Against a backdrop of low economic growth, US real estate investors may have to reassess their return expectations. Stephanie Schwartz-Driver reports

The problem in the market now, according to Russell Appel, president of Praedium, is that "risk-free rates have declined, growth is slow, but people are looking for the same returns".

When the market bounded back last year, it gave many investors false hope, Appel believes. "Many had very good returns when the market first rebounded because when liquidity came back into the marketplace, demand for assets was very high. Now prices are higher."

This summation goes to the heart of the investor's conundrum in the US at the moment and is an overview that William Hughes, global head of real estate research and strategy at UBS Realty Investors, agrees with. "Over the past two years, our group has frequently had a different outlook than the broad market view. We were cautious when the market took off, thinking that was temporary," he says.

"Since 2009, we have had a consistent view of our expectations. We have been expecting this to be a modest, slow, and turbulent recovery, but we still do see this as a recovery." In the UBS view, prices were abnormally inflated in 2006-07, as investors stopped pricing risk in order to chase yield.

But there are always effective investment strategies, even in a confounding market like today's. Praedium, for one, is able to earn its historical returns. The firm is focusing on two areas: multi-family and distress.

"We are mostly looking at multi-family, because there is growth in demand and good cash flow," says Appel. "We think if you buy multi-family today at a good price, you can get solid current yield plus growth.

At UBS, Hughes also has a positive view of the multi-family sector. "We are most confident about income growth in apartments," he says. "It is the space we are underwriting most aggressively but also where we are expecting pricing to be the highest, as many investors acknowledge the drivers of demand in that space".

Lenders are also viewing multi-family more favourably than other sectors, according to findings of PwC's third-quarter Real Estate Investor Survey. Respondents reported some of the highest loan-to-value ratios this quarter for the multi-family sector. For office, on the other hand, survey respondents believe that "lenders are not lending as much for office deals, given the underlying stress in that sector". Interest rates in the multi-family sector average 3.5%, against a broader average of 5.99%, which admittedly is 60 basis points lower than the survey average a year ago.

The PwC survey reveals another sign of strength in the multi-family sector: "As signs of recovery emerge, sellers have started to gain control of certain sectors of the industry, such as apartments and dominant office markets..." It is only certain regional apartment markets where this is the case, however. It might be a seller's market nationally, but in the mid-Atlantic states and the South-east, neither buyers nor sellers have the advantage.

On average, 31% of respondents believe that market conditions favour buyers overall - and this is down from almost 57% last year.

But in a challenging market, finding the right deals takes a broader focus than just sticking to the soundest sector. Praedium has a philosophy that is simple in concept. Appel says: "In a low-growth environment, there are three priorities: find out where there is growth; and/or buy cheap (either distress or notes or a recapitalisation deal); and/or have a specific plan to increase the cash flows."

Appel believes it is valid to make a trade-off between cash flows, on the one hand, and liquidity and growth on the other. It is possible to buy in a stronger demand market, like New York City, where there may be more growth and more liquidity, but relative current yields are constrained by the higher price tag. At the same time, from a risk standpoint, the investor is betting that the market will grow. If, on the other hand, the investor buys a steady, tenanted property in a less-sought-after location, there is secure income and less reliance on growth.

"Personally, in an environment where there is low growth, I like current yield," Appel says.

Research by PwC reveals that under current market conditions, this yield has a lot to offer diversified investors. "When there is prolonged volatility in equity markets, real estate is an interesting asset class to investors internationally," says Mitch Roschelle, US real estate advisory practice leader, PwC. "And when treasury rates are as low as they are, real estate returns are not low relative to that."

In addition, relative to other assets, real estate is less volatile. PwC compared the
overall real estate cap rate with the S&P 500 earnings yield, as a proxy for cap rates, and found that cap-rate volatility was distinctly less than that of the yield. "In a portfolio, real estate smooths out some of the rockiness of volatile markets," says Roschelle.
"The near-term reality," says Roschelle, "is that considering the near-term volatility, we may not see appreciation in values, but we will see stable income."

UBS also recognises the spread between low risk and higher risk. "During the spring of 2011, when the market was slowing a little, there was a great deal of discussion about how core was overpriced," said Hughes. "Our view is that this was appropriate pricing because of the risk we were facing. In a low-growth environment, it is hard to put a value on value-add or opportunistic deals. There should be a bigger spread between low risk and higher risk, and we are anticipating more pressure on core."

