Family Office Real Estate Trends

Good morning, Lisa.

Lisa Cappiello:

Can you tell us what are the major trends in multifamily and commercial real estate that are impacting family offices today?

EisnerAmper Senior Advisor:

Sure. Well, the most important trend is the rise in interest rates. That's having the biggest impact on real estate investments and has for the last six months. As you know, the fed increased interest rates by over 5% in a very short amount of time. And that really is an enormous amount and a very rapid increase in rates, which is translated into higher mortgage rates. And a higher cap cost of capital for real estate investments, means lower yields for investors, because more money's going to the lender instead of to the investors.

Lisa Cappiello:

So, what effect does inflation have on real estate investments?

EisnerAmper Senior Advisor:

Well, we've been writing a lot about the triple threat to real estate, which is higher interest rates, inflation and recession. So far, no recession, and hopefully it'll stay that way. But inflation is the second group and it has had a major impact, primarily through driving up operating costs of properties and the cost of building properties. So, for example, we know wages have gone up significantly, supplies have gone up, and insurance has gone up a lot. And all this has happened over the last year when rental rates are starting to slow down in their growth. So, less revenue, higher expenses, and that means that cash flow is being squeezed at many properties.

Lisa Cappiello:

When you put it all together, what does this mean for real estate investments?

EisnerAmper Senior Advisor:

Well, it means, as I've said, that yields are going down and cash flow is going down at many properties. And when that happens, values go down. So, right now, we're in a value decline trend. We're kind of in the middle. We don't know how long it's going to last, and we don't know how far down it's going to go. But obviously, when values are going down, investors are reluctant to invest, because they don't want to invest in something today that six months from now is going to be worth less. And lenders are pulling back too, because the lend on collateral value and that's uncertain.

So, there's a tremendous amount of uncertainty in the market right now around valuations. And as a result, transaction volumes have really slowed down. And the other thing, of course, is lenders are pulling back. And the combination of those two means things are in abeyance right now. And because there's no transactions, we don't really know what things are worth. And because we don't know what things are worth, we don't have transactions. So, we're in a vicious cycle at the moment.

Lisa Cappiello:

What are the ways family offices invest in real estate? And since some invest directly and others are passive investments, how are they impacted?

EisnerAmper Senior Advisor:

Yeah. Well, there's two groups of real estate family investments. One is the real estate families themselves, the ones who are in the real estate business and who have been building properties, or investing in properties and managing them for years. So, they obviously have the same challenges as everyone else. But because they operate the properties, they have day-to-day data on what's happening. They know what's in the marketplace, they have relationships with their lenders, and they can manage the properties to try to be successful in these difficult times. The other group of the family offices who are not in the real estate business, but instead have allocated a portion of their investment portfolio toward real estate. And some of them do do direct investments, but most do passive.

And so, they might invest in funds or in private equity individual deals with sponsors that are syndicated, a variety of different avenues. And as a result, they don't have direct access to all the information. They're reliant on the fund manager or the sponsor to give them information on a timely basis, so they can monitor their deals and know how their risks have changed. And as a result, what we need is a lot more communication with the sponsors and fund managers.

Lisa Cappiello:

So, do you feel that family offices have good information on their real estate investments and what additional information would benefit these family offices?

EisnerAmper Senior Advisor:

Well, typically, in a normal market, they had pretty good information, although it definitely varied by sponsor. But today, that typical information is no longer enough. It's insufficient to really understand the added risks and what's going to happen with the property going forward.

Lisa Cappiello:

I see.

EisnerAmper Senior Advisor:

So, they need a lot more information today about the property performance, about where rents are going, about where expenses are going, as I mentioned earlier. And they really need to understand what's happening with the debt. Is their debt going to mature? Is it floating rate debt? What's happening with that? And are there hedges? And really, given everything that's going on in the market, is the original strategy that they went into still the strategy today? Or is the sponsor going to change the strategy because they maybe can't effectuate the original strategy, they can't realize value add play where they were going to invest in the property and raise their rents? Maybe you can't realize that today.

Or maybe the idea was in the third or fourth year they were going to hit some goals and then do a refinance. The investors would've cashed out, gotten their capital return and goosed their yields. But today, you can't do that, because you really can't refinance easily. So, the strategy is changing, the cash flows are changing. And the more, again, dialogue that the family office has with its sponsors, the more they'll understand what's going on.

Lisa Cappiello:

So, what are the biggest trouble spots that family offices should be concerned about today with real estate investing?

EisnerAmper Senior Advisor:

Yeah. Well, unfortunately, there are many, and I'm going to talk about the three big ones. The first one is the office sector. And that's not news to anybody. Everybody understands that there's been a structural change in demand for office with hybrid work. We see work from home declining to a certain extent, but hybrid work is definitely increasing and it's here to stay. Now, it does vary by market and by industry, but all owners of office have to deal with this. And so, if a family office owns an office property, they're going to want to ask again, what's the change in strategy? What are they seeing with the tenants? Are they starting to sublet space? Have they indicated they want less space? Maybe it's so bad that the sponsor says, "We may have a different strategy for the building, maybe we'll convert it to a different use," et cetera.

And what's going to happen particularly in office when the debt comes due? And is it worth continuing to have this property and invest in a refinance, or are we going to let it go? And you've seen headlines all over recently of major institutional investors giving back their office properties to the bank. The next area is those refinancings, it's debt maturities. And the investors really need to know, when is the debt going to mature? And the reason is, one, because with higher interest rates and stricter underwriting guidelines, a lender is going to give less debt for the same property than you probably got when you did the loan 3, 5, 10 years ago. So, with the loan to value ratios coming down, say you had a $50 million loan on a retail property, today, maybe the bank will only give you $40 million. And so, what's changed is you have to put money into the deal.

