US Roundtable: View from the top

If there’s one question that some private equity real estate executives dislike answering, it is: where are we in the real estate cycle?

“People ask all the time, ‘what inning are we in?’” says Kim Hourihan, senior managing director at Los Angeles-based real estate investment manager CBRE Global Investors. “I absolutely hate that question, because it’s way too specific.”

The answer also isn’t necessarily clear-cut. “From a pricing perspective, I feel we’re approaching a peak,” says Matthew Strotton, head of US funds and investments at Australian alternatives investment firm QIC. “But unlike the previous cycle, the outlook on fundamentals is different. I believe that while pricing may be at these relatively high levels, property fundamentals in certain markets remain attractive.”

Rob Lester, managing director at Macquarie Capital, points out that while the US economy has been in expansion mode for seven to eight years, economic growth has remained at a subdued 0 percent to 2 percent, rather than the more robust 6 percent to 7 percent that has characterized the beginning of every other expansion. “Fundamentals are just catching up, there’s a lot of runway to get where we should have been.”

Meanwhile, Chris McGibbon, managing director at New York-based financial services organization TIAA-CREF, says the concept of a ‘peak’ is relative. “I don’t think the peak of previous cycles necessarily defines the peak of the next cycle,” he says. “We’ve never had two cycles in real estate that were caused by the same thing, that went down the same amount, that lasted the same amount. And the impact will be unique in different markets and different sectors and different parts of the world.”

Rather than in peaks and troughs, Hourihan prefers to define the real estate cycle in another way: “In this market today, is it a risk-on time, or is it a risk-off time?” she asks. She likes to break a real estate cycle into thirds, each characterized by a different level of risk appetite. The first third immediately follows a correction, when no one wants to buy anything. The second third is when “green shoots” start to appear and investors start to pile into core real estate. The final third is when core is overpriced and investors start to go up the risk curve. As for which third the real estate currently is in, Hourihan responds: “I think those green shoot days are numbered.”

Gathered on the 21st floor of TIAA-CREF’s headquarters building in Manhattan, the participants in this year’s US Roundtable agreed that the US commercial real estate market was still a couple of years away from a correction.

“We’re almost done with 2015, and it’s been a great year,” says Hourihan. “We finally see the rent growth across the board and across the asset classes that we’ve been predicting for the last couple of years. Supply is pretty muted, I feel okay about 2016, but then start to get a little queasy as we hit 2017.”

Strotton notes that the primary difference between the current real estate cycle and the one that preceded it is a deeper level of investment demand. “Do we start to see a divergence in expectations from investors that fundamentals are in question?” he says. “I think that this is unlikely to occur here in the US until perhaps as late as 2019, and then you may start to see some weakening signals.”

‘Wobbly in the US’
With a downturn on the distant horizon, the executives spoke about the need to invest more cautiously, not only because of current market conditions, but the macroeconomic factors affecting US real estate. Although Hourihan considers the US to be the healthiest of the global economies, she is concerned about the impact that an economic slowdown in countries such as China is having on the US.

“In terms of investments, I was cautious in thinking about the next five years,” she says. “And then as you saw what happened with the stock market, I think that’s a pretty clear indication that things can be wobbly in the US. So it certainly gives me pause as I look at it.”

Meanwhile, an anticipated rise in interest rates – which have remained at near zero for six years – is another potential concern. “A prolonged low interest rate environment may have created a new paradigm for cap rates,” says McGibbon. “Almost anywhere in the world, if you’re sticking to the top 20 cities, the cap rate for a high quality core asset is going to be on both sides of a 4, which is relatively new.” Historically the selling price for a property could be calculated by multiplying the net rental income by 10; nowadays that equation involves a multiplication factor of 20 or more, he says.

While McGibbon believes that interest rates will remain relatively low for a long time, even a small increase in cap rates will have an impact. “When you’re going from a 4-cap to a 5-cap or a 6-cap if there is widening, that’s a greater decline in value than if you’re going from a 7-cap to an 8-cap or an 8-cap to a 9-cap,” he says.

McGibbon adds that public real estate security risk premiums have widened significantly in the last year. In prior downturns, for example, real estate investment trusts (REITs), commercial mortgage-backed securities and public REIT debt all have led private equity real estate in terms of overall performance. “There’s a lag effect, at least there has been historically,” says McGibbon. “So we’re waiting for that to take hold, either in the form of rising rates or a widening risk premium for real estate, that gives us a bit of pause.”

Given the current cap rate situation, TIAA-CREF is viewing real estate opportunities with what McGibbon calls “a barbell approach.” On one end of the barbell, the organization is pursuing acquisitions of the very best properties, such as the Ala Moana Center in Honolulu, Hawaii, in which TIAA-CREF acquired a 12.5 percent stake from General Growth Properties in April. The property – of which QIC also is part owner – is one of the largest and most productive shopping malls in the world, with over $1,350 of tenant sales per square foot and approximately 2.2 million square feet of retail and office space.

At the other end of the barbell, TIAA-CREF is buying platforms and investing in niche strategies, including the formation of a 50:50 joint venture with NEINVER in January to invest in outlet malls in Europe.

“Quality is quality and it’s hard to go wrong dollar cost averaging into prime assets in the world’s major markets if you have a long term investment horizon, says McGibbon. “At the same time, there is excess yield available if you get creative and invest outside of the major flows of capital.”

Time to develop/redevelop
Given that prime US core real estate has now become fully priced, many investors are rethinking their traditional approach of acquiring core properties. “Our clients have moved from buying core assets two, three and five years ago, to trying to come up with different ways to create yield,” says Lester.

