A recent study from the Mortgage Bankers Association indicates that “commercial and multifamily real estate finance is at the end of the latest act in a long-running play” and that the next five years will be much different than the past five. Yet the trade group and industry experts expect to see select opportunities, even as interest rates continue to rise.

The fear of rising rates is causing the market to back away from anything bond-like, but real estate is very unlike bonds, says Joel Beam, a managing director and the senior portfolio manager for real estate strategies at Salient, a real asset and alternative investment firm with offices in Houston and San Francisco.

“The phrase that gets bandied about a lot is that real estate is an income-oriented investment,” he says, “but it’s not a fixed-income investment.”

If rates are rising because the economy is growing and if tenants are doing well, he says, then landlords can raise rents, and investments in these properties will prosper over time. Rents and real estate values also tend to rise with inflation. Most bonds, on the other hand, can’t change their coupon and therefore can’t raise payouts when interest rates rise, he explains, so bond prices adjust downward. Adjustable rate fixed-income securities are the exception.

Real estate’s many mergers and acquisitions in recent months “support the thesis that there’s value in the sector,” adds Beam. He expects the M&A theme to continue to play out this year, mostly because “prices are robust on Main Street and they’ve tilted a bit on Wall Street,” he says. Many public REITs are trading at a discount to the net asset value of their properties.

Most people wishing to fulfill their craving for real estate exposure think about buying residential property, says Beam. However, he views commercial property stocks as a good alternative because these REITs tend to be carefully run and investors don’t have to get as wrapped up in leverage and applicable tax deductibility. Under the new tax code, mortgage interest deductions now max out at $750,000 of debt (down from $1 million) on a main home or second home, he notes. Existing loans are grandfathered.

When evaluating REITs, Beam considers their debt service coverage ratios (EBITDA divided by interest plus preferred dividends) and valuation multiples (EBITDA divided by the value of the enterprise; “EBITDA” is earnings before interest, taxes, depreciation and amortization). He also thinks it’s critical to find management teams that can generate late-cycle value for commercial properties.

“The name of the game is to stay full and make sure you maintain your rents or maybe even push your rents,” he says. “It does take some expertise and some shrewdness to be able to make the right proposals, create the right incentives and arrive at the right pricing” when competing for prospective lessees.

As a value-oriented shop, Salient continues to seek opportunities in two real estate sectors that have been beaten up a lot—shopping centers and health care. The internet and the Amazon effect have taken a toll on retail. According to Beam, the best retail assets are in densely populated areas that have comparatively high income and wealth and existing infrastructure that supports a lot of commercial activity.

One shopping center REIT that Salient has exposure to in the Salient Real Estate Fund (FFREX) and the Salient Tactical Real Estate Fund (KSRAX) is Taubman Centers, an owner of high-end malls. Taubman has “an extraordinary collection of assets,” says Beam, and an activist shareholder is pushing the REIT to change its voting share structure to boost its stock price.

“Of course, if the mall is completely dead we’re going to be wrong,” says Beam. “But if you think the mall will survive, I think it’s one where you’d be well served to have some exposure.”

The primary reason health-care REITs have been battered, he says, is the regulatory risk for Medicare and Medicaid reimbursements. Rising interest rates have also deterred some investors because health-care facilities tend to have long lease durations, he says. Nursing homes, for example, are often leased to operators for many years.

Salient has embraced a favorable sentiment for nursing home REITs over the last couple of years. “It’s a sector that isn’t glamorous,” says Beam, “but I think it fulfills a vital need.” The stocks are priced with a very critical view of Medicare and Medicaid reimbursement, he says, but they don’t reflect that the supply of nursing homes is shrinking because of the physical deterioration of outdated existing facilities and the inadequate building of new facilities. Salient has exposure to the Sabra Health Care REIT, which holds two-thirds of its assets in nursing homes.

Beam favors public REITs over private real estate because they offer liquidity, can be used in tax-deferred 401(k) accounts and tend to rank high in asset quality and management quality.

“Your random Regulation D offering, if you’re an accredited investor, isn’t necessarily going to have the quality that you get in the public real estate space,” he says. (Regulation D of the Securities and Exchange Commission relates to private placements.)

Private Opportunities

Tim Wallen, the CEO and a principal of MLG Capital, a Brookfield, Wis.-headquartered firm that specializes in small to mid-cap commercial real estate acquisitions and offers private real estate investment funds to accredited investors, says it’s not too late to invest in commercial real estate even though a more stabilized economy and rising interest rates make it more difficult.

He thinks investors should consider holding both public REITs and private real estate. They operate very differently, he says, and many people don’t understand the nuances. REITs provide high liquidity and diversification, he says, while private real estate offers low correlation to the S&P 500 and dynamic tax planning opportunities.

