Hi {{first_name | there}},
Each Tuesday, I send a short note on commercial real estate to help you be a better investor. Topics may include deal stories, how I'm thinking about risk, lessons I'm learning, and market observations as we oversee our $500MM+ CRE portfolio and serve our 1,100+ investors.
One of our investors (Joe) recently sent me a good question...
Paraphrasing: the long end of the yield curve (U.S. Treasury bonds with maturities of 10 years or greater) has been climbing. What are you seeing in the industry, and is it harder to find the right deal with that headwind?
The answer is yes. Debt has become more expensive, and the opportunity cost of every potential CRE investment has changed.
We have roughly $10MM available to deploy today, with additional investors waiting to see our next deal before committing. This isn't theoretical for us.
I'm 33, and my long-term goal is to build Wellings into an enduring real estate private equity firm that prioritizes investor returns over simply growing AUM.
One tension I think about constantly is that we grow by raising and deploying capital, but growth can conflict with investor returns if putting money to work becomes the primary goal.
Treasuries at 5%+ raise the bar. Investors can earn a meaningful return while they wait, so a real estate deal has to offer enough additional return to justify the added risk, illiquidity, and complexity.
The easy response would be to loosen our underwriting standards so we can keep putting money to work. We're trying to do the opposite.
Here's how I'm thinking about it.
Treasuries Vs. Commercial Real Estate
Today, the five-year Treasury yields ~5% and the ten-year ~5.27%. Both are higher than after the Fed raised rates 11 times in 2022 and 2023.
That's real competition for capital. Hold a Treasury to maturity and you know your yield with essentially no credit risk. You can also sell before maturity, though the price may change.
Now compare that with a commercial real estate deal projecting a mid-teens return. You're taking illiquidity, leverage, market, and operator execution risk, plus uncertainty around the exit.
Commercial real estate can offer things a Treasury cannot, including tax benefits and better projected cash flow and appreciation.
Treasury interest is subject to federal income tax but generally exempt from state and local income tax, while real estate depreciation may shelter taxable distributions received from an investment.
CRE Pricing Hasn't Fully Adjusted to Higher Rates
Treasury yields have risen materially, raising both borrowing costs and investors' opportunity cost.
In theory, this should put upward pressure on real estate cap rates, which means lower prices.
But we haven't seen pricing adjust meaningfully yet.
That leaves buyers with an awkward combination:
Higher borrowing costs + a higher opportunity cost + property prices that haven't fallen enough to compensate.
You could go under contract on a deal today, for example, when the five-year Treasury yield is at 5%. Then maybe the five-year goes higher before closing happens 60-90 days later, and maybe the seller doesn’t agree to re-trade/reduce the purchase price to compensate and make the numbers work. Then the deal is dead.
Regarding industry stress, the Mortgage Bankers Association estimates that $875 billion, or 17% of outstanding commercial and multifamily mortgage balances, is scheduled to mature in 2026. Higher rates can mean higher payments and smaller replacement loans, requiring owners to contribute equity to refinance or sell when they don’t want to.
That could eventually create buying opportunities. CRE moves slowly, so time will tell.
For any private real estate investment today, the key question is: What does the return look like if rates and exit cap rates don't improve? Is that return still enough above a similar-duration Treasury to justify the added risk and illiquidity?
What We're Seeing in Our Pipeline
We continue to review 20-30 deals per week. As of today, we have 19 deals active in our pipeline:
7 in screening, where we quickly eliminate deals that fall outside our check-size, asset-type, geography, or operator-experience requirements
8 in review, which are deals that have passed initial screening and are getting a deeper look
3 where we’ve proposed our check size and structure to the operator
1 where the operator has verbally accepted our proposed structure and check size
0 with an executed LOI/term sheet, our most advanced pipeline stage
The four deals in our three most advanced stages consist of one retail deal and three multifamily deals. We're not confident that any of these will proceed.
There's also one mobile home park portfolio in review that could be compelling, but it's still early.
Truthfully, it's been frustrating to pass on so many deals, especially after getting very close on a handful and putting significant time and effort into them.
How I'm Thinking About Growth
The easiest way to measure progress for a real estate private equity firm is dollars raised, assets under management, and dollars deployed.
We want to do deals and we want to grow, but I don't think those are the right primary KPIs.
We cannot guarantee investment outcomes, but ROI to investors is our north star.
I believe that if we take care of our investors and deliver attractive risk-adjusted returns over time, growth will follow. We have to earn it.
All the best,
Ben Kahle
Managing Partner | Wellings Capital