It was more than four decades ago that legendary investor Sam Zell detailed the "risky art" of resurrecting properties in his letter 'The Grave Dancer,' but his insights have never been more prescient.
Today's economic landscape in the U.S. echoes that of the early '80s, as we grapple with a combination of rampant inflation, tightening credit availability and soaring interest rates not seen since that era.
As one of the most highly levered sectors, CRE is confronting an existential crisis. CRE asset values have already declined significantly yet are hardly out of the woods. CRE's long-standing dependence on debt has left it highly exposed to the formidable threats posed by a rapid escalation in operating expenses, dwindling access to credit, and a substantial rise in interest rates — obstacles that are likely to persist for the foreseeable future.
In the decades since Zell's letter, the risks he warned of have only been exacerbated by the proliferation of financial investors who are bringing a trader's approach to CRE by employing high leverage and complex capital structures. In trying to eke out short-term gains from CRE, they have burdened the assets with excessive debt and created a web of challenges for investors to navigate.
The art of bargain hunting in CRE demands the virtues of patience, precision and a steadfast commitment to invest with a substantial margin of safety — principles fundamental to a disciplined value investor. Discerning assets that are hidden gems from those that are value traps requires investors to have a keen eye for subtle intricacies: Many assets are broken, but not all are fixable.
It is essential for investors to recognize that the real challenge is not just in identifying whether an asset is cheap, but in understanding why it is cheap; unfortunately, many investors overlook this crucial "why" factor. In doing so, they inadvertently fall in the value traps. They may not realize their mistakes during prolonged periods of easy access to cheap capital, but the road ahead will cast light on how deep and inescapable that hole may be.
For instance, hidden gems may experience temporary distress, stemming from issues like over-leverage, fractured ownership (e.g., liquidating funds or operators no longer motivated to perform due to being out of the money on performance fees), or the need for significant capital injections.
To effectively find attractive opportunities in today's market, investors need to assess each asset through a credit lens by asking three critical questions:
- Is it cheap? Investors must consider whether an asset is a significant discount to replacement cost, liquidation value, and comparable trades during stressed times.
- Why is it cheap? Investors must weigh whether an asset truly serves a purpose in the market, is well-located to generate sustainable demand, and has a history of generating free cash flow and profitability. True gems are protected from obsolescence and benefit from competitive advantages or barriers to entry in the market. Even a suburban office building may be a hidden gem if it is well-located, has strong credit tenancy, high demand with both existing and prospective tenants and returns capital early through high yielding cash flows. Investors must ask why tenants are attracted to it (e.g., is it mission critical?) and whether the contemplated acquisition price would still be attractive in the worst case scenarios (e.g., tenants vacate or a recession). Importantly, investors cannot call the building cheap even if it is at a significantly lower price compared to a few years ago, as market occupancies, rents and cap rates have all meaningfully deteriorated.
- Is the return profile asymmetric? Even a deeply undervalued asset may not be a good investment. While analyzing potential downside scenarios (such as tenant vacancies or economic downturns), investors can get a clear picture of an asset's true potential risk-adjusted returns. This also means determining how favorable the potential upside is compared to how well the downside risks are boxed through scenario analyses.
Investors must be willing to wield their sickles to dissect the elements shaping an asset's valuation, separating the wheat from the chaff — identifying prospects for resurrection while skillfully sidestepping the treacherous pitfalls of value traps.
The road ahead promises a generational opportunity set, but value investors must remain exceptionally disciplined, scrutinizing each opportunity through a stringent credit lens while embracing the dance with significant uncertainty and volatility in today's market. As Sam Zell warned us decades ago, "The investor in distressed property walks a thin line between the extremes of success and failure."
Vik Uppal is the founder of the investment firm Mavik Capital Management. He is based in New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.