U.S. commercial real estate (CRE) continues to recover after the financial crisis, in large part due to the Federal Reserve’s accommodative monetary policy. Portfolio manager John Murray discusses the state of the CRE market today, and where PIMCO sees opportunities.
Q: What is the state of CRE today? Is it overpriced?
Murray: Central bank policies have quickly thawed the U.S. CRE market, but it’s not boiling over – we think the market is fairly priced overall. This recovery has benefitted considerably from the central-bank-induced environment of low rates as opposed to a notable improvement in fundamentals to date. However, fundamentals are improving and capitalization rates (initial year income yield expectations) should remain low amid low policy rates in The New Neutral. Further, we expect capital flows in both debt and equity to CRE to continue to increase.
Institutional investors, including pension funds, insurance companies, sovereign wealth funds and family offices, have indicated they will increase allocations to U.S. CRE over the coming years by 10+% compared with 2012, according to a 2013 survey by Cornell and Hodes Weill. As such, we believe CRE asset prices will grow about 3%–5% this year and core real estate (i.e., properties in prime locations, well-leased by tenants with strong credit) will likely remain well-bid in the near term. This higher volume of capital will likely move further out the risk curve, however, which should allow secondary markets or transitional assets to outperform core real estate on a relative basis.
Q: Price indexes would indicate that CRE is “back to 2006/2007” – do you agree?
Murray: The Moody’s/RCA Commercial Property Price Indices (CPPI), as well as capitalization rates (cap rates), would imply this is the case. However, there are some key differences.
In 2006, buyers accepted lower and lower cap rates because they believed in high rent growth. These views were amplified as leverage escalated through 2007, even though the cost of debt was significantly higher than it is today (the U.S. Treasury 10-year yield was over 4%).
Today, buyers are willing to pay low cap rates because they are accepting low yields, as opposed to underwriting high rent growth assumptions. While leverage is once again helping returns through low nominal rates, loan-to-value ratios remain 10%–20% lower than in 2006/2007 based on our underwriting. Generally speaking, low yield and low leverage create a more stable profile in terms of downside risk to CRE asset prices because borrowers have more equity in their deals.
Q: What might market participants have missed or forgotten to consider?
Murray: Given the disproportionate amount of capital flows to core real estate this cycle, I think some core real estate investors might be forgetting that lower cap rates imply greater duration risk for CRE assets. As an example, although absolute cap rate levels are below their 10-year average, the spread between primary and secondary market CRE cap rates is wider than its 10-year average, according to Marcus and Millichap. This implies that core real estate investors are paying a higher premium today (in the form of duration) for the liquidity and perceived safety of well-leased assets in primary markets versus secondary markets.
Somewhat similar to bonds, the implied duration (i.e., price sensitivity to rate changes) of a CRE asset increases as cap rates decrease. CRE assets are considered real assets; however, the relationship between rent growth and cap rates is not necessarily linear. In simple terms, an asset acquired at a 4% cap rate would require as much as 25% income growth to offset the market price drop if comparable cap rates increased to 5%, whereas an asset acquired at an 8% cap rate would require closer to 13% income growth to offset a cap rate increase to 9%. Given that assets in major markets are above peak prices and secondary market assets remain 10%–20% below peak prices according to the Moody’s CPPI, it is apparent that core investors may not be considering the increased cost of this implied duration for core real estate.
Finally, considering commercial mortgage-backed securities’ (CMBS) role in driving values this cycle, investors need to appreciate why CMBS demand has returned. It’s not that these buyers have a crystal ball on rent growth. Instead, I’d argue they simply lack alternatives in structured credit such as residential mortgage-backed securities (RMBS). We’ve gone from around a trillion per year of new-issuance non-agency RMBS in 2006/2007 to less than $65 billion since the financial crisis began (source: Deutsche Bank). Given the corporate debt market tightening, option-adjusted spreads in structured credit remain relatively attractive today. So, if you want exposure to longer duration structured credit, CMBS is one of the only games in town. To the extent this dynamic changes, however, it could be a negative for CMBS and, in turn, CRE asset values.
