The pandemic has so profoundly disrupted the private real estate market that certain longstanding assumptions about property investing no longer apply.
Let us take the term ‘obsolescence,’ for starters. ‘Obsolete’ buildings once were associated with old, dated-looking properties desperately in need of a refresh. But with covid driving a more heightened focus on sustainability and ESG, along with rapidly evolving tenant demands, even newer looking buildings are at risk of not being what the market wants, as we explore in our latest cover story. Indeed, many real estate owners have acknowledged they will need to assume higher capital expenditures to ensure their portfolios will be fit for the future.
Higher cap-ex, however, does not necessarily translate to enhanced rental growth or better returns. For example, US offices have a cap-ex reserve equal to 28 percent of net operating income, the second-highest in the market after US lodging, with a cap-ex reserve of 30 percent, according to an October report from California-based commercial real estate analytics firm Green Street. The long-term rental growth – 1.3 percent for US offices and 1.2 percent for US lodging – is on the low end of a range that runs from 0.2 percent to 3.4 percent across 17 US property sectors. But the latter has a risk-adjusted return of 6.5 percent, above the 6.3 percent average among the 17 sectors. The former, meanwhile, has an expected return of 5 percent – the lowest among the group.
This is one of the reasons why a key metric for measuring a property’s value – the capitalization rate – stands to become less relevant going forward, particularly for the office sector. As Matt Nicholson, senior managing director at JLL Capital Markets, tells us, “I don’t think cap rates are the most appropriate metric anymore for that asset class, because they are capital intensive.” This is especially the case for older multi-tenanted office properties with significant capital spend requirements in the near term.
Meanwhile, total returns and cashflows have become the more relevant metrics for investors, rather than what the average cap rates are for the sector at a given moment in time, he says. While the increased focus on internal rates of return and cash yields is not necessarily new, there is greater emphasis on these metrics now, Nicholson adds.
Indeed, trying to assess one component of the cap rate equation – asset value – has become much more challenging. When Brookfield Asset Management purchased a 12-property, 2.4-million-square-foot office portfolio in the Washington, DC metro area from local real estate investment trust WashREIT for $766 million during the third quarter, the assets traded at a low-8 percent cap rate and $325 per square foot. The sale price fell far short of expectations – in fact, 20 percent below the mid-6 percent cap rate and $410 per-square-foot pricing estimated by Green Street.
As the WashREIT example demonstrates, property pricing has become much more of a moving target and will be increasingly determined more by factors specific to a particular asset – such as its sustainability, flexibility and technology attributes – rather than similar properties in the same market.
It is a time of ongoing upheaval in private real estate. What investors and tenants want in properties has dramatically changed, and so has the way assets will be perceived in the market and how they will be valued going forward.