Appetite for real estate remains strong among US institutional investors, whose preference for core assets is no more than a return to more traditional, pre-boom behaviour, as Greg MacKinnon reports

For US institutional investors in real estate, these are interesting times.

This may or may not be a good thing. While US investors remain firmly committed to real estate as an asset class following the financial crisis, current market conditions have created some uncertainty about the optimal strategy to pursue.

Background to the decisions faced today by US investors can be found in the 2010 Investor Report recently released by the Pension Real Estate Association (PREA). This PREA survey of its investor members reported an average 7.5% allocation to commercial real estate as of year-end 2009, down from 9.9% in 2008. Much of the decrease is likely attributable to the drop in market values. It is important to note, however, that even after the decline in values through 2009, the actual allocation to real estate was still higher than five years previously (5.9% average allocation in 2004). Despite the upheaval of the last couple of years in the markets, the long-term trend towards higher allocations to real estate within institutional portfolios remains intact.

The PREA Investor Report also showed 90% of survey respondents expecting no change in target allocations in 2010. No respondent expected a decrease. Unlike previous cycles in real estate markets that often shook investors' confidence, institutions remain committed to commercial real estate as an integral part of their portfolios.

The PREA survey reveals that over two-thirds of respondents have target allocations to real estate above 8%. Given the average actual allocation has dipped to 7.5%, there is room for considerable capital to be deployed into the sector.

But where is capital going within the real estate sector? In the US, as in much of the developed world, there has been strong investor interest in high quality core properties. Preliminary results on the Open-End Diversified Core Equity (ODCE) fund index from NCREIF show a healthy 6% total return for Q3, even while broader indices of commercial real estate show overall real estate values have yet to enter a sustained upswing. Results from the Moody's/REAL CPPI index showed overall values down 3% in July, back near cyclical lows, while values for trophy properties in six major markets rose 8% in that month. Anecdotes abound of properties attracting multiple bidders and going at cap rates not seen since the market peak.

The issue for institutional investors is what all of this means for positioning real estate portfolios. Values of primary market core properties appear to be booming, while values more broadly continue to languish and default rates continue to rise. Is the flight to safety and resulting recovery in core values the first step to broader recovery in commercial real estate? Will lower yields in core push investors further up the risk-return spectrum, leading to recovery in the secondary markets and more opportunistic type properties? Or, has excess risk aversion resulted in a return to bubble prices for core? Which of the two scenarios holds true is an important issue for investors wrestling with how to best position their portfolio.

When evaluating the flow of capital into core properties, one should keep two issues in mind. First, while undoubtedly there is a flight to safety in reaction to the losses during the downturn, in many ways it can also be seen as a return to normal. Just over 50% of the average US institutional real estate portfolio was allocated to core investments in 2009, with the remainder split between value-add and opportunistic. But only five years previously over 70% had been allocated to core. Thus, during the boom years there was a major shift away from core and to higher risk-return properties among US institutional investors. The current flows back into core may simply be unwinding some of the excesses of the boom.

Second, even though cap rate compression has again become part of the lexicon, while it is constrained to high-quality primary market properties, pricing has to be considered within the context of a low interest rate environment. With yields on 10-year Treasuries at around 2.5%, cap rate spreads are still far above their long-run average. Cap rate spreads over BBB corporates are also above average. With defined benefit pension plans under pressure to meet actuarial rates of return in a low-rate environment, the extra yield with relatively low risk available in core real estate can appear quite attractive.

An issue for those institutions wishing to deploy capital is the continuing lack of transactions. The tsunami of defaulted properties that had been predicted to come to market never materialised, leaving substantial capital on the sidelines. While there are some signs that the extend-and-pretend paradigm among banks may be slowly ending, it remains difficult to put capital to work - in core because of the high competition for properties, and in higher-risk segments because of a lack of properties on the market and a bid-ask spread between buyers and sellers that remains stubbornly large. In some cases, institutions have begun to consider more seriously opportunistic debt strategies as a way to generate returns and obtain properties in the current environment.

While it is an overused term, ‘cautiously optimistic' perhaps best describes current institutional attitudes to the US commercial real estate market. There are certainly some complicated issues to deal with, but there seems to be general agreement that the worst is over and that the market is turning a corner, barring a double-dip recession or continued lack of employment growth. The PREA Consensus Forecast Survey for Q3 (surveying investment managers and research firms) showed the average forecast return on US commercial real estate for 2011 and 2012 as being above the long-run average.

Of course, only the future will tell whether this materialises, but it would certainly be a welcome respite from the past two years.

Greg MacKinnon is director of research, Pension Real Estate Association