Q: How should investment strategies adapt?
Murray: Global capital flows are influencing CRE values in all four “quadrants” of the CRE market: public and private debt, as well as public and private equity. This has been a positive for CRE, but it also comes with the cost of higher correlation to broader capital markets and, in turn, greater volatility. Just look at real estate investment trusts (REITs) in 2013. When real rates spiked after the Fed’s taper comments in May 2013, REIT prices dropped 15%–20% in less than a month, whereas private markets didn’t really budge based on our observations. Whether that drop was appropriate or not, the fact that relative pricing between private and public CRE equity changed by 15%–20% highlights how quickly relative valuations can change today. So, the best strategies are flexible ones that can invest across all four CRE quadrants.
Flexible strategies require diverse platforms. On top of expertise in asset- and development-level underwriting and management, platforms need expertise in structured products, as today’s multi-tranche CRE capital structures create an increasingly complicated collection of put and call options.
Q: Where do you see opportunities for investors today?
Murray: I see six big themes in CRE:
1. Get ahead of the capital wave: Investors looking for higher-yielding CRE returns are turning to value-add strategies. According to Preqin, global real estate private equity “dry powder” for value-add or opportunistic strategies has increased over 15% compared with 2012. In the U.S., these funds will need to target secondary markets, nontraditional CRE assets and transitional CRE assets to hit their marketed return objectives, so the opportunity is to get to these assets first. This gives you both upside potential and some downside protection, as this wave of capital arguably puts a floor on values.
2. Sign up now for the 10-year anniversary: Ironically, while private equity capital raises are back to 2005/2006 levels, the next three years mark the end of the typical lockup period for the private equity funds from 2005–2007, when over $300 billion of capital was raised, according to Preqin. Many of these peak-era fund managers will fail to hit their carried interest thresholds and/or have limited partners that are ready to switch to a new fund or manager. This dynamic creates opportunities to recapitalize assets or limited partner interests from these legacy “zombie” funds that may face a forced redemption.
3. Structured credit is still an opportunity: The 10-year anniversary is also hitting CMBS, with over $350 billion of 2005–2007 vintage 10-year loans maturing in the next three years. So while prices have tightened across the CMBS capital structure, there are still opportunities as dramatic changes in capital structures and pricing in legacy CMBS deals will likely ensue as these securities near maturity. Also, regulation has halved Wall Street dealer CMBS inventories over the past two years, creating potentially attractive entry points for nimble capital that can underwrite and price both the asset level risks and complex options in these capital structures during market sell-offs.
4. Demographic trends point to continued residential development opportunities: Despite a softer-than-expected new home selling season, we remain positive on the residential space and expect household formation will continue to create demand that exceeds supply in both the single-family and multifamily markets. Despite oversupply in some markets, the general landscape remains positive for investments in residential development. Positive employment surprises could amplify residential demand, as the “George Costanzas” who have been living with their parents will finally move out.
5. Regulatory reform is paving the way for non-bank lenders: On the debt side, regulatory reforms such as Basel III’s new risk weightings for certain types of CRE loans will continue to create lending opportunities for non-bank lending platforms. For example, the new Basel III regulations classify many types of non-residential development loans as “high volatility commercial real estate” (HVCRE) loans, which will require a 50% increase in the risk weighting. This creates opportunities for private lending platforms as development becomes attractive again in higher demand markets.
6. The link between REITs and capital markets is real and can create significant price dislocations for nimble capital: While REITs generally invest in core assets, their direct ties to equity and debt capital markets imply they have greater volatility. Events such as the May/June 2013 “taper tantrum” can offer attractive entry points for investors as the Fed manages rate policies and guidance.
Overall, improving fundamentals and increased capital flows from the low-rate environment provide a positive backdrop for U.S. CRE values. However, inefficiencies will persist as new capital meets the “10-year unwind” of the previous CMBS and private equity-fueled bubble. Therefore, flexible platforms that can underwrite, invest and manage across the capital landscape may outperform.