QE tapering will have different effects on different parts of the real estate market. Christopher O’Dea examines the outlook for the ‘four quadrants’
Global capital markets are “in a state of transition”, says Principal Real Estate Investors, as the US and developed economies decouple from emerging markets, and post-crisis monetary policy continues to evolve. “The pricing of real estate will, over the intermediate-to-longer term, be heavily influenced by how the turning point in US monetary policy impacts the dynamics of asset reflation that have thus far been the most powerful force behind the recovery in real estate values.”
Principal employs a ‘four quadrants’ model to assess the relative attractiveness of opportunities in public and private debt and equity for the $50bn (€36.6bn) in real estate assets it manages.
”What is not clear, though, is whether publicly-traded REITs are once again serving as a leading indicator of a possible turning point in private market real estate valuations”
The four quadrants have posted “varying performances” so far. One of the biggest gaps is the divergence between public and private equity. While US REITs “reacted quite adversely to tapering talk, the private real estate equity quadrant delivered another year of double-digit total returns on both an unleveraged and leveraged basis amid the market’s fifteenth consecutive quarter of net appreciation,” according to Principal. What is not clear, though, is whether publicly-traded REITs are once again serving as a leading indicator of a possible turning point in private market real estate valuations as was the case in February 2007 and March 2009.
The immediate re-pricing of liquid REITs relative to private real estate equity can lead to performance variation between the two quadrants. And right now, says Principal, the value of REITs as a leading indicator is complicated because they have been more highly correlated with the Treasury market than with the stock market. That could reflect differing views in the two quadrants as to the vulnerability of real estate to rising Treasury rates, but other factors could be at work. Principal notes REITs had climbed to price-to-earnings multiples well above their long-term average, so 2013’s performance may have been a return to the trend.
There are mixed messages on the debt side as well. Competition among private lenders is intensifying, which will likely cause continued downward pressure on spreads for much of 2014, especially if the economy continues to improve. From a total return perspective, CMBS had a challenging year in 2013, despite strong improvement in delinquency and special servicing rates, and CMBS spreads “have continued to gradually grind in over the past few months, albeit are not yet back to their 2013 narrowest point.” Principal believes this calendar year “will conceivably see private label CMBS new issuance break above $100bn for the first time since the global financial crisis began.” Insurance companies plan to increase loan production in 2014, they note, and banks are “more heavily utilising their lending capacity for CMBS origination instead of construction.”
Principal expects interest rates to rise, though at a more moderate trajectory. If 10-year Treasury rates were to stay below 3% for a substantial portion of 2014, the two public quadrants “should perform reasonably well”. However, over the intermediate to longer term, there is an upward bias in Treasury rates as tapering proceeds. “As such, staying shorter in duration in a rising interest-rate environment would, all else being equal, generally be advisable for total return-oriented investors.”
How do the quadrants stack up now? “Partly in response to the interest rate outlook, REITs have continued to rally and we notched them down a tad from an attractiveness standpoint,” Principal said in a statement. “CMBS upside is also somewhat more limited given the recent rally.” And despite the extended strong run in private equity, “we bumped up the attractiveness of value-add private equity given expectations for a broader real estate recovery to gain traction in 2014.”
The real estate team sees private equity opportunity in several sectors, including develop-to-core, which is emerging as a strategy to leapfrog increasing competition for top-tier assets by building new, high-quality properties, says Don Wise, president and CEO of Metzler Real Estate. Seattle-based Metzler Real Estate is an affiliate of Frankfurt private investment bank B. Metzler seel. Sohn & Co. KGaA, and sponsors the Metzler US Real Estate Fund, which represents German institutional investors.
Principal sees build-to-core opportunities in new construction for multi-family, and on a more select basis in office and industrial. Build-to-core strategies add development risk to leasing and marketing risks. A variation, leaseto- core, incurs only leasing and marketing risk – Principal sees potential value for the approach in selective suburban office properties where acquisitions may be priced at material discounts to replacement cost.
Perhaps the most compelling opportunity lies in industrial property. “A broad-based recovery in industrial is now beginning to unfold which should set the stage for improved net-absorption, especially of mid-sized boxes,” according to Principal.
Metzler agrees. “Fundamentals continue to improve for the industrial sector,” the firm says in its US outlook. Vacancy rates have dipped to levels not seen since early 2008, while large retailers are driving growth to meet their industrial-space needs. Industrial supply dipped as low as 0.4% of total inventory during 2013, well below the 1.5% rate during the previous economic recovery. But Metzler expects about 165m sqft of proposed space will start coming to market as vacancies continue to drop.