Tyler Goodwin: Why core is going to get more expensive

There is a lot of real estate capital on the sidelines as investors rightly focus on managing legacy-asset challenges and navigating through the fog of COVID-19. But it is important to look beyond the challenges immediately in front of us as part of our mandate to make five-year-plus investment decisions. Seaforth Land recently completed its annual research and strategy-vision statement and we have come to a conclusion that is contrary to current market behaviour.

Over my 30 years in the industry, I have never been more inspired by our industry’s solidarity during these past six months, exemplified by the sharing and debating of research and the constructive and transparent exchange with our industry peers. I hope by sharing Seaforth Land’s research we are doing our small part in maintaining this momentum of solidarity into the future.  

In the post-COVID world, there are three confluent events that we expect to join forces and materially accelerate the compression of core real estate yields: declining risk-free rates, rising institutional allocations, and shrinking supply of core. These forces are co-dependent, but can be broken down into two derivatives: declining risk-free rate, and rising allocations/declining supply.

This first derivative is fairly straightforward. Over the past 20 years, central London core yields (or, cap rates) have shown a strong correlation spread (r2 = 0.73) to the nominal risk-free rate (10-year gilts). In figure 1, you can see that over the past five years that spread has averaged 2.9% reflecting in part the uncertainty of Brexit. However, between 2000 and 2007 that spread averaged 0.7%, and during 2014 the spread between cap rates and gilts averaged only 1.8%.

With current 10-year gilts trading at 0.38%, simply applying the more conservative past-five-year’s average spread suggests London core yields could compress from today’s 4% to 3.3%.

Recent evidence showing the power of monetary easing on cap rates comes from France and Germany where their dovish approach to bonds following the 2008 financial crisis saw cap rates respond accordingly once asset price dislocation abated (see figure 2).

Before moving on, it is important to recap why core real estate matters. Core, along with core-plus, represents about 55% of the real estate investment-management market¹. Core real estate has particular appeal to investors during uncertain times as truly core assets require only passive asset management and should feature long-term reliable cash flows secured by credit tenants. Institutions allocating to core are searching for the inflation protection of real assets, bond-like income, and upside potential of equities but with historically lower volatility.  

In exchange for these characteristics, investors have been willing to accept over the long run returns of between 6% and 10% (including a conservative level of debt), with up to 75% of that total return coming from current income (as is the case for the US core ODCE funds index from inception) and the balance of return coming from capital appreciation. I believe the US ODCE index² is an excellent benchmark for investor expectations of core and core-plus given its size and transparency.

Core continues to grow in relevance. Between 2013 and 2018, allocations to core and core-plus grew at an impressive 11% compound annual growth rate³. Over the past decade institutional real estate allocations have graduated from simply an “alternative” asset class to a material recipient of total allocations with Canadian, Dutch and Australian pension funds holding as much as 25% of their total assets in real assets.  Core real estate’s significant share of allocations means it plays a critical role in our global economy – helping institutions like pension funds to meet their employee’s pension obligations, insurance companies to pay out on coverage, and endowments, foundations and sovereign wealth funds to fulfil their respective public and private mandates.  Even before COVID-19, institutional investors had been unable to meet their target allocations. Common complaints have been the competitive market and the self-liquidating nature of fund investments and reinvestment challenges.  

‘Doubling down’ then on core then is counterintuitive, further exacerbated by asset-level deterioration in net operating income (NOI), a weak debt market and market uncertainty. We believe some of what was presented as core probably never truly met the definition of core – which makes allocating and stock selection even more challenging.

More capital, smaller universe
I don’t think we need to dwell on the ‘wall of money’ point. Investors have sought to keep up with ever-increasing core targets that between 2005 and 2017 rose from 5% to 9% of US$3.1trn (€2.6trn) in assets under management⁴ – a number that is significantly larger when one considers the amount of core investment made directly by institutions, corporates, and private investors including family offices.

How allocations are made vary widely between investor, but a significant consideration is real interest rates, which over the past decade have rapidly declined. From 2011 to 2020 the UK has seen 24 quarters of negative real rates and the US 11 quarters.  

Today, we are in uncharted territory. The Bank of England’s benchmark rate is at a record low of 0.1%. In May it sold three-year gilts at just below 0% – the first negative yielding gilt auction in its 326-year history – and signalled that negative interest rates are still “in the toolbox”. In the US, the Fed has shifted from a “bygones” approach to an “average inflation target” of 2%, thus also signalling a dovish “low for longer” approach to interest rates and sanguine view on inflation. 

