For this week's edition of Person of the Week, MortgageOrb conducted a joint Q&A with Jonathan Dracos and John Fraser, co-heads of the real estate group at Investcorp, a private-equity real estate investor active across multiple commercial property types. Although the commercial real estate investment community is undeniably more cautious these days, according to these executives, many opportunities are also available for those who know how to take advantage of conditions and are probably not highly leveraged buyers.
Q: A recent report from PricewaterhouseCoopers emphasized a ‘palpable uncertainty’ seen right now among commercial real estate investors surveyed. Do you see this type of attitude among the commercial real estate investor community? In what ways? How many are on the sidelines right now due to market conditions?
Dracos & Fraser: The market has transitioned from one characterized by an abundance of relatively inexpensive debt to what it is today – a market characterized by constrained debt availability at much higher prices. This change has sidelined a number of the more highly leveraged buyers.
Against the backdrop of a slowing U.S. economy, many real estate investors, including Investcorp, are taking an increasingly cautious approach to the market. After the credit crunch hit, we were quick to adjust our underwriting and adapt to the new market paradigm, and because we have never been a highly leveraged buyer, we have been able to continue buying – albeit selectively.
Like many, we have seen slower transaction volume in our business of direct equity investments in real estate transactions. However, we remain an active bidder and have been able to leverage our strong operating partner and lending relationships to successfully complete a number of transactions over the last nine months.
Conversely, transaction volume has increased in our business of originating and acquiring debt. Here we have been very successful in buying whole loans, mezzanine loans and commercial mortgage-backed securities (CMBS) at a return profile we consider attractive.
Although liquidity appears to be slowly returning to the markets, there is still a gap between what buyers are offering and the prices sellers are willing to accept. We expect that it will take some time for this gap to fully narrow and for the market to reach its new equilibrium.
Q: In general, how have your sector preferences shifted over the past year or (pre-credit crunch and afterward in particular)? Which commercial property types now pose the most cause for concern?
Dracos & Fraser: As a value-oriented private equity investor, we pursue a broad range of transactions without a bias toward any particular investment profile, property type or geography.
We do not actively seek to capitalize on sector plays; rather, we look to make smart investment decisions across a broad spectrum of areas. However, we have been involved in the business of originating and acquiring mezzanine and mezzanine type debt for several years now and have significantly increased our focus in this area over the course of the last nine months.
We do not have significant exposure in for-sale residential, an area where market fundamentals are relatively soft. The commercial markets – including office, hotels and retail – are stronger and continue to perform well, albeit with some downward pressure in light of softening U.S. economy.
Q: While obviously nowhere near the levels seen in residential, how much of a worry are commercial mortgage delinquencies? Are the recent upticks seen considered meaningful? Do you expect the rates to rise much further?
Dracos & Fraser: We are watching the market very closely. To date, we have not seen a material increase in distressed sale situations or loan defaults, although anecdotally we are hearing that a number of banks and loan servicers have increased the number of loans on their watchlists.
In contrast to the last commercial real estate cyclical downturn in the early 1990s, which was characterized by significant new supply amidst softening demand, the operating environment today is different. Today, occupancy levels remain high, new supply is fairly limited, and demand remains relatively good.
As a result, real estate assets today continue to generate a level of underlying cashflow that smart investors are able to underwrite and use to structure good investments. Having said that, we do expect to see projects with relatively high leverage and near-term loan maturities begin to come under pressure.
Q: Your business approach for commercial real estate investments notes that ‘a smaller number of investments fall into either the 'core' or 'opportunistic' investment categories.’ Has the current environment affected the number of investments in that opportunistic category? In general, is this a good time for these types of investments?
Dracos & Fraser: In general, we believe the current market transition presents opportunities for Investcorp's debt and equity investment businesses. As market conditions change, we adjust our investment focus. So, rather than concentrating on only one property type, region or investment profile, we are pursuing a broad range of transactions with attractive risk/reward dynamics.
This approach is evident in our investment history and current portfolio with assets ranging from value-added to opportunistic in existing product and new development situations, using common equity, preferred equity, mezzanine debt or a combination. The expansion of our debt business is an example of our adapting to a changing market.
Q: What is the role of international real estate investors in the U.S. market right now? How much of a factor is the weak dollar? Any differences in attitude toward risk? How might the foreign investor presence affect the practices of domestic investors?
Dracos & Fraser: Foreign investors deploying capital in U.S. real estate is not a new trend. The weakening U.S. dollar has certainly increased the relative attractiveness of U.S. investments to many foreign buyers, but this is by no means the core driver.
Our primary clients, for example, are ultra-high net worth individuals and financial institutions located in the six countries of the Gulf Co-operation Council (GCC) in the Arabian Gulf. The countries are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.
But in addition to our network of clients in the Arabian Gulf, we're currently broadening its capital relationships to include an increasing number of investors from the U.S. and Europe. Our clients are not ‘moment-in-time’ investors and are not looking to the U.S. market today as a currency play. Instead, our clients are looking for an attractive risk return profile over a medium- to longer-term holding period.
