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Andy Sinclair

Portfolio > Alternative Investments > Real Estate

Why Commercial Real Estate's Pullback Means 'Opportunity': Fund Manager

By Jane Wollman Rusoff

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According to Morgan Stanley and other prominent voices in the financial services industry, the commercial real estate market is virtually teetering on the brink of disaster.

But that’s only one side of the story. The other is one of optimism and smart investing.

“Commercial real estate is entering a period of high growth in apartments, warehouses — even office and retail opportunities,” argues Andy Sinclair, founder, CEO and principal of the real estate investment firm Midloch Investment Partners, which has invested in more than $600 million in commercial and multi-family properties.

“For the future, the key is to find sectors that can withstand inflationary pressures and also have good long-term growth trends,” he says.

Sinclair considers these investments to be a sound bet this year and even sees “the opportunity to get outsized gains by taking advantage of commercial real estate’s pricing pullback or purchasing real estate from overleveraged owners who can no longer service their debt.”

Indeed, “there are pockets of overleveraged commercial real estate where owners are going to have some issues,” he adds.

Affirming that a sizeable pullback is already underway, he does not, however, foresee this developing into a crash.

For example, the dip in apartment prices “has been offset to a large degree by a high amount of rent growth,” he maintains.

In the interview, he explains how financial advisors can help their clients invest in commercial real estate (CRE), including ways to avoid real estate investment managers who are “bad apples and bad operators,” as he puts it.

Sinclair also warns financial advisors to beware of the “yield trap” in CRE investing and not to fixate on interest rates.

The firm he leads, Midloch, focuses mainly on Midwestern middle-market properties and is a value investor that has consistently outperformed its projected returns of 14% to 18%. It has two funds — Midloch Value Fund I (closed to new investors after acquiring about $340 million of real estate) and Midloch Value II.

In managing these funds, Sinclair looks for valuation “discrepancies” that serve to make investors money “regardless of what’s going on in the broad market,” he says.

Sinclair was previously a vice president at MLG Capital, a real estate private equity investment firm, and Palmer Capital, an institutional real estate brokerage.

ThinkAdvisor recently interviewed the Milwaukee-based Sinclair, who was speaking by phone from Cincinnati. In commenting on the down office sector, he notes, “The office sector is the most challenging of all the real estate assets to own. You’re better off [looking] at apartments, industrial warehouses and even retail shopping centers.”

Here are excerpts from our interview:

THINKADVISOR: Morgan Stanley is forecasting a crash in commercial real estate, or CRE, with fallout worse than that of the financial crisis of 2008-09.

UBS says a severe recession could bring significant declines in CRE to pressure bank stocks. Goldman Sachs foresees office and retail properties facing a bad risk of “functional obsolescence.”

What’s your response to all this?

ANDY SINCLAIR: Saying that everything is going to be a disaster for commercial real estate is painting with a very broad brush. It’s too much of a broad assessment.

Do you consider CRE a good investment this year?

I do because many investors have pulled back to a pretty [large] extent, so both the private and public real estate markets are at a new point despite the fundamentals of properties remaining very much intact.

Please elaborate on the pullback.

It’s been occurring. The sector that has the most to fall is apartments. They’re trading at very high prices, and in some cases, industrials, which have pulled back too.

This has been offset to a large degree by a high amount of rent growth. For instance, for industrial warehouse buildings and other industrial REITs [real estate investment trusts], rent growth is at record highs.

What are the chances of a major crisis in CRE?

I don’t think it’s going to be a major pullback. I do believe that, like everything else, real estate is cyclical. As I say, a pullback is already occurring.

REITs have seen it in their stock market prices. Private assets have seen a pullback in the prices of buildings that can be sold. There are pockets of overleveraged commercial real estate where owners are going to have some issues.

But you see opportunity for big gains, you’ve said. Please discuss.

I believe that there’s opportunity to get outsized gains by taking advantage of the pricing pullback or purchasing real estate from overleveraged owners who can no longer service their debt.

