Investor Universe - US: Playing under caution

Low interest rates are keeping US pension funds in property. But the market is also showing them a number of yellow cards, writes Christopher O’Dea

Many sports have embraced the yellow card as a warning since FIFA unveiled the colour-coded disciplinary scheme at the World Cup in Mexico City in 1970. And the US property sector is adopting its own version, with investors warning about the potential late-cycle risks of overheated pricing and declining yields, just as institutions continue to increase their allocations to property.

Property has become almost the only game in town for pension funds and other yield-starved institutional investors with significant amounts of capital to allocate. While the US Federal Reserve is expected to raise interest rates this year, the Fed’s new watchword is “patience”. 

US yields are not immune to global economic and monetary effects, and monetary policy in the EU and Japan helped push the 10-year Treasury yield below 1.8% earlier this year. At the same time, Fed-watchers say the Federal Open Market Committee is eyeing with concern a broad employment indicator that says there is still plenty of slack in the US labour market, reducing pressure on the Fed to raise rates.

Against that backdrop, property offers investors a fighting chance to stay in the yield game by allowing for rent increases if the economy improves. So, although some traditional US property investors have moved to the sidelines – and some market participants say the lessons of the financial crisis are being forgotten – US real estate is expected to continue attracting capital in 2015.

But just as players hit with a warning in sports must adapt their behaviour accordingly, property investors are advised to exercise caution. Money will continue to flow to real estate from across the capital markets, but investors should be increasingly concerned about getting caught late in the cycle and should anticipate the next cyclical downturn in a few years.

“Investors are concerned about what might happen if capital markets turn away from property”

Jacques Gordon

“Investors are concerned about what might happen if capital markets turn away from property,” says Jacques Gordon, global head of research and strategy at LaSalle Investment Management. While timing-strategies are difficult to apply to a relatively illiquid asset class like real estate, he adds, “adjusting portfolios as assets and markets move through their respective cycles can improve performance by enhancing returns and reducing risk”.

Reviewing core exposure
Institutions and their consultants are digging into property holdings to identify and ring-fence exposures, and to ensure that new property allocations are made to strategies that will diversify risk and preserve capital if interest rates rise or property prices become volatile.

“There are a lot of organisations interested in better understanding their real estate and real assets portfolios,” says Michael Humphrey, managing principal and co-founder of property consultancy Courtland Partners. “Clients are saying ‘we don’t want any surprises’,” he says.

Property can play various roles in a portfolio, but – especially at the lower end of the risk spectrum – it has become the go-to asset for replacing low bond yields with a source of steady income that has good capital preservation, Humphrey says. Global monetary policies aimed at jump-starting sluggish economies with low interest rates “have only exacerbated what’s going on,” he adds.

Core property funds have met the demand for income from pension funds. The resulting demand for prime properties, typically bought by core funds, has pushed the price of those assets to near-record levels, with some prime office property in US gateway markets trading at cap rates of around 4% – just as benchmark interest rates are expected to head higher. “That turns the traditional definitions of core, value-add and opportunistic on their heads,” says Humphrey.

Core assets are now exposed to price risk, making it imperative for pension investors to know what each of its core managers owns by major, secondary and tertiary market, average property size, and other factors. Courtland analyses manager holdings by breaking a core portfolio into senior mortgage and net-lease investments, beta-core and core-plus components, assessing how various interest-rate changes would affect the price and income returns from each fund. Assessing property details across several managers is critical for pension investors to “be able to further refine and define risk”, he says.

But many pension portfolios have reached their limit for allocations to those conservative core strategies, and consultants are steering them towards a broader range of property types, and to new sections of the capital stack that offer more capital protection than equities.

“One client believes interest rates are going to 5% in five years,” says Humphrey. “I think that’s less likely. But if interest rates move up significantly, there is risk in the core allocation that you need to focus on.”

To diversify that risk, Courtland works with clients to identify potential secondary and tertiary markets, as well as specialised sectors like senior housing and self-storage, which may offer higher income levels and less aggressive pricing than gateway cities. It is a challenge – Preqin says 41% of consultants said finding attractive investment opportunities was the most important issue in the property market during 2015, while the macro environment and fees was cited by 44% of consultants as the most important issue.

This is prompting big changes in the types of property consultants are advising their clients to allocate to this year. There is no slowdown in the pace of allocation to property overall, says Preqin in its 2015 Global Real Estate Report – 36% of institutions already allocate 11% or more of their assets to property, and 33% of consultants say they will advise clients to invest more capital in property during 2015. With 47% of consultants planning to advise clients to maintain current allocations, managers can expect ample inflows.

