When it comes to speculative construction deals, commercial real estate investors are ready, willing and able to proceed – albeit on a somewhat uneven playing field.
“Developers are saying they see demand and that they are not able to serve market adequately with available product,” says Tripp Eskridge, the Atlanta-based managing director at JLL’s Industrial Project & Development Services group.
According to third-quarter 2013 data released by JLL, speculative construction deals were taking place in 40 out of 48 U.S. markets. However, the quantity of deals may not be enough to satisfy current demand requirements. Indeed, the speculative approach appears to have created something of a patchwork effect across the country, with certain cities and regions seeing far more activity than others.
Kevin Randles, senior vice president at CBRE Capital Markets Inc. in Sacramento, Calif., and commercial division president of the California Mortgage Bankers Association, observes speculative construction deals in the office sector appear to be a coastal phenomenon.
“We are seeing an uptick that is only focused on gateway markets such as Boston, Washington, D.C., and San Diego – markets with continued job formation in past three to four years,” says Randles. “We have also seen speculative construction in multifamily housing in similar gateway markets, as well as many Texas markets. It has not spilled into weaker suburban markets, but we are sensing that will happen soon, as most of those markets are now stable.”
Ankur Gupta, partner in McDermott Will & Emery’s Corporate Advisory Group in Chicago, states that a similar patchwork pattern is taking place in the hospitality sector.
“Hospitality’s primary markets, including New York, have seen a very strong increase, as well as a number of secondary markets with limited service hotels that are now offering a more modernized product,” he says.
Jake Clopton, president of Chicago-based Clopton Capital, confirms this scenario. “Over the past one to two years, we’ve seen lot of requests for hotel loans,” he says. “We have seen a lot speculative investor deals in the Southeast and the East Coast, though we haven’t seen any construction deals in the Midwest or the South.”
But geography is not the only factor that determines the depth and scope of speculative construction. For example, an aging population is a key factor shaping speculative deals tied to health care construction.
“The demographics continue to change in the senior segment,” says Gupta. “That is driving need for more senior care nursing facilities and offsite emergency departments.”
Clopton adds that senior-focused multi-housing is seeing increased construction, as well as decreased competition as developers go through mergers and acquisitions. “There used to be a lot of one-off senior housing deals,” he says. “Now, senior housing is going through a period of consolidation.”
On the retail side, Randles states that speculative construction projects have dropped over the past decade.
“In 2004, that retail sector had, about 200 million square feet of shopping center space being developed,” he says. “In last the three years, less than approximately 20 million square feet was being developed. That is nowhere near the days where we were building a lot of shopping center spaces.”
JLL’s Construction Outlook for the third quarter of 2013 identified e-commerce as the fuel that is powering the retail sector – and if e-commerce entities were defined as a standalone industry, they would make up more than 10 percent of total U.S. construction. However, Eskridge expresses concern on whether the construction deals are being properly tailored to this digital industry’s needs.
“It is a risk that is unique to the marketplace changing a little bit,” he says. “There used to be traditional warehouses, the same facility built time and time again. Now, with e-commerce, the question is, ‘What is the right product to build?’ “If there is a need for e-commerce building and we are still building traditional warehouses, they we’ve built the wrong buildings.”
Richard Zahm, president of Darien, Conn.-based Red Sage Group, notes that speculative deals are also finding new ways of transforming vacant retail properties into different venues that can be used for sports, entertainment or other non-retail endeavors.
“Everything draws off pent up demand,” he says. “Depending on where you are, the big boxes are going dark and are being repurposed.”
And where is the funding coming from to propel these deals? Zahm states that a number of different sources are offering their monetary support for these endeavors.
“It depends on the properties and their size,” he says. “Traditional lenders provide the senior strip, mezz lenders provide the next piece, then equity investors. Lenders are a combination of banks and non-banks. REITs generally buy completed projects. Private equity in its various guises – individuals, 1031 investors, family offices, etc. – provide the equity. But hedge funds, generally, focus on investments other than real estate.”
But for those who see the proverbial glass as being half-empty, what are the risks of this new level of speculative activity? For starters, it seems that not everyone is able to take advantage of this new speculative boom. According to JLL’s data, tenants requiring more than 750,000 square feet “will not find many options in existing inventory and are pursuing build-to-suit alternatives.”
There is also the challenge of supply and demand. “If too much space comes to market before full recovery hits, that will slow our recovery,” Randles says.
On the hospitality side, Clopton expresses concern that these speculative deals are attracting people who have little familiarity with how the sector works.
“From a lender’s side, a lot of the speculative deals are total investor deals,” he says. “These are not even historical hotel operators – they have a third party managing the properties. It can be risky not to have an owner/operator who knows this sector.”
But Gupta believes that the situation is stable, for now, although a potential for trouble can occur.
“If managed and steady, it can continue for quite some time,” he says. “Now, a lot of speculators are building through structured analysis and partnerships. But if you have second tier of players getting into the development game, that could lead to overbuilding.”
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