And it used to be for the last 10 years, refinancing was easy and with every refinance, you took more cash out of the deal. So, now instead of cash out, it's cash in. So, the family office investor expected to get, the original plan was to get a nice chunk of change maybe in this year. And instead, when the loan comes due, there may be a capital call and they'll have to write a check instead. So, it's a very, very different dynamic for the passive investor. And then the third key change, which I mentioned before, is floating rate debt. And if you had a floating rate debt and you didn't have a hedge on it and there was no cap or anything, you've probably already seen your cashflow disappear, because the property cashflow is now going to the lender instead of to the investor.

Most deals did have hedges, whether it was a swap or a cap. And of course, if you're a family office passive investor, you probably weren't asking a lot of questions about that over the last years, because it wasn't really in people's minds. But now we may have a situation where there is a cap coming due and you have to re-up the cap. And that's going to take cash away from the investors, because it is hugely expensive to re-up that cap at this point.

Lisa Cappiello:

While we are talking about cash, what is the impact on anticipated distributions, and cash flow, and what should family offices be doing to review their real estate investments?

EisnerAmper Senior Advisor:

Well, most family offices go in with one of a few goals in real estate. One might be cash flow. They want a bond like yield, or they want a property that has tax efficient cash flows. And so, that obviously we talked about could be impacted here, where the cash flows don't come through. The next is they want outsized returns, maybe returns that they didn't think they could get in fixed income and equity investments. And so, they allocated this portion of the portfolio to that and those returns now might be eroded. And the third area is an inflation hedge. Many people will go into real estate for inflation hedge, but the problem today, of course, is values are declining, not going up as expected, and rent growth is declining as well. So, to make it a real inflation hedge that you've got to have rent growth, that's at least beating the inflation rate, which right now in most markets and property types, it's not.

So, what can happen when you put all this together, there is an industrial deal that I just looked at recently, and this was the darling of the industry, to buy industrial. And this was perfect industrial, a triple net lease in a great location. And the tenant, single tenant is Amazon. So, you can't do better than that. It's a long-term lease, everything is great, but it was done a few years ago with a floating rate. And so, the investors, like the family offices probably weren't asking at that time, what do we do about this floating rate and how are we hedging it? So, what happens now is we're three to four years into the deal, the hedge is going to expire at the end of this year. And so, the bank basically said, "I'm going to sweep all the cash from the properties throughout the year to ensure that you have enough cash at the end of the year to buy a new hedge."

And so, that means that in this really airtight industrial investment, the investors are not going to get any distributions this year. So, that's the kind of surprise that you can have. And the key is it's not just an office, it's even in industrial, which should have been airtight. So, what do you do to deal with all this? You need to have an action plan. And as I mentioned, they need to be talking with the sponsors or the fund managers and understanding the analysis of the property and the debt. And I think it's really important that family offices ask their sponsors to run a new model. The cashflow projection going out at a property level, the debt level, and the waterfall, with all the assumptions updated for current market conditions and the anticipated strategy going forward, if that strategy is going to change. And that new model will give them and their families an understanding of where these investments will go.

Lisa Cappiello:

So, with all of these uncertainties, are there still opportunities for family offices to invest in real estate and what should they now focus on when doing this real estate investing?

EisnerAmper Senior Advisor:

Absolutely. There's always opportunities to invest in real estate, and particularly in times of distress there's great opportunities. If the family office has the risk tolerance to do it, there's great high return, high risk investments out there. And one of the areas is what we call rescue capital, which is filling that equity gap I mentioned before. And it's very common actually right now, that a lot of family offices are doing that kind of rescue capital investment. They get great returns. And they need to closely monitor the risk, of course. And they can also, of course, invest in debt funds or distress debt funds. And lots of funds are being formed just for this purpose of taking advantage of all the distress out there.

But beyond the distress, there's just normal opportunities in real estate always. Self storage still has great opportunities. Certain segments of the retail segment have opportunities. Resort hotels are looking very good today. So, the key thing is you got to pick your spots. You have to have a very, very targeted investment thesis, and you have to do a lot of due diligence. You have to build that model and you really have to stress all the assumptions. That's what we're telling all our clients. You build a model and you stress test every single assumption to see what happens to yields, because you want to make sure you've got an airtight investment.

So, for example, I recently looked at a development in the western part of the country, great market, growing market, super demand, multifamily, beautiful design, everything terrific. And we got the model and we start stress testing it. You pick up the cap rate, you lower the rent growth a little bit, and we found the yields were wiped out right away. So, you've really got to do your homework if you're going to invest in this market.

Lisa Cappiello:

So, with all of this information, what should the leaders of the family offices be communicating with their family members?

EisnerAmper Senior Advisor:

Well, the key in working with family offices for us is always keeping the harmony of the family and making sure the family stays together without conflict. And to do that, communication is essential. And so, our main focus is lots of communication between the leaders and the rest of the family, explaining what's going on, investment by investment if necessary. This is how the market changed. It wasn't that they made bad investments, everybody got caught, but understanding the market changes had these results. And because of that, your yields and cash flows are going to be impacted.

And it may be that just like we need more reporting from the sponsors and the funds, we need more reporting within the family office itself to take all that disparate information from their portfolio investments, and convert it into dashboards and other reports that the family members can see. So, they know what's going on going forward. And the more they know, the less surprises and hopefully the less conflicts, and everybody will have a better understanding of what's ahead.

Lisa Cappiello:

That was some great content. Thank you so much for sharing your insights on this hot topic. Family offices clearly need to be more diligent in monitoring their allocation to real estate, obtaining the necessary information to ensure the best investment decisions, and they need to be aware of the new risks that impact cash distributions and cash flow. Thank you for joining in today. And please visit our website where you'll find an abundance of information on family offices and real estate.

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