In the biggest change, nearly 30% of consultants say they are advising clients to allocate less capital to core strategies. Among consultants advising clients to increase their allocations to property, 42% recommend increasing capital invested in opportunistic strategies, and 40% advise going further along the risk spectrum to value-added strategies, Preqin says. Also indicating caution about placing fresh capital with core managers, Preqin found that 27% of consultants will advise clients to increase allocations to secondary-market strategies that acquire limited partnership interests at a discount from fund managers or other investors.

Capital allocations show that pension funds are doing just that. Advised by Dallas-based consultancy Gregory W Group, in the third quarter of 2014 Oklahoma Teachers’ Retirement System bulked up its property portfolio with the appointment of six managers to run an additional $300m in non-core strategies, including apartments, value-added US office and industrial property and opportunistic situations. Net return targets ranged from 11-13% for value-add strategies to 15-17% for opportunistic investments.

Property markets around the world are at different stages in terms of their fundamentals, capital market conditions and performance. Thus, Gordon says, investors should follow an investment strategy that takes advantage of real estate cycles, using cycle-sensitive strategies such as harvesting gains and selling properties in frothy capital markets, taking advantage of higher levels of leasing or rental growth in growth markets, and focusing on locations or sectors that are positioned to qualify as mainstream core assets in a few years.

Preparing for the next cycle
Despite global headwinds, LaSalle says overall transaction levels for US property will come close to, or surpass, the pre-recession peak, as lenders become increasingly aggressive in deploying capital, driving “very strong” flows of debt and equity capital into US property. Rather than bet on sectors or regions only, Gordon says investors should focus on secular trends such as demographics, technology and urbanisation – many companies will be willing to pay higher rents in 2015 for properties located in central business districts that improve the ability to recruit talented millennials. Sustainability factors such energy efficiency and recycling should also be priorities, whether buying or repositioning buildings. “Capital markets will be paying much more attention to environmental standards in the years ahead,” he says.

Commercial property remains attractive to investors, with robust activity across lenders, property types and strategies. 

“Borrowing costs for permanent, fixed-rate loans are declining and leading to increased property acquisitions,” says Brian Stoffers, global president, debt and structured finance at CBRE Capital Markets.

While plentiful liquidity has contributed to demand for property, CBRE says improvement in real estate fundamentals has spread from multifamily to office, industrial and retail. 

Loan volume for industrial and office property was up 31% and 20%, respectively, during the first three quarters of 2014, while loans secured by retail property rose more than 50% in the period. “Investors are looking for more opportunistic, higher-yielding opportunities in the [retail] sector,” CBRE says, and the overall financing surge has contributed to increased risk taking.

“With more borrowers aggressively pursuing value-add deals,” says Stoffers, “the risk spectrum has shifted outward in commercial real estate as investors continue to seek yield”.

The search for yield has prompted some traditional equity property owners to head for the sidelines as cap rates have moved towards 4% on trophy properties in gateway cities, says Bruce Meyerson, co-chair of the real estate capital markets and debt group at law firm Goulston & Storrs. The availability of debt capital has allowed loan-to-value ratios to rise to 80% on class-A and B-plus property from the 60-65% level of the past few years, he says. “I’m not sure how many lessons have been learned,” he adds.

The increased appetite for risk can be seen in the multifamily sector, which has been one of the main destinations for institutional investment in the US for the past four years. While capital continues to be attracted to multifamily housing, CBRE says growth appears to have levelled off as bidding for prime opportunities has become highly competitive.

This is prompting institutions to move further into value-added territory to find returns. In the largest multifamily asset purchase in Southern California in nearly two decades, a syndicate of US and international institutional investors in January invested $482m in an off-market acquisition of a 14-property portfolio of value-added, class-B multifamily units that will be upgraded into affordable, higher-quality workforce housing. The group included Allstate Life Insurance Company, a subsidiary of NYSE-listed Allstate Corporation and The Guardian Life Insurance Company of America. 

The transaction was led by TruAmerica Multifamily, an 80/20 joint venture between Guardian and Robert Hart, who served as CEO and president of Kennedy Wilson Multifamily Management Group before launching TruAmerica in 2013. It was the second such deal for the multifamily investment platform. With homeownership rates in the US at a 20-year low and rental demand increasing in almost every age bracket “we are transitioning into more of a multifamily-oriented society”, Hart said. “Our new partnership with Allstate,” he added, will enable institutions to start “investing in opportunities that provide affordable, workforce housing to fulfil growing demands”.

