ExchangeRight Has the Right Stuff
September 28, 2020 | James Sprow | Blue Vault
Blue Vault recently interviewed Joshua Ungerecht at ExchangeRight, the real estate sponsor that offers diversified portfolios invested in recession-resilient necessity retail and healthcare properties for 1031 and REIT investors. Even as the pandemic continues to dramatically impact some property sectors, notably discretionary retail and hospitality, the portfolios that ExchangeRight syndicates in their offerings continue to perform well. In fact, business tenants in those portfolios have in many cases seen sales increase. We last spoke with Joshua and Warren Thomas back in April, so this interview represents a check-up to see how their strategies are faring amidst the economic turmoil.
We began our interview by asking Joshua if there have been any changes in the list of tenants that ExchangeRight targets for its offerings. He let us know that despite all that has been going on, their acquisition criteria have stayed pretty much the same: “ExchangeRight continues to invest in the same investment-grade credit tenants in necessity-based retail and healthcare industries. One thing that may have changed with the COVID-19 crisis is the perception by the public of just how resilient some of these properties are. We’ve been calling them necessity-based retail and healthcare properties for a long time—in these times, the government designates them as ‘essential’.” ExchangeRight’s focus on tenants operating essential businesses has helped the company maintain their perfect collections record even through the pandemic, receiving 100% of rent from its net-leased properties without needing to offer forbearance to any tenants across its total portfolio of over 700 properties.
Despite the stable performance of their existing deals, the economic fallout from the pandemic has had an effect on ExchangeRight’s way of developing new offerings, motivating them to be innovative and to adopt more flexible syndication and acquisition strategies.
For example, in late March, Bank of America informed ExchangeRight that the debt market was completely locked up, making financing impossible to secure for their upcoming deals. Rather than pause or slow their pipeline of net-leased portfolios in the face of the continued need for secure investments on the part of the representatives and advisors they serve, ExchangeRight instead decided to structure their Net-Leased Portfolio 33 and Net-Leased Portfolio 34 as all-cash offerings to continue providing recession-resilient product for 1031 investors. They were able to provide a home for about $50 million in equity with these offerings, both focusing on ExchangeRight’s favored type of necessity-based tenants. The company plans to offer the investors in these all-cash offerings the unique option to refinance out some of their capital before the offerings go full cycle and are aggregated into the company’s REIT platform.
Since most 1031 investors require financing to complete their exchange, ExchangeRight pivoted to working with regional lenders to provide financing for their portfolios while waiting for the larger banks to resume lending, which has since occurred. For all their offerings since Net-Leased Portfolio 34, they have been able to secure financing, returning to larger bank financings starting with Net-Leased Portfolio 37. During the beginning of the pandemic, banks weren’t underwriting interest-only financing, which ExchangeRight prefers because it results in higher returns for investors. To protect their investors from the impact of having to use amortized loans, they chose to structure those few offerings to make up the net difference in cash flow and to reduce the impact of phantom income taxes, at the company’s expense.
ExchangeRight has also seen some repercussions from the pandemic on the acquisitions side. “We’ve seen a squeeze on supply, not necessarily in terms of the number of properties available, but in their pricing,” said Joshua. “With the COVID-19 crisis, there was a mad dash for properties leased to essential businesses, which has driven cap rates for the properties in our target asset class below what we are willing to pay for. We operate within uncompromising limitations concerning the cap rates we will accept, which has made acquisitions somewhat more challenging in this time, especially given the overwhelming demand for our recession-resilient offerings. Still, we have been able to maintain our acquisitions pace in large part through off-market properties direct from developers and from the investment-grade tenants we have fostered relationships with. But also more people are beginning to get realistic on pricing given the present weakness in the economy, so cap rates are moving more in line with what we want to see in our pipeline of deals.”
Asked to elaborate on his overall view of the economy, Joshua shared that he thinks that currently the market is massively overvalued: “There is a disconnect between the market and the economy. If you look at the economy, you have high unemployment and a large number of businesses going out of business. But if you look at what makes up the S&P, a lot of those companies aren’t suffering nearly as badly. So there’s a disconnect.” Speaking to how that disconnect might resolve, Joshua said, “I’m a big believer that markets are cyclical—you can’t kick the can forever. So looking forward, on one hand you have a natural market correction and deflation, and on the other hand you have what the Fed is trying to do—spend us out of this. The Fed is attempting to delay by basically buying up everything, and it looks like they’re allowing the government to spend as much as it wants to that end. But even on that approach it looks like you still eventually get deflation, if you look at what Japan has done. At the end of the day, you can’t escape reality. We could get stagflation, with a really depressed economy and a currency devaluation at the same time that would really make people miserable.”
Directing the conversation back to ExchangeRight, we asked Joshua about what kind of negative impact such potential macroeconomic outcomes might have on ExchangeRight’s future business in his view, and he expressed confidence that it would be minimal. “We’ve been preparing for the next downturn ever since the last one, by focusing exclusively on tenants and industries that remain stable through recessions, and by structuring our portfolios to be secure even in spite of the evisceration of the middle class. The present economic volatility has been an object lesson for us, with our essential business tenants staying open and operational, continuing to pay their rent. We continue to take the long view, designing every portfolio of properties that we add to our total assets under management with our aggregation and exit strategy in mind, taking into account both economic cycles and how investors may eventually be able to realize a potential premium through a strategic exit via a public listing, IPO, merger, or acquisition.”
The company’s long-term aggregation and exit strategy remains the same. As the individual net-leased offerings in their total portfolio go full cycle, their strategy is to continue to aggregate those assets into their REIT platform. For net-leased offerings that have done this so far, investors have been given flexible exit options, being able to cash out, to perform another 1031 exchange, or to perform a tax-deferred 721 exchange into the acquiring aggregated offering. Part of ExchangeRight’s overall aggregation strategy is that investors who take the 721 option gain increased liquidity, value, and security by investing in a drastically more diversified portfolio.
Building from their current AUM of around $2.8 billion, ExchangeRight continues to add to their total assets by about $600 to $700 million per year. The plan is that once their total aggregated portfolio reaches $4-$5 billion to take it to the public markets with either a direct public listing, an IPO, a sale, or merger. Joshua believes that this portfolio is going to be very attractive down the road: “If you look at publicly traded net-lease REITs, pre-COVID they were trading at high 3% to low 4% cap rate range, and now they are in the mid 4% cap rate range. Their yields are in the 4% to 4.5% yield range. During COVID ExchangeRight has a 100% collection rate, vs. an 81% average collection rate for those public comps. The average dividend rate across its total assets under management is 62% higher.”
Joshua made clear that all of the thought and work behind this long-term aggregation and exit strategy is ultimately to create value for ExchangeRight’s investors. “ExchangeRight grew out of the wealth management business and we carry that client-centered focus with us in every decision we make. One way that we reinforce that commitment to our clients’ interest is by aligning ours with theirs. ExchangeRight’s managing partners have invested more than $15 million in our REIT platform, whereas most sponsors in the industry will own somewhere between 0% and 1% of their own offerings. Warren Thomas and I still have wealth management clients and about 30% of ExchangeRight’s programs have been invested in by our own clients, so that’s another real incentive we have to see these offerings perform well. We structure our property and asset management fees to be only about 1/3 to 1/4 of the rate that other sponsors charge. We want those fees to cover the property management and asset management sides of our business, but we do not want those fees to be a profit center, which might disincentivize us from pursuing a liquidity event down the road. All of this is a reflection of ExchangeRight’s passion, which is to empower people to be secure, free, and generous.”
