The risk that interest rates will return to the historical -average is the only cloud on an otherwise bright horizon for US real estate, says Randy Mundt
The 2008 global credit crisis and recession took a major toll not only on the US economy and jobs market but also on US real estate and capital markets. However, the overall outlook for the US economy has brightened significantly, as it appears ready to shift out of its 2010 soft patch into a stronger and more sustainable expansion mode. Real GDP has already eclipsed that of its pre-recession peak in 2008, and real exports are close to doing so. And while employment remains well below its previous peak, it looks set to shift to a higher trajectory in 2011 and 2012, providing a much needed boost to to space market fundamentals.
As the economy expands, real estate capital flows are expected to increase in breadth and depth. Commercial mortgage-backed securities (CMBS) issuance looks set for a strong return, increasing the flow of capital into secondary and tertiary markets. It is also likely that both debt and equity capital flows will expand beyond core into value-add and opportunistic.
By way of example, while most capital flows in 2010 were directed towards fully leased, stabilised properties (core), the search for higher returns will likely cause 2011 strategies to branch out into the acquisition of poorly leased properties (value-add strategies), or even more speculative initiatives such as the vertical development of multifamily properties (opportunistic strategies).
However, as has been the case throughout the economic recovery, relative value differs across and within the four real estate quadrants: public equity, private equity, public debt and private debt. In the fourth quarter of 2010, volatility increased slightly in the public quadrants as investors digested a sharp rise in Treasury rates. And while that put downward pressure on CMBS prices, spread tightening helped offset it and contributed to an excellent total-return year, especially for lower-rated tranches.
Competition in the private debt quadrant has intensified, including more aggressive pricing and higher loan-to-value ratios. And the price recovery in the private real estate equity quadrant continues, with three consecutive quarters of appreciation to end 2010, and momentum building for additional appreciation in 2011 as the economic and jobs outlook strengthens.
Most US publicly traded real estate investment trusts (REITs) have taken advantage of improving capital markets to complete the de-risking and deleveraging of their balance sheets. Favourable capital markets have improved access to both equity and debt capital for REITs. Like most other corporate entities, REITs generally have continued to meet or exceed earnings expectations, helping support prices. And yet a number of indicators suggest that REITs may be getting close to being fully valued, including a shrinking relationship of dividend yields to risk-free rates and a price-to-earnings ratio at year-end 2010 that remained well above the broader stock market. Given these factors, the US property securities sector perhaps offers investors the least relative value of the four quadrants of commercial real estate.
Despite an increase in loan delinquencies, CMBS rallied strongly across the risk spectrum in 2010-11, showing just how severe a decline in commercial real estate prices had previously been reflected in CMBS prices, and the degree to which such loss expectations lessened as the year progressed. However, despite the price increases in CMBS, a high degree of investment selectivity will be needed to outperform.
Core real estate strategies continue to dominate private equity, as investors look for opportunities to acquire income-producing assets at a material discount to peak pricing levels. However, partly because of increasingly intense bidding for core assets, it appears as though value-add strategies (particularly higher-quality properties in primary markets) might offer better relative value within the private equity quadrant in 2011. Well-capitalised investors with strong leasing capabilities have significant advantages in the value-add space. Indeed, such strategies can perform well even if employment growth falls short of expectations, given opportunities for better-capitalised investors to buy poorly leased assets below replacement costs and subsequently take leasing market share away from overleveraged competitors. In addition, the opportunity to acquire poorly leased properties is likely to increase in 2011, as lenders become more willing to sell distressed assets as prices improve.
The more favourable economic and employment environment is expected to help the real estate market to recover. Vacancy rates for all property types, except retail, declined in the fourth quarter of 2010, driven by improving tenant demand and reduced supply. Stronger office and industrial net absorption reflects improvements in the overall economy. In the already robust multifamily sector, strong net demand continued in the fourth quarter of 2010 amid few signs of the typical seasonal slowdown. In contrast, the retail sector, despite a second consecutive quarter of positive demand, has shown only limited improvement in vacancy rates. Overall, trends in space markets are clearly becoming more favourable as economic conditions improve.
The primary risk confronting the asset class is the speed of space market recovery relative to the pace of interst rate normalisation. The eventual reversal of a more accommodating monetary policy and QE2 is likely to produce further rises in interest rates that, all else being equal, will generally be unfavourable for real estate cap rates, discount rates, and mortgage interest rates. While rising interest rates have so far not adversely affected core property values, the suddenness and magnitude of the jump in risk-free rates serves as a poignant reminder that capital markets change much more quickly than space markets.
And that, in turn, highlights one of the risk elements that could serve as a potential roadblock to what might otherwise be a steady recovery in property values: namely, increases in property net operating income could be partially negated by interest rates moving closer to historical averages and, in turn, putting upward pressure on cap and discount rates.
That risk implies that investors stay closely attuned to excellence at the operational level, with a focus on increasing occupancies, pushing rents as much as possible (despite what is still a tenant market), and aggressively reducing operating expenses.
The back-to-basics approach to real estate in the post-financial engineering era continues to be as important as ever in optimising investment performance.
Randy Mundt is CIO, Principal Real Estate Investors