When looking at the spread in apartment cap rates relative to the 5 yr treasury, along with the period right before the 2008 crash, this is the worst spread level for at least the past 23 years. What is FT-AIR’s view on how private real estate investments can stlll achieve their historical returns?
Directionally, we’d agree with the broader point Rich is making in that any time you get as significant moves in financing rates as we’ve seen, the basic “math” and the go-forward return expectations across CRE markets should adjust accordingly. One overarching comment that our team often thinks about is that real estate is the most heterogeneous market out there with each strategy, each market, and each operator having different moats and different expected impacts from interest rate moves or other risk factors.
With Hillpointe specifically, one of the key differentiators of their strategy from day one has been all of the levers that they are able to pull on to develop these assets at meaningfully lower costs than almost any other development group, resulting in Hillpointe enjoying a much wider development spread than many other developers and other groups in the market. In our view, this provides an additional level of downside protection as it relates to expected returns as, most importantly, Hillpointe has always kept their underwriting very conservative to ensure that there is ample cushion to account for cap rate movement or other market dynamics (i.e. even if Hillpointe thought that they could sell an asset once developed at a 4% cap rate, they always kept their projected exit cap rate much higher than that to ensure that a project would still “pencil” to their base-case return targets if they ended up transacting at a higher cap rate).
That said, exit valuations have certainly come down in the space just based on debt cost and availability for the natural buyers of Hillpointe assets. However, based on their conservative approach to underwriting and defensible development spread, we continue to feel confident in Hillpointe’s ability to generate their base-case returns even in this market environment. As a brief example of this / the value creation Hillpointe is able to generate through their development process, one of the assets in fund II was refinanced earlier this year at a ~$100mm appraised value compared to the total project cost basis of ~$40mm and $14.7mm of equity cost.