of a kicker at the end. So that’s what we prefer.
The thing is that people say: ‘What would you put your granny into?’ We’ve developed a product especially for our sort of evolving market, which is a little portfolio of all our existing buildings that will probably be spread – ODH 5 is the one that’s currently available. There’ll probably be 100 tenants and 20 buildings across multiple states once it’s fully deployed.
That’s the kind of product that I’d put my granny into, and we’re talking about a 7% cash-on-cash and a 10% RoR [rate of return] over the period of the five years.
So I think that’s kind of where we are going, moving away from the slightly higher risk, if I can say – single buildings that are more opportunistic.
CIARAN RYAN: Okay. Talking about these value-add deals, your next offering is due to launch next week in Albuquerque, New Mexico. Why Albuquerque?
JUSTIN CLARKE: This is a great topic. I think for South Africans we kind of know California and New York and we actually expect these big cities [to do well]. But, first of all, cap rates in New York – even at this particular time – and California are very low, which means you pay a huge premium for these buildings. If you’re really looking for good returns, you have to also look at the underlying fundamentals of that state.
There is this interesting phenomenon, which I’m sure all of your listeners will understand, that there are people moving out of the likes of the east and the west coasts towards the ‘Smile’ states – specifically Arizona, Florida, Texas. There’s this movement of people and capital and businesses out of the east and the west. These are very interesting growth curves.
If you are investing in commercial real estate and you’ve got an accelerating economy and a growing populace, the wind is behind you; you can’t really go wrong.
So we came across the deal in Albuquerque, which is in a state called New Mexico, pretty close to Phoenix, Arizona, which many will know is an absolute growth story – and we kind of like to follow the smart money. So we see where the big investments are happening, and Albuquerque has a pretty low cost of running a business. [These investors] are very dynamic in their thinking in terms of attracting investments, and there has been a huge amount of cash piled into Albuquerque recently, such that there is very little vacancy of offices, and in fact medical offices are down to 2.5% vacancy.
Really the ones that are vacant are offices that may be B-grade, not really lettable. So basically demand exceeds supply for commercial medical real estate.
The investment going into Albuquerque is crazy. If you look at it, Netflix is building a whole studio here in excess of a billion-dollar investment. Facebook is putting up their new data centre there. Intel is, I think, investing around two to three-and-a-half billion dollars in their latest plant. So you can see this is a state that has really strong fundamentals and it’s kind of picking up a lot of overflow from corporations and companies that want to take advantage of the investment opportunities there.
So yes, that’s a fantastic growth city. It’s a great building that we were able to buy for the right price.
CIARAN RYAN: Okay. I see that you are having a webinar with Moneyweb’s Simon Brown on Wednesday, June 8. You’re going to talk about this topic in more detail. So how do listeners get registered for that?
JUSTIN CLARKE: Yes, absolutely. Your colleague Simon will be billing ourselves and Martin Freeman, our CEO, and the team in the US. I think we’ll cover a little bit about the US economy directly from Martin, and of course get into a little bit more detail on the Albuquerque deals – why it’s a great investment opportunity. There are a number of ways that you can do it. There will be various social media campaigns, I think, on Moneyweb. And otherwise, if you want a simple solution, you can email me directly: Justin@orbvest.com, or you can just email email@example.com and we’ll certainly register you up for that webinar on the evening of Wednesday 8 June.
CIARAN RYAN: Right. So that’s Justin@orbvest.com, which is O-R-B-V-E-S-T. com. Justin Clarke we’re going to leave it there, but we look forward to this webinar with Simon Brown coming up on Wednesday, June 8. Thanks very much for joining us, Justin.