I think that commercial real estate is entering a period of high growth, and that’s not just in one sector — it’s apartments, warehouses — even office and retail opportunities.

They’re all experiencing some level of rent growth, which will lead to income growth, making real estate more attractive over the long term.

Suppose a financial advisor’s client wants to invest in CRE. What should the advisor’s first steps be?

There are two ways to do it.

There’s the public market, which is REITs. Buying REITs is [like] buying your real estate from 7-Eleven, versus private real estate, which is typically [like] buying your real estate at Costco.

With the public sector, you’re paying a higher price for daily liquidity.

The financial advisor has to make the decision: Are they going to put their client in public REITs at a premium but which have daily liquidity? Or are they going to invest with private investment managers and private real estate, which usually has a lockout period of three to five years [when you can request a refund]? But typically, it has much better returns.

To be sure, the individual investor needs to conduct due diligence. Can financial advisors help with that?

Absolutely. What I’ve found throughout my career is that real estate investors are usually equipped with a financial advisor.

The advisor is going to help pre-screen and perform due diligence on real estate investment managers and make sure they’re upholding their business plan as well as the real estate principles that they invest with.

That allows individual investors to avoid bad apples and bad operators.

What’s the key concern that advisors should focus on right now?

Look at a balanced approach of both income and growth. In particular, do the real estate investment managers that they’re investing with have adequate levels of cash reserve and low enough debt?

The most important thing for a financial advisor is not to be taken advantage of by a “yield trap” — solely looking for the highest possible returns and upside.

What’s your longer-term outlook for the future of investing in CRE?

Commercial real estate has lots of different shades of possible outcomes.

For the future, the key is to find sectors that can withstand inflationary pressures and also have good long-term growth trends.

Often people associate real estate with a bond and what’s going on with interest rates. Rates are important, but unlike bonds, real estate has the ability to grow its income and revenue.

Interest rates only [really] matter if you’re overleveraged. So people who are buying real estate or own it should be careful not to overly focus on interest rates.

What about inflation risk?

Many commercial real estate properties have a net lease, meaning that any expense increase is passed through and shared with all the tenants of the property. So if inflation impacts a building, the tenants share that increased cost. [Therefore], the landlord and investors are ultimately less impacted by it.

Also, real estate is typically financed with fixed interest payments despite inflation. When you have rising revenues and income due to inflation, your debt payments stay fixed, yet your income stream is growing.

The office sector isn’t doing well, I’m sure you’ll agree. How large is that component of CRE?

It’s a medium-sized part of commercial real estate. Office is the most challenging of all the real estate assets to own. So you’re better off [looking] at apartments, industrial warehouses and even retail shopping centers.

Office is an OK investment if bought heavily distressed. There are pockets of office declining because [many] people are working from home. However, the best office buildings are seeing somewhat more rent growth.

So it’s really a have-and-have-not for office buildings. If you’ve got an old, dilapidated building, you’re in trouble. But if you have a high-quality desirable office building, you’re going to be just fine.

For high-quality buildings, occupancy remains strong for office, and they’re seeing strong rent growth. Rents per foot have gone up.

I’m not advocating that office is the best spot to put your money, but it’s not as dire, maybe, as every publication says it is.

Can CRE be a haven in the way that gold is? It’s a tangible asset and holds value, and also, low prices offer opportunity to invest. Your thoughts?

Absolutely. Real estate has the ability to generate income from the rent it can charge tenants. Also, as inflation takes hold, it allows commercial real estate landlords to charge higher rent and build their income.

Do you expect artificial intelligence to play a role in the CRE scenario?

Real estate typically is the last industry to implement heavy technology changes.

Artificial intelligence will likely impact the operations for running buildings, like integrating smart doorbells and smartphones.

But it likely won’t impact the leasing of buildings or other parts of real estate in the short term.

Pictured: Andy Sinclair

Jane Wollman Rusoff

@jrusoff2

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