While investors are digging deeper to find value in apartments, rental housing is an early-cycle property type and momentum is shifting to later-cycle sectors. In a report on the 2015 outlook for REITs, Fitch says office, retail and industrial property “should continue to benefit from low levels of new supply”. What’s more, leases signed at distress rates during the financial crisis are starting to expire, presenting an opportunity to bring rents back to market levels. “Rent increases for these property types have only recently begun to make development feasible in select markets and bank appetites for construction lending to these sectors remains low,” according to Fitch managing director Steve Marks.

The best area for growth in 2015 might be light industrial facilities. Properties smaller than 200,000sqft “have historically outperformed larger distribution centres in terms of rental growth, but have lagged behind in the current cycle,” says CBRE. 

While the demographics-technology-urbanisation trend is most often applied to urban office, retail and apartment sectors, CBRE says technology and automation are also driving increased US manufacturing production, which will boost light industrial fundamentals in 2015 as “demand rises for facilities in smaller infill locations in land- and supply-constrained urban areas.”

New Mexico Educational Retirement Board added $70m to senior housing and value-added strategies in follow-on commitments to existing managers. The senior housing strategy, which is targeting returns between 10% and 14%, will invest across the industry, including independent living, assisted living and memory-care senior housing. It will also consider a wide range of vehicles, including acquisitions, joint ventures, mezzanine debt and forward commitments on new developments.

While it is not a foregone conclusion that core property will suffer price declines, there is a lot at stake for institutions that have hefty core allocations. 

Some hedge funds are betting that weakening economic growth around the world is already taking a bite out of the property sector. Recent local press reports indicated that several hedge funds had taken short positions in London property brokerage firms that were starting to suffer as sales of central London luxury property slowed dramatically late in 2014. Weakness in that sector might not portend rough sailing for office buildings and multifamily projects, and other hedge funds have been moving into the US mezzanine debt market, helping to fill the gap between equity and senior mortgage debt.

“If interest rates move up significantly, there is risk in the core allocation that you need to focus on”

Michael Humphrey

“Borrowing costs for permanent, fixed-rate loans are declining and leading to increased property acquisitions”

Brian Stoffers

Some large US funds are deeply engaged with their consultants on significant expansions of their real estate investments, which could result in more capital being allocated to both core and specialised strategies. Working with consultant RVK (formerly RV Kuhns), the Ohio Bureau of Workers’ Compensation is considering a proposal to add capital to core and value-add strategies as part of a plan to double its real estate allocation from 6% to 12% of assets. The $1.4bn property portfolio equates to 5.6% of the plan’s $24.7bn total assets.

If approved, the investment would include increases of 4.5% to 7% and 1.5% to 2% for core and value-added allocations, respectively, and could also see a new allocation of 3% for core-plus investments. The plan was due to be considered at a board meeting in March. Ohio classifies core-plus investments as properties bought at discount which need value-added capital improvements and more robust leasing efforts. Core-plus deals would also include leverage of 30% to 60%.

While the potential new core allocation is likely to be invested with Ohio’s eight existing open-ended fund managers, the proposed plan includes an effective “position limit”, capping investment in the funds at 1%, or approximately $200m-225m, of the total plan assets. If the new plan is approved, RVK will work with the fund’s investment staff to find new managers.

Aon Hewitt Investment Consulting has advised The Colorado Public Employees Retirement Association, which oversees more than $45bn in assets, to adopt a new allocation plan to reduce the plan’s exposure to global equity and fixed-income strategies. Under the allocation, Colorado PERS would increase the amount of capital invested in its main real estate programme from 7% to 8.5% of total assets. 

The allocation would reduce global equity to 53% of assets from 56%, and fixed income to 23% from 25%. The proposal also includes a new 1% target allocation to cash to help PERA reduce surprises all around by better managing cash flows related to benefit payments, contributions, capital calls and distributions.

The Aon Hewitt proposal also advises an increase of 1%, or $1.6bn, in the capital allocated to the plan’s opportunity fund. That would mark a big boost in capital for an alternative property sector – timber investments are 40% of the opportunity fund, which also includes commodities, risk parity strategies and tactical opportunities. Colorado PERA already has positions with external timberland managers composed of 14 timber properties with locations in the US, Canada, Australia, and New Zealand.

This will certainly be a year when consultants advising pension funds on property investment earn their keep. 

Despite widespread expectations that US benchmark interest rates will rise later this year, the rise could be modest, or delayed further if the economy weakens.

In that case “it may not be the right move to take chips off the table in core property and major markets,” says Humphrey. The main message to pension fund managers, he says, is to understand the fund’s goals and how property fits the plan. 

“In our view, be more income-focused, be aware of your leverage exposure and the cap rate used for valuation,” he says. And in today’s environment that’s not second-guessing managers, “that’s being prudent”.

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