Core deals could be ‘more risky’ than value-add

Buying core real estate assets at low cap rates could be as risky a bet today as investing in under-leased or “capital-stressed” deals.

With more than $122 billion of equity currently eyeing core real estate deals in the US, concern is mounting that the sector could be as risky as some value-added, even opportunistic, investments, according to a white paper from advisory firm, Hodes Weill & Associates.

The sheer volume of equity targeting core assets, particularly well-leased properties in key cities such as New York, Washington and San Francisco, has prompted a “feeding frenzy” at some auctions, with more than 30 bidders showing up helping push prices up and cap rates down.

However, Hodes Weill founders David Hodes and Doug Weill said with economic growth expected to be muted over the next few years, such low cap rate deals didn’t “appear to be a good risk-adjusted investment.

“We remain unconvinced that recent cap rates for well-leased properties are justified in terms of future growth prospects for operating cash flow,” the white paper said. “Well-leased buildings purchased at low cap rates may actually be more risky than investing in under-leased or capital-stressed investments where the opportunity exists to drive cash flow and add value.”

Many institutional investors are increasing their allocations to core real estate in the wake of massive write downs in their value-added and opportunistic portfolios. Hodes and Weill said, over a full real estate cycle, a plan sponsor’s real estate assets should be weighted to core.

However, bearing in mind the competition and risks currently inherent in the sector any portfolio realignment should be done over the next three to five years instead of immediately.

“Patience will be rewarded and it is prudent to wait for investments that pencil out on a “price per pound” basis, as opposed to underwriting that requires a rebound in operating fundamentals. In this uncertain economic environment, growth should be the gravy on the investment, not the beef,” the report added.