RIP Bob Uecker.

Unless you’re shopping for vacant office buildings in ghostly business parks or depleted central business districts, there aren’t many bargains in commercial real estate. Investment cap rates defy logic. Plentiful sources of capital chase yields that are often below the cost of debt. This “negative leverage” conundrum only makes sense if we have major rent inflation. While this may well turn out to be true, inflation isn’t a one-way street. It will be difficult for rents to outpace operating expenses. Insurance and labor costs march relentlessly upwards, and I don’t expect struggling city governments to offer any property tax relief. But when your debt costs are fixed, inflation is usually your friend.

So are we witnessing a rational investment decision based on inflation outrunning the cost of debt, or are investors simply justfying a need to deploy capital? I suspect its mostly the latter. Asset prices across all sectors are at peak metrics. The casino is open. ETFs outnumber stocks, cryptocurrency treasury companies trade for double their underlying “assets”, and credit markets are priced to perfection. NVDIA dropped 3.4% on Friday. While this decline is eye-catching, the fact that it amounts to $143 billion – a dollar figure on par with the entire market capitalization of companies like Progressive Insurance and Lowe’s – should make one pause.

Nothing causes whiplash more than a painful case of mean reversion. Spreads have rarely been tighter. BBB spreads, a decent proxy for real estate cap rates, are below 1%. Meanwhile, new apartment deliveries are at generational highs. Many “hot” markets like Austin and Denver, now face an apartment glut. That rent inflation you were hoping for? It may take a while.

Given this backdrop, finding bargains among publicly traded apartment real estate investment trusts (REITs) is even more difficult. Let’s take the case of Centerspace, a Minot, North Dakota REIT with a market capitalization of $983 million. Centerspace (CSR) owns 13,353 units across the northern Midwest. Debt exceeds $1.1 billion. CSR has a strong presence in the Minneapolis area but has made an expansion push into Rocky Mountain markets. The 5.15% dividend yield looks appealing from a distance. Unfortunately, recent acquisitions at lofty prices will probably not improve the share price.

Investors in CSR have not had much joy over the past five years. Shares hover near $60, which is about where it stood prior to the pandemic. To management’s credit, CSR has begun to trade out of aging B-quality assets in favor of newly constructed apartment communities. The company also benefits from savvy borrowing moves during the COVID era. The cost of debt is safely below 4% and has a long maturity runway.

Efforts to modernize the portfolio seem to be having a positive impact on cash flow. Recent new acquisitions include a $149 million purchase of 341 units in Salt Lake City and a 420-unit property in Fort Collins, Colorado for $132.2 million.

In 2024, Centerspace generated $88.7 million in funds from operations (FFO). After capital improvements of $56.7 million, distributions to JV partners and shareholder dividends, free cash flow was negative $22.8 million. The dividend appears to be on a more sustainable path today. Capital improvements are on trend to decrease to $29.5 million which will produce $5.7 million of positive cash flow.

The acquisitions should enhance these results as they begin to filter through the income statement. However, it is hard to see how CSR meaningfully improves the languishing share price. The acquisition of Sugarmont, the 341-unit Salt Lake City property, wasn’t exactly a bargain.  CSR paid $149 million for the vintage 2021 asset. I am not familiar with the SLC market, but it seems likely that the $437,000 per-unit price is not far from today’s inflated replacement costs. My estimation is that the purchase was made at a cap rate below 4.5%. Although CSR stands to benefit from the lower operating costs of a newer asset and a market with solid demographics, asset purchases at rates below the current dividend yield are unlikely to levitate share performance.

CSR informs us that they bought Sugarmont with average in-place rents of $2,222 per month. To be generous, I added 10% for other income. This would include items like pet fees, application fees, parking rent, and utility reimbursements. I was even more generous by assuming zero vacancy. Next, I took management at face value and assumed an NOI margin above 67%. The resulting net operating income (NOI) is $6.74 million. This figure translates into a capitalization rate of 4.52% on $149 million.

The reality is that even vertically integrated REITs have a very hard time running properties more efficiently than a 62% NOI margin. I don’t know the real estate tax and insurance landscape in Utah, but maintaining such a low level of operating expenses will be a challenge for Centerspace. As the company continues to shed aging properties for new assets, the cash flow performance should improve as capital improvement requirements decrease. However, acquisitions at lofty prices, and at cap rates below the dividend yield, will not improve investor returns. As loans begin to mature, even at a palatable pace, the debt must reset to rates that are 100-200 basis points above current levels. Centerspace is a pass for me.

I have made this point many times in these pages: a REIT that fails to deploy capital at advantageous rates cannot grow without issuing new shares. Real estate investment trusts are exempt from income taxes so long as they distribute 90% of taxable income. The inability to grow through the reinvestment of retained earnings turns a REIT into a dilution machine. Chose wisely.

Until next time.

DISCLAIMER

The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.