CSQ Analysis of recent CRE article in the WSJ

Hello Partners,

Recently, several of you sent me an article “A Real Estate Haven Turns Perilous with Roughly $1 Trillion Coming Due”.  I’d seen the article and I appreciate those who also sent me a copy.  After reading it I knew that there would be concerns and questions and I hope to address most of them in this email.

https://apple.news/A086hePAQRGuW4jWRpwHItA

What we try to do at CSQ is very different than what most RE funds and REITs are doing.  We are not in the “fee game” and our benchmark is not just producing a published rate of return.  Most of our deals are development deals, the preferred interest the deal pays to investors is basically a road map to a total return.  It really only comes into play if the project dramatically underperforms our expectations and limits the sponsors ability to get a return until investors are paid that minimum pref. interest.  Our business model is to attempt to provide outstanding returns substantially above market returns while looking to minimize risk. CSQ does not “live” on the upfront fee’s but participates in the back end only after investors have earned their returns. 

Some specific points to the article:

“Investors bid up the prices of multifamily buildings for years” 

 This is true and it’s what we hope for.  We don’t buy finished projects, we develop our own, effectively building wholesale and selling retail to those people that will “overpay”.  The reason we only did two deals in 2022 was because prices were too high.  I was seeing deals offered at a 3.5% cap rate, we passed on those.   In the Compass Pointe project, we paid less than $15,000 a door for the property. In Maybank we paid less than $20,000/door; we were offered the equivalent of $60,000 per door for it a few days after we closed. 

“The apartment sector’s main problem isn’t a lack of demand-rents have soared-its interest rates”. 

 Again, I couldn’t agree more, rents are much higher, but interest rates are the key right now. Some of our deals have had to deal with higher rates but many also have rates that are way below current market, Seascape at 3.375% and NJCU at 5.75%.  Our other construction projects mitigate the higher intertest expenses by locking in rates via a swap or cap, raising additional capital and relying less on leverage. 

“Borrowing costs have doubled, rent growth is slowing and building expenses are rising.” 

 Again, all true.  This is why we either purchase an interest rate cap or enter a swap.  The rate we have for our latest Savannah deal is 6.16% fixed for 5 years.  We get this by lowering our debt to only 60% and our developer personally guarantees the loan.  The debt on all our completed projects is fixed. Rent growth in any of my proformas is 3% even when I know growth in that market is much higher.  Building expenses are higher, and that’s why on most of our projects we demand a Guaranteed Maximum Price (GMP) contract, it’s not all inclusive, sometimes there are carveouts, but it gives us some level of certainty.  In Compass Pointe we went a step further and negotiated a Fixed Price Contract which has no carveouts, the final price is certain and non-negotiable.

“MF building owners in Los Angeles, Houston and SF have defaulted on thousands of apartments.”  

I’m guessing most of these owners overpaid at the height of the market. I would also bet they’re not the builders of these projects. Overpaying is the greatest mistake you can make.  We do everything we can not to fall into that trap.  We are always very conservative in our assumptions, and we build in locations that are experiencing dramatic population and job growth like Savannah Ga and The Leland/Wilmington NC locale is the fastest growing area in the entire state. 

https://www.townofleland.com/news/leland-ranks-fastest-growing-town-nc

“Inflation allows landlords to raise rents higher than usual.” 

This is absolutely true and the reason why pension funds, insurers, and private equity all look to purchase stabilized multifamily assets.  Once your building is completed inflation is your friend allowing you to raise rents and making the cost of replacement that much higher.  It’s the only asset I know where you can depreciate the book value for tax purposes while its actually appreciating in the marketplace.

Multifamily commercial real estate has outperformed the S&P500 over the last 25 years and as the article mentioned this asset class also performs well during economic slowdowns, especially student housing.  Populations are being pushed into rentals due to a lack of affordable, single family home supply and higher interest rates.  Despite this impressive performance I still wouldn’t put my last penny into this asset class but instead use it as a way to diversify my holdings with little correlation to the overall stock markets.  The difficulties that developers are having now with costs are forcing them to abandon deals.  The coming lack of supply in the next few years is exactly what we saw more than a decade ago and bodes well for the values of our completed projects in the near future. 

“Be greedy when others are fearful” Warren Buffet