In my last update, I spoke of the relative calm in the public markets and the U.S. economy at large. Since then, we’ve seen the passage of a major tax overhaul, the appointment of a new Fed Chairman and, more recently, implementation of protectionist tariffs and the prospect of more to come. Volatility in the stock market notwithstanding, the economy continues to exhibit broad strength and stability, with unemployment at record lows and robust job growth – as of May, unemployment stood at 3.8%, the lowest in 18 years, and 223,000 job were added – the 92nd straight month of gains, a new record¹. The number of Americans filing for unemployment benefits has fallen to the lowest levels since the 1960’s². Meanwhile, consumer confidence – that steady wind under the sails of the U.S. economy – is at its highest point in decades: the share of Americans expecting their incomes to decline over the next six months—6%—fell to the lowest level since December 2000³.
This sustained period of growth flies in the face of pessimistic readings of past cyclic trends. While fears of inflation, protectionist international trade measures, and an overheating residential housing market have tempered expectations from investors, the economy continues to grow – with over 100 consecutive months of expansion, the U.S. economy is now enjoying its second-longest expansion on record.
While many economic indicators remain persistently positive, any complacency on the part of real estate investors would be folly – cycles are real and “this time is different” is a dangerous line of thinking. The key is to be smart and adaptive because the current economic climate holds both opportunity and risk. Here are some of the big topics that are top of mind at the close of Q2:
The Impact of Economic Policy
Wall Street generally cheered the tax bill that was signed at the close of 2017. With a new 20% deduction for pass-through income, and carried interest and 1031 exchanges left intact, the bill is unambiguously positive for real estate investors in the short term. However, looming decisions on fiscal, monetary, and macroeconomic policy could have a significant and immediate impact on real estate capital markets:
- Trade Policy: The current administration has struck a decidedly protectionist stance, enacting tariffs on steel and aluminum over objections from leading voices in the GOP and international business community. The White House has spoken about further sanctions and renegotiations of existing trade agreements. These changes to trade policy will create winners and losers in the U.S. economy and, by extension, impact commercial real estate assets. Increasing the cost of imported goods within supply chains could hurt demand for industrial space in certain industries (like automotive), while boosting demand for industrial space in others (like domestic steel). While tariffs could result in materially higher costs for building inputs (hence raising construction costs) savvy developers will find workarounds, either through tariff exemptions or through substitutes like wood beam construction.
- Immigration Policy: Without immigration, U.S. population and labor force growth is barely positive. Cutting immigration in half – as House and Senate proposals have suggested – could lower GDP by 50 to 75 bps and hurt labor force productivity in industries from agriculture to tech.
- Infrastructure: An opportunity for bipartisanship, a well-crafted bill to repair and expand transportation infrastructure could improve labor force participation, productivity and traffic, and prompt net migration to suburbs and exurbs. An opportunity for bipartisanship, a well-crafted bill to repair and expand transportation infrastructure could improve labor force participation, productivity and traffic, and prompt net migration to suburbs and exurbs. With self-driving cars looming in the decade ahead, infrastructure investment will have magnified importance.
- Monetary Policy: It remains unknown how aggressively new Fed Chairman Jerome Powell will combat inflation. While continued rate hikes may increase the cost of capital, too much of a “let it ride” attitude may eventually result in inflation, dampening real returns. The good news for commercial real estate investors: the asset class provides a built-in hedge against inflation as lease renewals provide regular opportunities for market resets.
Cap Rates: Nowhere to Go But Up
Cap rates in gateway markets are likely to rise eventually, possibly in H2 of 2018 after a period of flatness, due to reduced foreign capital inflows and rising interest rates. Investors in certain markets will not be able to rely on appreciation to deliver strong returns, as was the case earlier in the cycle. You’ll notice that the projected exit cap rates on the projects found on our platform are consistently higher than the cap rate the Sponsor is purchasing the property for. While no one knows where cap rates will land, it needs to be accounted for in underwriting.
We will continue to look for sponsors and projects in markets and submarkets characterized by strong demographic trends, with preference toward those investments that offer strong current cash flow and/or immediate value add opportunities. Particularly with the looming possibility of inflation, we will seek to partner with Sponsors who are adept at generating value through optimal leasing strategies and properties where diversified leases allow for both stability and market resets. You may have noticed that we’re gradually shifting more of our focus to preferred equity opportunities, rather than common equity. While the upside potential of preferred equity is capped, it offers downside protection in the event that a project underperforms expectations. Given where the market stands, we find this is a tradeoff we often like, though we will continue to offer compelling equity opportunities. Similarly, we plan to continue pushing into debt, where changes in cap rates are less impactful to your likelihood of making your anticipated return.
