I hope you are doing well, and that you and your loved ones are staying safe. I know this is a challenging time for everyone personally and we face a period of continued challenge and uncertainty. The purpose of this letter is to provide some insight into how we think about investing in this moment and moving forward. I have held off on sending this because our organizational focus has been on managing our existing portfolio. We have dedicated more internal resources to the asset management team, distributed sector updates, and are in the process of distributing operational updates for all your investments. We will continue to prioritize maximizing value on existing investments, while looking forward for new investments as disruption creates opportunities for outsized returns.
I will start with the thoughts of two men wiser than me. The first is a quote from 18th century banker Baron Rothschild (of the famous banking family) that you may have heard: “Buy when there’s blood in the streets, even if the blood is your own.” The language is dramatic but the point is simple – buy when others are afraid. It also hammers home that the best investors are able to ignore sunk costs because past value is unimportant, only future value matters. That brings me to the second piece of more contemporary wisdom from Howard Marks of Oaktree Capital; Marks defines investing as “the act of positioning capital to profit from future events”. This necessarily involves making educated guesses (forecasts if you prefer to avoid the word guess) about the future. The best way to understand the future is to look back at the past, remembering that the precedent is instructive but not definitive.
The Bottom Will Create Opportunity
The most useful information we can pull from the past is often the broadest. A simple example is economic cycles – we have seen cycles of rising and falling economic growth and asset values for so long that we have a very high degree of confidence this trend will continue. As you try to extrapolate details, such as duration of the cycle or peak-to-trough value adjustment, prognostication becomes more unreliable. Starting with the broadest lesson from past recessions, I feel confident saying that we will see a meaningful drop in asset values and that buying at those lower values will create attractive opportunities for investment. I feel far less confident predicting when the bottom will occur and how rapid the recovery will be. The past is less instructive in this regard and our present knowledge is still limited about key factors such as:
- When will a successful treatment or, better yet, vaccine be developed for COVID-19?
- Can the availability of widespread testing help accelerate a recovery even before treatment is available?
- How far will the federal government go with stimulus and how effective will it be?
These factors and many others mean that the range of possible outcomes of the recession and recovery are quite broad. It is tempting to assume that a middle range outcome (a U-shaped recovery) is most likely in this situation, but it is important to recognize that a V-shaped recovery is possible, as is a more prolonged recession (a Nike Swoosh recovery). In practice this means that trying to time the bottom is impossible and that applying some form of dollar-cost averaging—the practice of spreading your investment in a particular strategy out over time so you are less susceptible to buying at a temporarily inflated value—can make sense, especially in the context of private market commercial real estate transactions. Similarly, this can be a time when investing in funds is more attractive because:
- By definition your money will be invested over time rather than at a single moment;
- Investments will be diversified over a collection of deals within the fund strategy;
- Fund managers will be well positioned to act quickly and opportunistically when distressed investments become available;
- Longer hold periods allow fund managers to opportunistically time exits for particular investments to maximize value.
How This Compares with the Last Recession
Recognizing the limitations of historical comparisons, it’s still instructive to look at the Great Recession, which is fresh in many minds even a decade later. Though most industry leaders agreed that real estate values were at their cyclic high prior to COVID-19, the real estate market was not a primary actor in causing the downturn as it was in the Great Recession, when overleverage set the stage for collapse.
The Great Recession ignited a massive credit crunch – loans that were easy to find in 2007 were impossible to source by the end of 2008. Given the relative health of the banking system today compared to the Great Recession, the credit crunch will likely take a different form. That said, not all banks are created equal. While the largest banks have much healthier balance sheets, smaller banks may not be as well positioned. The shadow banking ecosystem, which has matured significantly in the last decade, has a broad range of players, some of which will survive and others that will liquidate. What we can say for certain is that right now many lenders have temporarily pulled back or are out of the market completely. Properties which would have had multiple loan offers at attractive rates are now turning to bridge lenders for higher rates and shorter term loans, often at lower leverage points. We see two immediate opportunities for investment from this situation:
- Bridge Lending – Until banks, shadow banks and other credit actors begin participating in a more typical fashion, providers of bridge capital will have a massive opportunity to lend at higher rates on better deals than they did a few months ago. There is an enormous amount of institutional capital flowing into debt funds right now as a result (Oaktree is raising a $15B debt fund, the largest ever), which by their nature will be focused on larger transactions. There will be a similar opportunity for bridge lenders that are focused on the middle market, where there is less competition and more transaction volume. Middle market bridge lending will be a big focus of EquityMultiple for the rest of 2020.
- Filling the Gaps – Investments that were receiving 70% LTV senior loans may now receive 55% LTV senior loans. This creates an opportunity for gap financing at attractive rates, particularly in the middle market. Mezzanine debt and preferred equity can fill that gap.
One thing that has changed since the Great Recession is who is investing and how. For individual investors, access to private market investments has increased dramatically in the last decade. Most individual investors experienced the Great Recession – and recovery from it – as a moment of acute pain followed by institutional investors and Wall Street capitalizing on the opportunity. Home values and many investor portfolios recovered at a slower speed than the opportunistic returns of professional investors. Fortunately, there has been a paradigm shift in investing, and access to private investments and alpha has flattened. EquityMultiple’s goal during the recession and recovery is to provide investors like you access to distressed, opportunistic and under-valued opportunities.
The Bottom Line
EquityMultiple has always managed our success conservatively and financed ourselves as a company with eye towards weathering the market’s cyclical storms and black swans. As such, we are stronger than ever and here to stay. For our investors, we continue to evaluate new investments on a daily basis and our criteria has shifted with the market. Our focus is on investments that reflect the unique opportunities that changes in private commercial real estate market conditions are creating.
- Funds – The relative appeal of funds is stronger for the reasons mentioned above. Funds typically have investment windows of 1-3 years so funds are raising capital now to invest during a period where asset prices are likely to be attractive.
- Bridge Lending – This is the time when bridge lenders shine and the balance of risk and return lean in the investor’s favor. We particularly like bridge lending funds and are speaking to a range of potential partners.
- Gap Financing – As asset prices continued to climb, much of our focus in 2019 was on preferred equity and subordinate debt. We continue to like those structures but believe we will see some combination of higher rates, lower LTVs and better Sponsors and assets.
- Significant Discounts or Distress – If asset prices go down significantly, equity investments will be increasingly attractive. For now, we are seeing a significant bid-ask spread on deals (i.e., buyers and sellers are far apart on what constitutes market value), leading to lower transaction volume. We continue to actively engage quality Sponsors so we are poised to act when they find a distressed or discounted property and need equity capital.
- COVID-19 resilient business plan – Not every property type has been or will be impacted equally by both the spread of the virus or the government’s reaction to it. An industrial facility with Amazon as a tenant is fundamentally different from a hotel. Special consideration will be given to properties that are well situated based on known current market conditions.
We know that the impact of COVID-19 will be top of mind as you make investment decisions in the short and medium term. Our offerings will now include supporting detail on how the asset fits within our updated underwriting standards, and qualitative background on why we feel that the investment thesis is sound given present market conditions.
At EquityMultiple we see this as a moment to further shore up our operations and fundamental business practices. I know that thousands of businesses across the country – including many of our partners – are taking a similar view. There is no question that the economy will resume, it is just a matter of when and how. As the global economy gets back on its feet, cities and communities across the country will require new investment. We look forward to taking part, and to passing along these opportunities to you.