IMS recently hosted a webinar discussing how to access and deploy capital efficiently in CRE. Noah Miller, VP of Acquisitions and Finance at Pensam Capital, joined Ron Rossi, VP of Business Development at IMS, to talk through the benefits of open-ended funds and closed-end funds, the advantages of debt versus equity, how to issue an effective capital call, and how technology can be leveraged to more efficiently access and deploy capital.
So why is this such a hot topic? Well in a 2018 survey, almost 2/3 of CRE sponsors indicated that they would like to increase the amount of capital they deploy, yet some are struggling in the execution. Many of these firms demonstrate a willingness to embrace disruptive technologies that address these roadblocks and changing market conditions, but they are not always sure how to do so effectively. Noah and Ron laid out a roadmap for successful capital deployment and outlined some industry best practices.
The webinar kicked off with a market overview. After Ron shared that 64% of CRE sponsors intend to increase the amount of capital they deploy, Noah offered market insights from a sponsor’s perspective and discussed several ways that lending and acquisition activity is changing.
First, it is more difficult to find deals. Rising borrower costs and higher interest rates are chipping away at possible ROI, making profitable deals more competitive. Further, emerging firms that lack market expertise are bidding up deals. As Noah puts it, “What we’re seeing is a lot of new groups who are raising equity from various different sources: family office, high net worth individuals, internationally … they’re coming in with guns blazing and really bidding up properties.”
Second, lenders are reducing their exposure to property types that are more vulnerable during downturns. Noah’s prediction for 2019 is that it’s going to look very similar to 2018, with relatively flat yields and increasing rates. These trends make it more important than ever before to have capital readily available to stay in the game and acquire properties that may be bid on by 35 or more firms.
Ron then named the top challenges to getting deals done:
1) The gap between buyer and seller expectations
2) Competition in the marketplace
3) Limited transparency
The speakers briefly touched on value-add opportunities, with Noah advising that there should be greater emphasis on management value-add. “At the end of the day, this is someone’s home. […] You need to make sure that your management is much superior to your competition. That’s where you keep tenants.”
Open versus Closed Funds
The speakers moved into the topic of funds, discussing the pros and cons of each. Noah said that Pensam Capital prefers to work on a deal-by-deal basis but that newer firms may find advantages in funds because they have more assurance that they can fund their purchases. “The last thing you want to do, especially as a new owner operator, is tie up a deal, have 30 days to raise the money and then need to back out of the deal because you can’t raise the capital.”
According to Ron, the pressure to deploy capital that comes with closed-ended funds can lead to a lower risk tolerance or yield expectation. Open-ended funds come with less pressure to deploy. The infinite life of the fund, open shares, and opportunistic nature makes it a preferable option for many. “There’s less of those outside pressures to really make sure that the business plan is sound and that you’re executing according to that plan in a timely manner.”
Debt versus Equity
Ron laid out the three definitions relating to debt and equity:
- Debt – borrowing capital to finance the purchase of a property
- Preferred Equity – cash that is typically deployed for a reposition or value-add
- Equity – cash contributed towards the purchase of a property in exchange for an equity share
Debt comes with the benefits of being readily available, having tax advantages, offering lower interest rates, and potentially generating greater rewards. However, there is more risk and a prepayment penalty, creditworthiness must be considered, and documentation can be an obstacle.
Equity offers flexibility in repayment timing, commitments, capital contributions, and a solid cash flow. However, the accountability, loss of control, and profit sharing are the downside of this capital source.
Noah praised the combination of debt and equity, but he cautioned against possible losses for those less experienced. “We have seen a lot of people become very successful putting debt and equity together and also a lot of people who have lost real estate deals and had to give them back to the bank because they don’t have the right divide of debt and equity.”
Effective Capital Calls
Pensam Capital always models on the conservative side to avoid issuing a capital call, but sometimes a capital call is necessary. And both speakers emphasized that capital calls are not necessarily a bad thing. Ron explained that leveraging technology to manage capital calls during the life of a deal streamlines the process. Notifying investors can be done all at once without having to make individual contact, paperwork can be submitted and managed digitally, and investors have all the information they want in one place to determine whether to fund the call. This transparency may increase the likelihood that investors will choose to recommit.
As more Millennials get involved in real estate, leveraging technology becomes increasingly important. Noah mentioned that Millennials watched the stock market dip, and because of this they fear the volatility of stocks and prefer real estate because it is backed by a hard asset. Crowdfunding lowers the barrier of entry, creating opportunity for Millennials to bring more capital to the market.
Noah recommends that every group spends a lot of time and focus on CRE technology, which offers benefits including increased back office efficiency, higher investor satisfaction, effective access to capital and a consolidated tech stack. He says that Pensam Capital prefers to work with groups that have adopted CRE tech. “It just makes everyone’s life much easier.”