A Step Further: Below-the-Radar Trends, The Urbanization of the Suburbs, and Alternative Sub-asset Classes
In a broader sense, investors are expressing caution amid sociopolitical, macroeconomic, and cyclical concerns. However, we still feel it’s an exciting time for commercial real estate investors.
Affordable and Alternative Housing
Demand for amenity-rich multifamily living in 18-hour cities has surged over the past four years, with gateway urban cores remaining magnets for young professionals and resurgent downtowns like Detroit attracting new live-work-play vibrance. Developers have responded, with Class A multifamily supply finally catching up (or surpassing) demand in many markets. On the flip side, America continues to struggle with an affordability crisis, with historically low rates of home ownership and a severe shortage of affordable Class B and C rental units. Forward-thinking developers and operators are moving to address this challenge by renovating aging properties for the workforce – adding services like transportation assistance, child care, and computer literacy courses – while taking advantage of tax incentives and generating favorable returns for investors. Others are addressing affordability with building innovations like density ‘micro-units’, creating amenity-rich “co-living” properties with a built-in community vibe, or destigmatizing existing concepts like manufactured homes with better marketing and management.
In many cases, these developers and operators will be able to generate excellent risk-adjusted returns through comparative advantage and investing in properties and markets that are less competitive. We will continue to look for opportunities to co-invest in this space.
How the Suburbs Got Their Groove Back
While urban cores in established markets continue to command attention, suburbs and certain tertiary markets have strong growth potential across commercial real estate asset classes. Several trends are driving this phenomenon:
- Millennial Preferences: The generation that came of age during the Recession are seeking better quality of life and affordability, but still desire the kinds of amenities typically associated with urban cores: boutique shopping and dining, live-work-play environments, and cultural vibrance. From Bend, OR to Trumbull, CT, there is ample demand for boutique retail and bespoke multifamily offerings. In time, office demand will surge in these select markets, as firms respond to cheaper per-square-foot office space and influxes of educated talent.
- Downsizing Baby Boomers: Boomers nearing retirement are also exhibiting a preference for city amenities without the pricetag or frenetic pace of premier urban markets. Contrary to the post-war suburban family paradigm, two-thirds of suburban households don’t have kids in them*. As this population ages, demand for healthcare facility space will grow apace.
- The Remote Workforce: As telecommuting becomes more accepted in white-collar industries, young professionals will continue to flock to suburbs and exurbs that offer outdoor recreation opportunities, a lower cost of living, and cultural vibrance. Remote white-collar migrants will boost demand for co-working space, density living near transit hubs, and boutique retail and shopping. Should self-driving vehicles see broad adoption, this trend will gain even more momentum.
There is still plenty of opportunity for yield in select submarkets in Tier 1 cities. We believe, though, that shifting lifestyle preferences and emerging secondary and tertiary markets will open a diverse array of investment opportunities
As we look toward the rest of 2018 and beyond, we are optimistic about the state of commercial real estate. Policy ambiguities, frothiness in some markets, and the possibility of higher interest rates and/or inflation are all complicating factors that, in sum, may introduce risk in the capital markets. As always, success will depend upon co-investing with experienced Sponsors and Lenders, diligent underwriting, and selecting investments that offer superior risk-adjusted returns in light of micro and macro factors.
I’ll turn now to some EquityMultiple-specific updates.
As of May, we have closed on 44 transactions across 30 markets. Our investors have contributed over $30 million to commercial real estate projects with a total aggregate capitalization of over $600 million. Q4 2017 had been our highest-volume quarter on record, with $5.7 million invested across 7 offerings – a 90% quarter-over-quarter increase in dollars invested. In Q1 2018 we beat our own record, with nearly $7 million invested and for Q2, we project to exceed $9m.
To date, we’ve evaluated over 100 potential investments and selected approximately 5%.
We remain focused on quality over quantity, on scaling our portfolio of offerings gradually and responsibly, and on continually improving our asset management and reporting practices. That said, our real estate team is working hard to provide a steady flow of diverse commercial real estate investments to meet investor demand. As you may have noticed, the typical target raise of our offerings has increased dramatically in 2018 to accommodate growing investor demand. We are actively hiring to make sure we continue to deliver the same quality of deals and investor experience as we scale our business.
As you would imagine, we routinely get questions on investment performance. We will provide an overview of performance here but we are also working towards our goal of providing performance information either directly on the platform or upon request at any time. We believe this is a fundamentally important part of maintaining our commitment to transparency.
