Many commercial real estate (CRE) investors are rethinking their strategies to find more sustainable and lower-risk models. With inflation running high, interest rates fluctuating, and concerns about an economic decline, there’s an increased focus on investments that provide stable, predictable returns while minimizing exposure to market downturns. The recent panel discussion – Commercial Real Estate Market Outlook: Strategic Investment Planning Amid Economic Shifts – hosted by Tempo Family of Funds and Syndications highlighted several ways investors are navigating these challenges with sustainable investment approaches.
At the core of this shift is the pursuit of steady cash flow over speculative high returns, often achieved through methods like preferred equity and mezzanine debt investments, and focusing on fundamentals. Panelists emphasized that in an unpredictable market, protecting your downside is just as important as capturing upside potential.
Why Preferred Equity and Mezzanine Debt is Gaining Popularity
One of the most discussed strategies for mitigating risk in CRE is preferred equity. Paul Moore, co-founder of Wellings Capital, spoke about how preferred equity offers a balance between stability and return. “Preferred equity is a lower-risk way to capture returns, but with lower upside,” Moore explained. Unlike common equity, where investors can participate in unlimited upside but are first in line to take losses, preferred equity offers consistent cash flow and a priority claim on assets in case of liquidation.
Preferred equity essentially acts as a hybrid between debt and equity. Investors earn a fixed return on their investment, similar to a bond, while still having the potential for some capital appreciation. According to Moore, preferred equity deals in today’s market are offering cash flows between 7% and 10%, with the potential for an additional 5% to 8% upside. Similarly, the Tempo Advantage Fund provides an 8% annual preferred return and a 16-18% target annual net return. The fund leverages preferred equity and mezzanine debt, another popular strategy for CRE investors seeking to mitigate risk while still securing favorable returns.
Mezzanine debt functions similarly to preferred equity but operates as debt rather than equity, giving it a different position in the capital stack. Investors in mezzanine debt typically benefit from regular interest payments, with less exposure to equity-like risks. The TAF typically charges borrowers a combination of regular interest payments and deferred interest, ensuring investors receive steady income with the potential for additional upside upon loan repayment.
This dual approach provides a reliable and resilient investment model, even in uncertain markets. By combining preferred equity and mezzanine debt, investors can enjoy the security of priority payments while still achieving equity-like returns. This balance of risk and reward has made these strategies increasingly popular among CRE investors looking for sustainability and predictability.
The Appeal of Cash Flow Over Capital Gains
For many investors, the past few years have been marked by chasing big returns in speculative markets like tech, stocks, and high-growth real estate sectors. But now, the focus has shifted to generating steady cash flow. Mike Zlotnik, CEO of Tempo Family of Funds and Syndications, emphasized that in a high-risk market, consistent income is more important than ever. The reason for this shift is simple: cash flow provides security. Investors don’t have to rely on market conditions being perfect when they know they’re receiving regular income from their assets.
Chris Miles, from Money Ripples, pointed out, “The truth is there’s risk everywhere right now, so people are asking, ‘Where can I place my money to ensure it’s going to come back to me?'” Investors are increasingly prioritizing assets that generate income consistently, such as real estate, which provides a buffer against market volatility.
Zlotnik went on to say that the key to success in this environment is finding opportunities that offer reliable income streams, even if the overall market is volatile. It’s about making sure you’re protecting your downside. You can’t always predict what’s going to happen, but you can make sure you’re in a strong position to handle whatever comes. In high-risk environments, it’s less about chasing the next big thing and more about safeguarding your investments while ensuring they continue to generate income. This mindset underscores the importance of cash flow as a stabilizing factor in any portfolio, helping investors withstand economic downturns while maintaining steady returns.
Diversification Across Asset Classes
Another crucial component of a sustainable investment model is diversification. By spreading investments across different asset types and regions, investors can reduce their exposure to localized economic shocks or industry-specific downturns. Rob Levy, Managing Partner at LBX Investments, has adopted a diversified investment approach by targeting multiple asset classes, particularly retail and multifamily properties.
Over the past seven years, LBX has focused on the retail space, amassing over four million square feet across regions like the Southeast, Midwest, and the Middle Atlantic states. Levy describes his strategy as contrarian, noting that while many feared the “death of retail” due to the Amazon effect, LBX saw untapped potential in the sector. More recently, Levy has diversified further by expanding into the multifamily market, despite its previous overvaluation. “We felt it was overpriced way overpriced in 2020, 21, 22… but that has changed, and there’s value in the multifamily market today.”
Levy’s approach demonstrates the value of diversification in a high-risk market. For example, while multifamily housing may face challenges in some regions, retail in others may be experiencing a resurgence. By balancing investments across various asset types, investors create a more resilient portfolio that can weather different economic conditions.
Operational Efficiencies to Maximize Value
Another strategy for achieving sustainable returns in an unstable market is focusing on operational efficiencies within existing assets. Jake Vander Slice, of Van West Partners, noted that his firm is focusing on self-storage facilities that are operationally underperforming. “We’re targeting under-managed self-storage properties, improving them through capital improvements and operational efficiencies,” Vander Slice said. By acquiring properties with inefficiencies, investors can drive value without having to rely on external market forces, making these investments more sustainable over time.
Operational improvements can range from better property management to capital upgrades, such as energy-efficient systems or adding new amenities. These upgrades not only improve the property’s performance but also increase its resilience against economic fluctuations by ensuring it operates as efficiently as possible.
Managing Debt Carefully
Leverage is another factor that investors must manage carefully in today’s high-risk market. With interest rates at elevated levels, over-leveraging can put even the best investments in jeopardy. Mike Zlotnik advised investors to be cautious with debt, particularly in an uncertain environment. “We have been high for too long and it’s been a tough environment if you’re trying to refinance or acquire new financing. Lower leverage and debt service coverage ratio constraints make it more difficult,” Zlotnik explained. He also highlighted that with interest rate cuts expected soon, things are likely to improve for commercial real estate investments.
Investors should aim to keep debt levels manageable and avoid excessive leverage that could lead to problems if the economy slows down or goes into recession. As Zlotnik noted, the Federal Reserve’s tightening policies have created liquidity constraints, making it challenging for many investors to acquire financing. Focusing on lower-leverage investments, particularly in asset classes and investment strategies that produce stable cash flow, can help reduce exposure to market risks.
Zlotnik expanded on the importance of navigating these economic cycles, stating, “It’s almost to the point where I don’t wish for a recession, but the economy needs to go through these cycles.” He emphasized that these downturns serve a purpose by resetting inflated market values and rebalancing the economy. “A little bit more unemployment, a little more layoffs would significantly motivate the Fed chair to act, and that will be a significant tailwind for our industry,” he explained.
While recessions are painful, they also bring necessary corrections to overheated markets. For investors, this means being prepared for market adjustments by maintaining low leverage and focusing on assets that can perform well even in a downturn. As the Federal Reserve eventually cuts rates to stimulate growth, those who manage their leverage carefully will be in a stronger position to capitalize on the rebound.
Conclusion
In a high-risk market, adopting a sustainable investment model is crucial for long-term success. Investors are increasingly shifting away from speculative high returns, instead focusing on strategies that provide consistent income and protect their downside in volatile conditions. By leveraging preferred equity, mezzanine debt, and operational improvements, they can enhance resilience against economic fluctuations. As interest rate cuts loom and the economic cycle resets, those who maintain balanced, lower-leverage portfolios will be best positioned to capitalize on future growth opportunities.
