Looking Back at 2017 & Forward to 2018
Running in Mud, A Look Back at 2017
For roughly three million people, the ultimate personal and team challenge is a Tough Mudder race. These races are obstacle courses between 10 to 12 miles long and the obstacles play on human fears like fire, water, electricity and heights. According to the Tough Mudder organization, the main principle revolves around teamwork. In talking with our team throughout the last year, I have come to believe that there are a lot of parallels between running a Tough Mudder race and the year we experienced. In the end, we completed the year in a strong position, we worked well together and had some real wins. However, it was not without its fears, its slow pace and its unknowns.
For those of you who are invested in the stock market, this analogy of running in the mud might not make sense. The Dow went up 25% in 2017 and the S&P returned 19.2%. Even Bitcoin, which started the year at $1,000 hit as high as $20,000. That isn’t mud, that’s Hyperloop speed. However, value-add real estate investments are much slower to play out – they are an illiquid, longer term play and they behaved as such in 2017.
Clearly the highlight of the year for Rising Realty Partners was the acquisition of 1 Cal Plaza with our co general partner, Colony Northstar (NYSE: CLNS). The approximately 1M square foot, Class A, Downtown Los Angeles asset was not only headline-grabbing, both domestically and internationally, it was a long and slow process, with no guarantees the acquisition would go through. It demanded a lot of everyone on our team, and I am pleased to say we closed the transaction without any hiccups. Further, the general partnership team was successful in attracting two international investors as limited partners which exposed our brand and reputation far beyond downtown Los Angeles. This was an exceptional win for all involved and Nelson and I take great pride in the team’s execution. We also take great pride in our developing long term partnership with Colony Northstar. Our two teams continue to work well together and are looking for more opportunities to create value.
In looking back on the year, I feel the analogy of running in the mud makes a lot of sense. We worked long and hard to grow the company and the assets under management. We increased our profitability even as we grew our headcount. But nothing was easy. Companies across our portfolio did not grow their leased square footage at any appreciable rate, and in fact, we are still seeing credit tenants contract their footprints across Southern California. Yet, we also saw an incredible amount of investor interest for certain assets. For instance, there was a sale in El Segundo this year that exceeded broker guidance by about 17%, and our initial offer by over 25%. Only a few assets performed this way, as many others were adversely affected by broker guidance which the market did not meet. Many times this year, our team felt comfortable that we understood a submarket, an asset, and an opportunity, and the market spoke otherwise. We always fall back on the concept that some of the best deals we do are the deals we don’t do, but we would like to articulate the motivations behind the capital flows more comfortably. In 2017, we felt like we understood it some of the time, but less than in years past.
I believe that this disjointed and sloggy 2017 was the result of several factors. There was an apparent hangover from the Trump election in late 2016. The markets had underwritten a Hillary Clinton win and the expectation seemed to be that her policies would extend a slow growth, higher tax and more regulated environment. In looking back, I think many companies had charted their course before the election and it was very difficult to change business plans and budgets quickly. Therefore, businesses did not quickly move to expand or make long term commitments.
Also, in the context of low interest rates, especially those we have seen over the last few years, investors looking for higher-than-market returns allocated a lot of money to commercial real estate value-add funds. Our private equity partners all raised a lot of money in 2016 and 2017 and it sat on the sidelines with the exception of a few investments that everyone jumped on. From a pure bid/ask perspective, it was amazing to see the run up in pricing for certain markets and the total failure to get close to broker guidance in other markets. In my opinion, this forced a lot of sellers to pull property sales off the market or not bring them to market in 4Q17. In a recent Wall Street Journal article, it was noted that many private equity firms sat on the sidelines in 2017 and are sitting on a lot of cash to invest in 2018.
Further, as we all were getting ready for Christmas, Congress passed the most comprehensive change in the tax code since 1986. For those that may remember, that 1986 change fundamentally hurt and changed the real estate business. We do not yet know for sure how the changes made this December will affect real estate, but there is a consensus amongst real estate pros that this change will ultimately help the real estate sector far more than the changes made in 1986.
No Mud, But Watch for Those Rolling Hills in 2018
As we look to 2018, there several data points on our radar. We believe it will be difficult to compete on most marketed deals because there is so much capital chasing them. Our view is that we must be very strategic in how we use our time because there will be lots of competition. We also believe that the opportunities that will make the most sense are those opportunities where we have some inside knowledge. This may be due to our position in the leasing market as a large landlord in downtown Los Angeles. It may be due to our strong relationships and reputation for being a good buyer. Or, it may be because we found a use for an asset that others had missed. All three of these points reflect skills we have developed as a team and have proven to be successful in the past.
As it relates to our view on how the economy will change and how it will effect the real estate market, we are generally positive and looking forward to a good year of transactions for both sales/acquisitions and leasing. First, we believe there will be a real positive impact on those at the top and the bottom in terms tax savings. Of course, the blue states like California won’t necessarily see the real benefits due to Congress capping the state and local tax deductions, but companies will most certainly have more money to invest should they choose to do so. Under the new tax code, the tax rate for repatriation of capital fell from 35% to 15.5%. We believe this significant drop will bring a lot money back to corporation’s US balance sheets across an array of industries, but tech companies especially will benefit tremendously. We think the market should see not only an expansion in the real estate needs of tech companies, but also a real increase in business for firms that service tech companies like law and accounting firms.
We believe 2018 will be a good year, but it will require a lot of making our own deals happen. We think that we have a great opportunity to build on our positive reputation and our past success. I would identify three themes for Rising Realty Partners in 2018:
- Due to the tax changes, we live in a new world. The tax code is dramatically different. We cannot be sure how that will affect business investment in the US, but we suspect it will not look like the last few years. The tax code changes are designed to stimulate business investment and to give companies more cash for investment. We believe this new world will lead to more activity in the leasing markets that we follow. The western U.S. markets we follow closely have strong millennial demographics which are good for tech companies and service companies. We believe that the real estate economy will perform well in our markets in 2018. Therefore, we can’t just keep pace with the market, we have to think ahead of it. We must work as a team with our leasing brokers, to lease our assets and position them for strong net operating income growth. There will good opportunities to sell assets.
- It will be hard to buy fully marketed “value add” deals in 2018. Given the amount of capital raised through private equity vehicles, we believe that marketed deals will be thoroughly picked over and priced to perfection. Therefore, we will have to rely on ability to garner market intelligence so that our investment lens is shaded differently than our competition. We believe this will mean focusing on off-market opportunities, partnering with capital in an incentive fee structure rather than as a pure GP; and finding larger portfolio plays with geographic diversity. We have a proven track record in finding off-market deals. We also have executed the incentive fee structure with quality equity partners in the past. We have an acquisitions team with experience in complicated portfolio transactions. Therefore, we believe that will have a strong year in acquisitions. Our goal is still one LOI per week and our experience leads us to believe that this will lead to acquiring between 2 and 4 assets of varying square footage. We are focused on portfolios as well, which could increase our total amount of square footage.
- Finding the Off Market Deal or Synergistic Plays is the Key in 2018. We have built our reputation on finding deals that the market has missed. This will be extraordinarily important in 2018. Incentivizing brokers to come up with out-of-the-box ideas, talking with existing tenants about space needs and digging up that super complicated project will drive our growth this year. We will also be focused on incentivized core/core plus deals – deals where we can bring our innovative third party property management team and telecom company to the table and drive value for existing or potential core/core plus owners and buyers.
Thank you to all of you who have been supportive since we started building Rising Realty Partners. We made a huge step forward in 2017 and we will be completing a lot of our construction work on some exciting assets. We feel we are well positioned for great success in 2018.