Investors have been caught up in the momentum during the good times, but going back to fundamentals is a lesson to be learned for a tougher climate. Greg MacKinnon reports

The roller coaster that has been the markets over the last three years has provided many lessons to commercial real estate investors in the US. While the dynamics of the markets have been somewhat different in Europe and the US, the basic lessons learned are likely quite similar on both sides of the Atlantic. One major lesson is that, at cocktail receptions, when investors overhear a conversation about a ‘new paradigm' for real estate investing they would be well served to move in the opposite direction and quickly join another group discussing last night's football match.

Cap rates well below 6% in 2006/07 were said to reflect the new reality of permanently reduced risk premia, due in large part to an endless fountain of CMBS capital. Many (perhaps even most) investors were caught up in the hyperbole and overconfidence, which was sometimes accompanied by exhortations from investment managers to invest before the opportunity passed, or insinuations that the investor would be left out of the next hot fund if they did not invest now. In retrospect, of course, this was simply a bubble imported from the debt markets. The old saying that value is created ‘on the buy', forgotten during the boom, is now being remembered; cap rates on new transactions are north of 8% and fairly close to their long-term average.

The fact that leverage is a double-edged sword is a lesson that has also been painfully relearned. Heavily geared investments can certainly result in outsized returns in good times, but also increase the risk exposure of the portfolio. While easy to forget after a long period of nothing but increasing property values, leverage magnifies not only good returns but also bad. With many properties that had been purchased using high loan-to-value ratios now showing negative equity, many institutional investors are beginning to rethink their approach to leverage and its place within their overall strategy.

There is an increasing realisation that investments must be evaluated on the merits of the asset, not of the financing structure. While leverage can be used to juice returns, returns on a risk-adjusted basis are no better or worse if leverage is used - it is simply a trade-off of higher return expectations for reduced certainty. While there is certainly a place for it in a portfolio, leverage alone does not create alpha.

Further, refinancing risk has returned to the market with a vengeance. In years past the risk of not being able to roll over property financing at maturity kept investors up at night, but this was forgotten during the boom in values. With a seemingly endless ‘wall of capital' available, the notion of worrying about how to roll over debt seemed almost quaint in 2005-07. Although banks have for the most part played the pretend and extend game thus far, maturity defaults remain a significant source of risk for the commercial property markets and going forward investors must return to longer-term planning of financing strategies.

In part, the lessons learned concerning leverage have gone hand-in-hand with a realisation that the property and capital markets are more highly integrated than ever before. No longer is real estate an island isolated from the volatility of the equity and debt markets. The ebb and flow of capital means that cap rates can change quickly and produce volatility in property values that can overwhelm fundamentals.

Investors have also begun to pay far more attention to liquidity risk. The financial crisis brought to the fore the idea that even though many institutional investors have long investment horizons, liquidity needs can still be an extremely important issue. Portfolio rebalancing, payouts to beneficiaries, and the need to meet margin calls and capital calls from funds all require liquidity. Given that property markets are by nature relatively illiquid, and liquidity varies greatly over the cycle, real estate is an asset class for which a strategy to deal with these issues is crucial to establishing its place within a mixed-asset portfolio.

Attempts to improve liquidity in the asset class with structures such as open-ended funds have met their own troubles in this cycle with long redemption queues at some funds. Liquidity is an issue that has certainly now come to the fore, although a well defined strategy to deal with it has yet to emerge.

A final lesson learned by many US investors is a new appreciation of the importance of the governance of the funds in which they invest. Falling markets have created tensions between GPs and LPs, with many LPs frustrated by a lack of transparency and control. There seems to be a growing realisation that LPs gave away too much bargaining power during the upswing due to a perceived shortage of managerial talent relative to the capital available.

With the tables now turned, LPs are exploring new models for investment structures and making more demands of their GPs. For their own part GPs have also learned a lesson: open communication with LPs is of paramount importance. As always, however, it is the details that are important; going forward, more time will be spent on determining if the governing documents have all details clearly spelled out and whether both parties would still be satisfied with the documents if market conditions were suddenly to change.

While US investors have learned a number of lessons from the recent rise and fall of the property markets, one might note that some of these lessons are ones that were forgotten and have now been relearned. The question now is whether these issues will stick in people's minds for the long term, or fade in the excitement of the next upswing.

Whether this episode in the market creates permanent changes may well have a great influence on how the next cycle unfolds. Only time will tell how things develop in the future, but one hopes that this time a lesson learned is a lesson remembered.

Greg MacKinnon is director of research, Pension Real Estate Association