Ron Popeil, the late great infomercial guru, used to tout one of his many time-saving, life-changing devices as “set it and forget it.” Once you get the ingredients into the Ronco ST5000 Showtime Rotisserie Platinum Edition, you can go on with your life until your kale, feta and olive-stuffed leg of lamb is ready in about 10 hours.
“Set it and forget it” got me thinking about the massive changes in commercial real estate, especially with respect to operational risk. When I grew up in this business, good commercial real estate was like Mr. Popeil’s “set it and forget it” cooker. After going through the massive effort of a lease negotiation and execution, you were rewarded by “setting it and forgetting it” with respect to that tenant. The base building and common areas were also pretty much set subject to routine maintenance for at least the average term of the leases in the building. This stands in contrast to “alternative” forms of commercial real estate, like hotels, that have high operational risk since their average length of tenancy is one night and not seven to 10 years.
The prize for long-term stable leases used to be higher multiples (aka lower cap rates) than those for alternative forms of real estate. Now cap rates for the “base” asset types and for real estate alternatives are converging. When I got into this business, the difference in cap rates for base assets and for alternatives was typically 100 basis points or more. As noted in the chart below, except for hotels and seniors housing, the difference between base and alternative assets is now very small.
At first, I thought this convergence was solely due to the flow of new money into alternative assets and the late-cycle investment trend of cap rates between primary/secondary and more risky forms of commercial real estate often converging. While there historically have been a few institutional and REIT specialists in each of the alternative asset classes, the dearth of traditional institutional capital kept cap rates high. Manufactured housing is a great example. Many of the private equity/smart money folks I speak with daily, who historically wouldn’t get near this asset class, now can’t get enough of it. Alternative asset cap rates are falling as the money flows in.
But wait, there’s more (another Popeil contribution to the American zeitgeist)! Office and retail tenants are signing shorter leases (in retail, some new developments are going with licenses or really short leases) and are renewing at a much lower rate. In the office sector, this is combined with the secular shift of coworking, which in addition to enhancing this shorter-lease trend is forcing landlords to spend much more and much sooner on common area refreshes than they had in the past. In the blood sport to retain tenants, this is making office more “operational” than ever. If an investor takes operational risk on a base-asset type, the relative risk on the alternatives is lower by comparison.
By contrast, in the multifamily and industrial sectors, there is an opposite trend of tenants signing longer leases and making these assets less operational as a result. Despite this relative durability, lower cap rates for alternative industrial and multifamily assets prove that the “chase for yield” is causing cap rate convergence perhaps even more than the devaluation of operational risk.
As seen on TV, infomercials always make things seem a lot easier than they are really. Commercial real estate is getting harder as operational risk is increasing in office and retail. More investors are taking more operational risk in alternatives since they are taking this risk in the base asset class anyway. For those in commercial real estate who still want to set it and forget it, you can buy industrial or you can go with the Ronco ST5000 Showtime Rotisserie Platinum Edition available for only $281.99 + shipping and handling. Act now while supplies last!
By Spencer Levy, Chairman & Senior Economic Advisor, Americas Research, CBRE.