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

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?