By Shihao Feng
Mark Green, chief investment officer at Los Angeles-based manager Cottonwood Group, says the firm is looking at the potential for investing in office-to-residential conversions as it looks for opportunity throughout the capital stack.
“People are continuing to talk about the distress in the office sector. What’s interesting is how you play it from a lender’s position or even as an equity provider. For us, we’re currently looking at the office-to-residential conversions,” Green told Real Estate Capital USA.
Though there has been momentum in implementing office-to-residential conversions, Green remains cautious on some of the potential challenges.
“Whether it could be just retrofitting a larger floor plate, or [replacing] the HVAC system, getting it rezoned [and] entitled for residential or multifamily versus the office use … It is not easy whatsoever, and there’s a lot of capital expenditures that need to go in,” he said.
Green added it also depends on whether the converted residential building can be filled up with people who want to live in the area that used to be a location for office properties.
Investment strategy
Willingness to look across the capital stack, asset classes and types of loans is proving to be a key differentiator in today’s market, Green says.
Senior lenders are looking for alternative lenders who can provide structured financing across the capital stack and have relevant development and asset management resources to complete a project, Green said.
“I do feel there’s a greater need for lenders like Cottonwood that could have development expertise, internal infrastructure and asset management capabilities, so that if something does go wrong, we could step in and complete it,” Green noted.
He added this demand comes as alternative lenders take a growing market share while bank lenders pulled back from commercial real estate due to regulatory concerns and the unfavorable interest rates environment.
“We’ve seen this in so many different cycles: whenever there’s a market dislocation or disruption, new lenders come into the picture,” he added.
Ability to pivot
In response to market demand, Green noted Cottonwood closed several loans last year at various positions including mezzanine debt, subordinate debt and stretched senior loan.
These transactions strengthened the firm’s outreach to lending opportunities. “I feel like there’s a great amount of momentum and tailwind for us because of what we did last year from an origination standpoint,” Green said.
With the ability to invest up and down the capital structure, Green noted the company has been investing in both equity and debt while keeping the ability to pivot for specific projects’ needs.
“When interest rates were unbelievably low, it was more favorable to look at equity opportunities. However, as interest rates increased, [the market saw a] lack of lenders that were able to lend, we then filled the gap of going higher leverage and taking a market share that we wouldn’t have been able to take two years ago,” Green said.
Sometimes, senior lenders would like to direct transactions to Cottonwood because the firm has diverse capabilities to follow the deals down the road.
When participating in such lending transactions, Green said the company will go through a rigorous due diligence process to understand on-the ground details of the project and to examine the demand and cost projection of the properties.
“There have been times where we’ve looked at deals, and we are unable to get comfortable due to market dynamics, or if there is a supply/demand imbalance, so we pass on the deal,” Green added.
Outlook
Looking ahead, Green expected to see a higher-for-longer interest rates landscape, as well as more competition in the lending market.
Green believes there is a slew of factors that may influence the Federal Reserve’s decisions on potential rate cuts, which include not only the inflation statistics but also the performance of the US Treasury market and other macroeconomic and political sentiments.
He also noted the expectation of aggressive rate cuts in 2024 has been diminished, and it is now anticipated that one or two rate cuts will be made by year’s end. “There have even been some forecasters who question whether the Fed will raise rates next, but it’s unlikely,” he added.
In addition, Green said the competition in the lending market has come back from the beginning of the year. “I don’t know how long it will stay or not, [but] you’re seeing the pricing weighed in on certain asset classes and it’s become more competitive,” he added.