For the November/December issue’s “Five Questions with” SHB spoke to Fred Pierce, president and CEO of San Diego-based Pierce Education Properties, to get his take on the climate for acquisitions in today’s volatile capital markets environment.
SHB: Rising interest rates have put a major crimp on the investment sales market across all sectors of commercial real estate. In your position, from where you sit, what’s the situation in the student housing space specifically?
Pierce: I’d say it’s no different than other sectors of commercial real estate. My observations are completely consistent with your question. The entire investment universe — including student housing — is trying to get their arms around what the interest rate adjusted valuations are. Owners who do not absolutely need to sell are not. Until there’s some volume of closed transactions to observe, many would-be buyers are a little leery of how to set a value so they do not want to overpay in the middle of this rising interest rate environment.
SHB: Where are we with price discovery in the market? Are sellers willing to adjust pricing?
Pierce: I’d say we’re midstream. Owners choosing to sell now are facing certain circumstances, such as: a) they’re at the end of a commingled fund life; or b) they executed their business plan on the asset, and they think it is the right time in the investment cycle to sell. Another consideration is maybe an owner is not going to make as much as they would have in 2021 when there were super low cap rates and ultra-premium pricing. However, instead of earning a 25 percent internal rate of return (IRR), they might earn a 19 percent or 21 percent IRR. And guess what — that’s still a better return than they originally anticipated. Those scenarios reflect many of the owners who are choosing to sell in this environment. Other owners, especially those who are not otherwise feeling compelled to sell, are holding back on disposing, thinking that once interest rates start trending down again, values are going to start trading back up. Even if they have to wait until Q4 2023, some sponsors will do so, if they believe they can sell into a stronger market and earn back seven figures in promote, etc…
SHB: From the lender’s side, it seems like there is not a lot of debt capital available to do deals right now. What assessment can you give us there?
Pierce: The sources and depth of debt providers are presently more constrained. Second, no matter how you evaluate it, debt pricing is higher. The indexes are obviously as high as they’ve been in decades, and the spreads have widened. To transact on the debt side is going to cost you more. Like many in the industry, we focus more on shorter-term debt, with shorter-term business plans and holds. In that regard, and where we can get a decent valuation, the ultimate cost of the debt was not what was driving our return. We’re still finding deals to do, and we’re still finding debt. Some of our key lenders are still lending — we’ve got a deal now for which we are doing a loan assumption which looks better than before in this environment. We have got another pending acquisition where we’ve gone to our normal stables of lenders, and they’ve been willing to quote us, albeit at current market terms. Without reservation, the very plentiful debt that we saw before the interest rate hikes started in early 2022 has narrowed and that is impacting the willingness of many to transact. But most of the bigger student housing owners are going to find debt. The question is how attractive does a deal look under the terms of that debt scenario and the price at which an asset can be acquired?
SHB: The wild card in this environment is the phenomenal pre-leasing we’ve seen for the past two years. How is that impacting acquisitions? And why is it all of a sudden so trendy to lease properties a year in advance?
Pierce: Well, it certainly does help the investment market, because what you’re seeing is higher occupancy across the board. More than ever we are seeing a flight to quality in higher education: applications, admissions and enrollment growth are up at stronger universities. The Power 5 football conferences are getting way more applications than other universities. We’re in a period where macroeconomically, higher education is seeing ever-so-small enrollment growth. Over the next six years, the growth projected by the National Center for Education Statistics, in the aggregate, is approximately 1.6 percent or something like 300,000 students in total. When you start peeling that apart, however, and look at the most elite universities, that’s where all the enrollment growth is going now. To address your question on why it’s more popular to lease earlier, the best explanation is the “echo of COVID.” Some kids didn’t enroll immediately and ultimately came to higher education after a year off. Others missed what college was like and are now seeing college back to its pre-COVID environment. I think that has affected an incremental portion of the college population and made them more secure to lease, and to do so earlier than in the past as student housing markets tighten. In some markets like California, the student housing shortage is getting severe and students are moving earlier to secure a place to live.
SHB: If you had a crystal ball, how do you think the next 12 months will play out when it comes to student housing, specifically student housing investment sales and financing?
Pierce: Operational performance is going to be about as good as it’s been, driven by occupancy. With high occupancy, good things happen. Pre-leasing is already outpacing fall 2022, which is great. Student housing investment sales are going to continue at a slower pace, as we review inflation, interest rates, the economy — especially as it relates to a possible recession. Globally, in the beginning of 2023 you will see investment sales — in all of commercial real estate — standing on the sidelines more so than a normal year. As we enter next fall, you’re going to see a substantial pickup in investment sales activity. Picture this scenario: we start the fall 2023 academic year, and student housing is highly occupied again and we’re in a recession. A recession always bodes well for student housing. People are laying people off left and right. There’s always an uptick in graduate school enrollment during a recession. I think you’re going to see even stronger enrollments, potentially starting as early as next fall. With regard to the debt markets, I think they are going to follow what’s going on in the economy and the varying sectors. I can see debt markets more broadly opening up and pricing getting stronger for borrowers in student housing in the second half of 2023, as the sector differentiates itself from others. Lenders are following the economy, and they generally have a conservative mentality when there’s a recession going on.
This article was originally published in the November/December issue of Student Housing Business magazine.