Large public REITs tend to pay a 3% to 4% dividend, he says, using the iShares U.S. Real Estate ETF (IYR) as a benchmark. Private real estate firms offer between 7% and 10% cash-on-cash yields (before-tax cash flow divided by equity), he says, as well as the “promote structure” (a real estate industry term for profit-sharing).

Private real estate is a “very fractured, fragmented industry” that involves many people, he says. “The real opportunity today is finding somebody’s mistake or missed opportunity that we can buy and fix or take advantage of,” Wallen says. “It takes a lot of searching to find those diamonds in the rough,” he adds.

For example, institutional investors/real estate operators may sell property off-market at a discount instead of having it professionally marketed, or they may fail to maintain properties. One can’t charge as much rent, attract as many tenants or sell a property for as appealing a multiple if it’s an “old, tired asset,” he says.

MLG Capital, which gets to know local markets well, also finds opportunities when institutional investors/operators lack “depth of local talent” or sell large real estate portfolios at bulk pricing. “Oftentimes, this approach leaves money on the table,” says Rick Stoll, the assistant vice president of private equity at MLG Capital, because the individual assets are worth more. MLG Capital looks to buy these portfolios and “sell the assets one-off at retail pricing,” he says.

The firm’s favorite sectors are multifamily and industrial real estate. Each sports a national occupancy rate of about 95%, but he and Wallen stress the need to evaluate supply and demand in specific markets. Warehouses, especially where land for new construction is limited, are thriving in a stronger economy, they say, and multifamily properties are benefiting from an aging population and student debt that’s hampering home purchases.

“We love buying multifamily when it’s 100% occupied,” says Wallen. “The market is telling the owner they’re charging below market rents.”

The challenge MLG Capital finds with office and retail properties is that high capital expenditures are generally required as tenants come and go. There are exceptions. For office properties, “It’s a landlords’ market in Boston, San Francisco and downtown Dallas,” says Wallen.

Retail real estate, also 95% occupied nationally, he says, can benefit from population growth and muted new construction due to e-commerce jitters. “Amazon is not taking over the world,” Wallen says. It captured just 4% of total U.S. retail sales in 2017 and it purchased Whole Foods because, he says, “It needed the bricks to go with the clicks.”

MLG Capital’s funds, for accredited investors, typically offer exposure to 20 to 25 private real estate deals across six to 10 states, he says.

Meanwhile, retail investors interested in private real estate investments can now find more options in the quickly expanding NAV REIT market. NAV REITs are non-exchange-traded vehicles that, unlike the old private REITs, are designed to have a perpetual life span and operate more like mutual funds. NAVs price their net asset value daily or monthly and offer a lot more liquidity than private REITs.

Firms that have entered the NAV REIT market include Blackstone, Nuveen, Starwood Capital and Griffin Capital.

Growing Appeal

Jordan Heller, CEO of Heller Wealth Advisors LLC of Summit, N.J., and New York City, says most of his 200 or so clients have an allocation to real estate in their portfolios. The independent wealth management firm has exposure to public and private real estate.

Heller, who brought many REITs public between 1987 and 2000 while working on Wall Street, has had an underweight position in real estate because of the late stage of the economic cycle. “However, at this moment, REITs tend to offer a nice value,” he says, “and there’s justification for a stronger position” if one is selective.

According to Heller, REITs are typically trading at a 5% to 20% discount to their private-market peers, based on net asset value. “This provides investors with more of a floor on the downside while you’re getting the yield and the long-term growth,” he says, and it’s resulting in more M&A activity.

REITs tend to lag their NAV while interest rates transition, he says. He also thinks REITs could be a barometer of things to come in the private real estate market. “When the economy goes south, there’s a stickiness,” he says, before real estate responds with lower rents, lower occupancy rates and a slowdown in construction.

A number of real estate sectors tend to be more resistant to economic downturns and less sensitive to changes in interest rates, says Heller, including health-care facilities, student housing, storage facilities and manufactured home communities.

American Campus Communities builds student housing on or next to many large college campuses. “You won’t get overbuilding because of the location,” he says, “and there’s a constant flow of demand” from matriculating students.

Well-managed shopping center REITs with good assets “should be able to stand the test of time,” he adds, and some are converting their properties to mixed-use developments or apartments. Urban Edge Properties, Federal Realty Investment Trust and the Howard Hughes Corp. have repurposed properties in infill locations where supply is constrained, he notes.

Heller tends to use actively managed funds or ETFs in the REIT space because they fit his business model. He uses third-party managers for private real estate—either funds or one-off deals (such as investing in an industrial building or an apartment building).

But for now, REITs hold much of his interest. “They’re cheaper, if I want to I can get out, they’re professionally managed,” he says, “and they’re relatively transparent.”