We believe the OECD-wide dovish stance on higher inflation and low interest rates coupled with the general risk-off institutional investment environment thanks to COVID-19 will lead to an increase in the wall of capital heading into core despite it having already been a competitive investing environment prior to the pandemic.

Meanwhile, the universe of core real estate is shrinking – not just in terms of value, owing to the valuation effects of COVID-19, but in terms of physical stock.

To understand why, we need to look back at the definition of core real estate and the role it plays in an allocation strategy. Truly core-office real estate should require only passive asset management and feature long-term reliable cash flows. NCREIF recently reported the Q2 2020 ODCE return results that commercial real estate returns were -1.56% – the worst since 2009. In fact, the net income returns only declined 0.11% from the previous quarter to 0.91%, which is well below the five and 10-year quarterly averages of 1.06% and 1.19%, but the capital appreciation was -2.46%, driving total returns negative. Annual outflows from US ODCE funds have exceeded inflows by US$1.9bn for the period ending June 2020. I imagine many of these investors would disagree that the outlook for core is positive.

Only part of the reason for these core outflows should be attributed to COVID-19 and investors calling the top of the market. Some core funds have exposure to what we consider inherently weak assets. Some of these assets might have a decent history of stable returns, but on a forward-looking basis they should expect downward reversionary rent and value deterioration. Core investors are also voting with redemptions on those funds that are viewed as over-exposed to such assets. Even prior to COVID-19, in February one fund was reportedly facing a $7bn redemption queue, representing about a third of its total equity under management.

Indeed, over the short-term there should be NOI deterioration and arguably a short-term risk premium that will push valuers to reprice assets. But we believe that COVID-19 has also simply exposed assets that were inherently weak when viewed through a core definition. Of course, each asset needs to be viewed individually – an investment-grade covenant on a 20-year, inflation-indexed lease over a poorly designed old building is still core. 

Notwithstanding this, we are all aware of the disruption facing a range of assets, for example:

● The disintermediation of the retail sector by online;
● The mismatch between short-dated income and long-dated debt in serviced offices;
● The fickle price-driven demand for commoditised office space versus the premium being paid for ‘creative’ office buildings;
● The shift to online retail hugely benefiting warehousing.

The fact is, by definition, assets that are asset-management intensive or have unreliable long-term cash flows are no longer core. They used to be and could well become core again, but many will need to go through significant active asset management, repositioning, adaptive re-use, re-tenanting, or writedowns to a new price-clearing basis. These are all actions that defeat the core investor’s intention of owning real estate as an alternative to fixed income.  

Therefore, while the size of the value of the core universe has been negatively affected, the compounding effect of the actual reduction of core physical stock must also be factored in. The shrinking of the core universe will create even further downward pressure on yields as more investors compete for less stock.

We expect three variables to drive down cap rates for core:
● Declining risk-free rates: Notwithstanding current spreads owing to COVID-19 risk premiums, over time core yields will return to track the risk-free rate;
● Rising institutional allocations: Central banks are communicating a dovish inflation policy, pledging ‘low for longer’, which will hurt institutional allocations to bonds while benefiting real assets;
● Shrinking supply of core: Market changes and COVID-19 have led to a shrinking of the world’s core investment universe.

For decades, institutional investors have had the relatively passive option of buying the market beta of core through open-ended and closed-ended commingled funds, and fund managers have been incentivised to grow those funds to offer their investors diversification across geography and asset classes. The very thing they have become means that many of these funds are now massive freighters that can take years to turn and rebalance but, in the meantime, might be illiquid and experience price volatility when their ‘core beta’ is under threat of being tainted by non-core assets.

The rise in separate account investing, where institutional investors award investment managers discretionary and non-discretionary mandates to build bespoke portfolios, can offer investors more control over stock selection and sale decisions and the ability to determine their own definition of core. Direct investing is also increasing, with and without investment managers.

Investment strategies and tactics need to be built around each institution’s broader needs. Should significant yield compression materialise, there are implications for almost all real estate investment strategies across the capital stack and risk-return spectrum.

Footnotes:
1 Mckinsey & Company, A Turning Point for Real Estate Investment Management, Nov 2019
 2 This index tracks the property level returns of 24 open ended comingled funds pursuing core investment strategies that currently total $264.4bn in gross real estate assets.
3 Mckinsey & Company, A Turning Point for Real Estate Investment Management, Nov 2019
4 Preqin

Tyler Goodwin is the founder and CEO of Seaforth Land