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INTELLECTUAL PROPERTY: Risks at the core

It is human nature that after a fall, we pay much more care and attention to what we’re doing. In fact, it’s immediately after a tumble when we become proactively risk-averse, seeking the safest options on the way ahead. Such a reaction is gripping the US real estate investment community today.

Following valuation declines of up to 50 percent, many investors and fund managers are retreating down the risk spectrum as they seek ways of deploying capital without taking unnecessary chances. The cash-flowing core sector has been the main beneficiary of such a swing in investment appetite.

However, with almost 43 percent of all equity targeting the US eyeing core and core-plus investments, according to the latest Emerging Trends report from the Urban Land Institute and PricewaterhouseCoopers, there are mounting fears the sheer weight of capital focused on the sector is making it as risky as value-added and opportunistic strategies.

Just because an asset has a high occupancy rate and employs low leverage doesn’t mean it is without risks in today’s economy.

In such a low interest rate environment though, it is easy to see the attraction of core. Even lower-yielding core assets offer a premium to the risk-free rate not seen for almost a decade. According to a second quarter ING Clarion research report, the cap rate spread over 10-year Treasuries stood at 506 basis points, compared to the peak of 545bp seen in 2003. The long-term average spread is 260bp.

Couple that with the fact that core assets can usually be acquired at good discounts to replacement cost — and significant discounts to their peak pricing — and there is room for returns to grow as the economy recovers.

It is part of the reason why the industry has seen cap rates for some deals fall to levels not seen since 2005 and 2006. Indeed, in Manhattan, cap rates for ultra core office properties have fallen below 5 percent, while apartments – fuelled by the availability of cheap, government-backed debt – are frequently coming in around 4.5 to 5 percent.

There is, however, one unanswered question in all this: where will the growth come from? In an economy where unemployment remains stuck at 9.6 percent and GDP continues to lose momentum, where is demand for commercial real estate (today and in the near future) set to come from? In a market where corporate and individual spending is still subdued, how can investors underwrite annual rent growth of between 10 percent and 12 percent for the next three years, as was seen recently in one Manhattan office deal, according to people familiar with the transaction.

I get paid as much for achieving solid 8 percent returns through core as for making bigger returns on opportunistic strategies, without the higher risk of losing my job if I bomb.

A US pension plan office

It is a situation that has left many real estate professionals, including limited partners, scratching their heads in wonder. Just because an asset has a high occupancy rate and employs low leverage doesn’t mean it is without risks in today’s economy.

Despite this — and human nature being what it is — appetite for core will remain strong for the foreseeable future. Limited partners, globally, have learned only too well that there is no such thing as consistent 20 percent-plus returns for real estate without a corresponding higher level of risk.

As such, fund managers can expect LPs to continue to reallocate additional capital to the core sector, not just through separate accounts and joint ventures, but increasingly through private core funds. One large US pension executive PERE spoke to said his plan was to increase its allocation to core by 15 percent over the next three to five years and would look – for the first time – at investing in commingled core vehicles, as well as in core assets outside the US, to meet that target.

At the heart of the core attraction, though, is something more fundamental, more human, than most fund managers probably appreciate. It is simply that “life is too short,” as one US pension investment officer told ULI and PwC. “I get paid as much for achieving solid 8 percent returns through core as for making bigger returns on opportunistic strategies, without the higher risk of losing my job if I bomb.”

There may be hidden risks within today’s core real estate sector, but after the traumatic experiences of the past two years, LPs will find it easier explaining to their board possible losses from a fully leased office in Washington, DC, than they would a speculative condo development in Las Vegas.