Interestingly, Hughes points to retail as a potential source of good opportunities. "There is a dichotomy there between how the market is responding and the fundamentals," he notes, pointing out that retail sales have recovered - in September, retail sales rose 1.1% from August, the strongest monthly growth for six months and up nearly 8% from the previous year. Nonetheless, investors have retained their distaste for retail properties. As a result, transaction activity is light.

One set of investors looking away from core markets is foreign investors. While most foreign investors in US real estate have been focusing on core properties in coastal markets, Jones Lang LaSalle (JLL) has found that European and Asian investors are increasingly interested in secondary markets, value-add and distressed properties.

According to Steve Collins, international director, international capital groups at JLL, there has been an increasing appetite for secondary, value-add and distressed properties by foreign investors since the end of the second quarter this year. "With the turmoil in Europe, real estate investment started getting a little murky for big investors," he said, noting that, in contrast, the US and Canada are the most transparent real estate markets.

In addition, foreign investors are taking a clearer look at the US real estate market, says Hughes. "In 2008, there was a perspective that the US caused everybody's real-estate problems, and investors retrenched, focusing on their home countries," he said. "Today they understand the background to the crisis better and they have also learned that the crisis in single-family housing is different from commercial real estate."

Real Capital Analytics shows that cross-border acquisitions in the US for the third quarter alone will amount to more than $5bn (€3.59bn), the highest since 2007. Two-thirds of this is heading to the major gateway markets, with Manhattan alone accounting for as much as 40%.

Even though initially foreign investors focused on New York, Washington DC, San Francisco, and Los Angeles, as this space has become more crowded, they have broadened their outlook to include core-plus (or core with some vacancy) and started to look outside the major markets. For example, in August, Allianz, along with CCP Investment Board of Canada, purchased two Boston multi-family properties, and in the same month, a Korean-Japanese joint venture bought Three First National Plaza in Chicago.

Opportunistic deals, but only in core markets, have also been attracting attention, at least from those foreign investors that already have offices in the US. Collins points out that, in general, foreign investors that do not have bases here are more cautious.

Development deals have also been attracting the attention of foreign investors, capitalising on the fact that there has been virtually no new construction in the past two years. Building now should come online in time for economic recovery. Collins cites Hines' CityCenterDC development, with the Qatari Diar Real Estate Investment Company (the real estate investment arm of the Qatari Investment Authority) as the anchor investor, as an example of foreign investors getting in on the start of new building in the US. CityCenterDC is a 10-acre mixed-use development in downtown Washington DC.

In addition to Middle Eastern interest, German investors are also looking for development partnerships with firms with strong track records, Collins says. Interest is also coming from Asia-Pacific investors. Collins says that he has recently had conversations with three Asia-Pacific investors looking at possibilities in the multi-family space. " They want to develop here on their own; they are willing to take the risk and do not want to partner," said Collins.

The US market, in fact, is ripe for development, especially since this is the first crisis in which overbuilding did not play a role, Roschelle says. It is true that residential was overdeveloped somewhat, but the bigger problem in that sector was too much debt. In general, however, because there was not overbuilding, demand will ultimately push rates up, and the US market now displays "some reasonably interesting supply-and-demand fundamentals", says Roschelle.

Although US real estate is operating against some pretty significant headwinds - a sluggish US economy and economic ambiguity around the globe, as well as domestically a lack of job creation - there are also some distinct positives. For one, there is a relatively low and stable interest-rate environment, says Roschelle. "I feel better about the next couple of years in commercial real estate than I do about other markets," he adds.

And, importantly for the sector prospects, Appel believes that the distress is clearing out, but doing so in an inconspicious way. Many assets valued under $50m sell without a lot of fanfare and do not attract the attention of the press. In addition, banks are working with the borrowers and some deals are being done quietly between the banks and their current borrowers.

"There is a steady flow of these transactions. There is not a public record if a borrower pays off a loan at par or at a discount, because title to the property does not change. More of this is happening than the market thinks," says Appel.

But while there is a consistent flow of deleveraging, which is undeniably healthy for the market, "it is not as fast as I would like", Appel admits. He estimates that we will continue to see recapitalisation deals for the next five years.