Friday Letter Premium investing

With concern mounting over inflation and future jobs growth, should investors eyeing the US start asking for a risk premium on their real estate investments?  

As events in Egypt have shown only too clearly this week, there can be unforeseen risks in investing internationally, especially in emerging markets. Whether it be for political, fiscal, currency or cultural risks, GPs targeting countries from China and Brazil to Vietnam and Colombia undoubtedly will be asked to deliver a risk premium over and above expected returns in more developed markets, such as the US and UK.

However, delegates attending the Association of Foreign Investors in Real Estate (AFIRE) winter conference in New York this week were cautioned to carefully consider the need for risk premiums in the US, as global – and domestic – investors increasingly eye the country for opportunities.

An AFIRE survey of its 200 members, which together represent $627 billion of global real estate, revealed that 72 percent of investors expected to invest more capital in 2011 compared to 2010, with a further 60 percent of respondents claiming the US offered the best potential for capital appreciation – the highest level since 2000. In 2006, just 23 percent of investors gave the US the same seal of approval.

The surge of capital targeting US real estate is part of investors’ natural reaction to retreat to safety in the wake of the crisis. But with transaction volume still in the early stages of recovery, the US is suffering from an excess of demand and severe under-supply. Evidence of this already has been seen for core assets in top markets, with many office deals in New York attracting 20 to 30 bidders and helping to send cap rates below the sub-5 percent mark. This is causing many to wonder whether core real estate deals are now as, if not, more risky than value-added and opportunistic strategies.

The ultimate issue though, AFIRE delegates heard, was uncertainty over real estate fundamentals. With expectations of future interest rate hikes and slow jobs growth, questions remain over when and where demand for US real estate will come. As Bob White, founder of data provider Real Capital Analytics, said during the two-day forum: “There is a risk the capital is out in front of the fundamentals, and [investors] are banking too much on an economic recovery and rental growth over the near term.”

And this concern is as much targeted to the US’ core markets as it is to its secondary and tertiary locations. With the US’ top markets suffering a dislocation in supply and demand, attention is now turning to the country’s secondary markets and assets. In venturing into cities such as Dallas, Cleveland, Pittsburgh and – some would even argue – Boston, investors and their fund managers have to ask whether job growth will return in any sizeable form.

Barden Gale, chief executive officer of JER Partners, said judging the “dynamism” of a secondary market was critical. “In secondary markets you have to sharpen your pencil even more because there are definitely going to be winners and losers.” As a result, he argued, GPs should be looking for cap rate risk premiums of between 200 basis points and 300 basis points on secondary market deals.

Caution, therefore, will continue to be the name of the game in 2011 for foreign and domestic investors alike. Just as Starwood Capital Group founder Barry Sternlicht said: “It’s a fascinating time for investors, but you really have to be very cautious as you could get trapped.”