As of May 15th, 2018, here is how the EquityMultiple “portfolio” is performing:
- Over $30 million invested across 44 investments. 27 are wholly repaid or producing returns for investors; 6 more expected to join that group in Q2 2018. The rest are equity deals that are in their construction or renovation periods or that recently closed.
- 6 investments have gone full-cycle, returning full principal to investors. All performed at or above expectations, with an average weighted IRR of 22%**
- Average net return to date on debt and pref equity is over 10%. This excludes the accrual payments that will be paid out on maturity.
- Average net returns for all cash-flowing investments – measured from their first payment period – are slightly lower, at around 9%. This number also doesn’t include appreciation and profit from sale for equity investments, which is frequently 50% or more of the total projected return.
- Of the 44 closed investments…
- 4 significantly underperforming expectations (9%)
- 5 significantly (more than 6 months) behind schedule (11.4%)
- 5 have or are projected to materially outperform projections (11.4%)
- 30 are performing largely in-line with underwriting (68.25%)
Chief Technology Office Peter Shankar and our Product Development Team remain committed to our core principles in designing and improving the platform: security, efficiency, and transparency. The team has rolled out the following major upgrades over the past two quarters:
- Upgraded Portfolio: The revamped My Portfolio page provides better detail on the performance of your EQUITYMULTIPLE portfolio, with improved earnings calculations, a breakout of total earnings vs. current balance, and active vs. repaid investments. The new page also provides better visibility into the status of your payments.
- A Robust Asset Management Feed: Investors can now view performance and status updates regarding their investments directly in the platform, and filter by investment. We feel that this is critical to providing transparency throughout the lifetime of investments.
- More Efficient Onboarding, Quicker Investing Process We’ve switched the regulatory structure of our offerings, now operating under the 506b exemption. This means that (legally) we can only market offerings to accredited individuals who have signed up for our platform, with whom we have established a substantive relationship. We find this matches up better with our business and our focus on customer service and quality transactions. More importantly, it removes our third-party accreditation requirement: investors will no longer have to recertify accreditation every three months.
In the coming months, our Product Development Team will focus on continued improvements to your Portfolio, more diverse and flexible investor notifications, improved cross-device compatibility with a focus on mobile, and a revamped invite program for investors who like EQUITYMULTIPLE enough to recommend it to friends or colleagues.
Thank you for your time and interest in EQUITYMULTIPLE. We are very excited about the growth and direction of our business but couldn’t do any of it without the investors and real estate firms who put their trust in us.
Co-Founder & CEO | EQUITYMULTIPLE
**Two more investments went full cycle in the second half of May. One was a preferred equity investment that paid a 13% fixed return as projected and the other was an equity investment which underperformed underwriting, producing an 8% IRR over a six month hold period, compared to a 21% IRR over a 3-year hold as projected. In the case of the underperforming project, the Sponsor discovered unforeseen renovation issues and opted to sell early to preserve investor capital and give them the opportunities to redeploy into more promising opportunities.
***Based on current underwriting, cash flow to date, project timeline and overall projected returns. Projects are re-underwritten following a material event. Results with a 20% deviation in either direction are considered largely in-line with underwriting.
Legal Information and Disclosures:
This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. EquityMultiple has no duty or obligation to update the information contained herein. Further, EquityMultiple makes no representation, and it should not be assumed, that past investment performance is an indication of future results. These materials contain projections and other forward-looking statements. Any statements that are not historical facts are forward-looking statements that involve risks and are inherently uncertain. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Equity Multiple, Inc. (“EquityMultiple”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.
This email message is intended only for the recipient to whom it is addressed and may contain information that is privileged and confidential. If you are not the intended recipient of this message, any use, dissemination, distribution or copying of this communication is strictly prohibited. If you have received this communication in error, please immediately notify the sender and permanently delete all copies that you may have.
EQUITYMULTIPLE does not give investment advice, endorsements, analysis or recommendations with respect to any securities. Nothing contained in this email constitutes tax, legal, insurance or investment advice, nor does it constitute a solicitation or an offer to buy or sell any security or other financial instrument, which only can be made through official offering documents that contain important information about risks, fees and expenses. Any investment information contained herein has been secured from sources EQUITYMULTIPLE believes are reliable, but we make no representations or warranties as to the accuracy of such information and accept no liability therefor. Securities are offered through Growth Capital Services, member FINRA, SIPC, Office of Supervisory Jurisdiction located at 582 Market Street, Suite 300, San Francisco, CA 94104. We recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks associated with any investment opportunity.