Like TIAA-CREF, one way that some investors are creating yield is by investing in value-add or niche strategies, such as self-storage or senior care. Another is buying platforms and using the platform to grow yield. “It’s not enough for a lot of groups to buy one building,” he says. “But if they buy a portfolio of 20 or 30 assets, they think that can be the cornerstone to build a platform and grow yield over time.”

It is this same search for yield that is driving some private real estate investors, particularly foreign institutions, into development. Lester notes that develop-to-core ventures and forward-funding agreements, where an investor buys up a development pipeline in advance, can be an attractive means of creating yield in today’s climate.

“From our perspective it has become increasingly difficult to acquire value assets, particularly over the last two years,” notes Strotton, whose firm currently has 10 real estate assets under management in the US, eight of which are through a joint venture with Forest City Enterprises. “As pricing has firmed and acquiring appropriate assets has become that much more challenging, we’ve focused more of our attention on building our development pipeline.”

McGibbon agrees. “I think the other thing that’s really important now is not losing sight of replacement costs, because in some cases we’re seeing assets trade at 20 percent or more above replacement costs,” he says. “I think sooner or later, that will bite you.”

The lack of access to stock, with a lot of capital chasing the same high-quality properties, has created such a premium in markets like London, and it is precisely those markets where TIAA-CREF is now developing. “It’s not happening all the time, but you’re seeing enough of it to cause a bit of alarm,” says McGibbon. “So if we can develop, we know we’re getting in at replacement costs while other property is trading already at 20 percent or 30 percent above replacement costs. Then you get the feeling that you’re already starting ahead of the game somewhat from a market value perspective.”

Moreover, it’s not just development, but redevelopment, that has emerged as a high-performing investment opportunity. “The way we’re looking at our existing portfolio, and new opportunities, is how we can generate outperformance through redevelopment,” says Strotton. “We’ve been spending a great deal of time undertaking a master-planned review on a five-, 10- and 20-year horizon on those properties to determine where their next phase of growth is going to be.”

TIAA-CREF also has ramped its redevelopment activity, investing significant capital over the last few years in expansions and re-positioning rather than new acquisitions. “It’s relatively easy to pencil out double-digit returns on the incremental capital investment when your basis is low and you’ve owned something for a long time,” says McGibbon. “You can get a really decent return investing in your existing stock as opposed to competing for new property.”

This is especially the case with older retail, apartment and office properties, where upgrades and other improvements help to boost occupancies by attracting new tenants and to justify higher rental rates. “You’re taking something that might be functionally obsolete and turning it into something that’s in demand now.”

Creating alpha
Despite the difficulty of investing in the current part of the cycle, however, the roundtable’s speakers expect to meet their return targets on their investments. For Hourihan, who is the portfolio manager for one of CBRE GI’s US funds, that goal is an 8 percent to 10 percent levered total return over the long term. That target, she says, is achievable by buying assets at different points in the real estate cycle, where properties acquired during the first third of the cycle are likely to generate returns higher than 8 percent or 10 percent, while investments made during the last third of the cycle are likely to generate returns lower than the target. “You’re combined at a 10, and looking at it that way,” Hourihan says. “So it depends a little bit on the cycle.”
McGibbon has a similar investment approach with real estate performance targets for TIAA-CREF’s general account. The insurance company aims to generate 8 percent to 10 percent returns, whether or not the acquisitions made from the fourth quarter of this year through the end of 2016 hit those numbers.

“It doesn’t really matter,” he says. “I think the more important thing is on a portfolio perspective, in and over long periods of time. Hopefully you pick the right sectors and you pick the right markets and you manage them a little better than the competition, and you create a little bit of alpha with that.”

Other executives, meanwhile, aim to reach their targeted returns by combining investments with different risk profiles. Strotton, for example, has a total return expectation in the 9 percent to 12 percent range for QIC’s US real estate investments, thanks to a mix of core and non-core investments. “If we can get to unlevered returns of 7 to 9, we would be pleased, but we wouldn’t underwrite significant growth from development necessarily,” he says. “We’re a little higher up the risk spectrum than a straight core fund, and a little higher on the return scale. We’re a retail sector specialist, focusing on regional malls, and our alpha comes from redevelopment.”

So while some investors may be paying full price for prime properties, they are also investing in platforms or asset portfolios where they do not expect cap rate compression, and are in fact underwriting cap rate expansion, adds Lester. “Net income and cash flow growth is going to drive returns rather than price appreciation,” he says. “So that’s where they’re looking at different types of assets and different types of strategies to get that higher yield. That’s the alpha.”

Buy or sell?
As to whether it’s a good time to buy or sell, McGibbon says that largely depends on the investor. Investors that are in short-term funds will be net sellers and are not going to be buying much right now.

“At times like these in the cycle, you sell everything that is not a long-term hold, not a strategic hold,” he says. “It’s a great time to sell out of secondary and tertiary markets as pricing is very favorable compared to long term averages.”

Investors with a long-term horizon, however, not only are selling, but are buying. “They realize that if they called the end today and stopped buying, a) they could be wrong, b) if they don’t do anything for two or three years, they’re going to have a big hole in their strategic allocation,” says McGibbon. “Sometimes you’ll get it right and sometimes you won’t from a cycle perspective, but again, over the long term, you’ll get it right if you stick to a solid strategy.”

Lester notes that investors that “buy and hold and have never sold” own a significant amount of the real estate in major US cities, especially New York. Such long-term holders, both foreign and domestic, tend to be less fixated on cap rates, because while they may be viewed as overpaying today, that price will look cheap two generations from now, he says.

Hourihan, however, asserts that most properties are not worth holding onto forever. She points out that the core funds that have performed well have used modest amounts of leverage, had dry powder and could buy into good markets but also were selling at the right time. “What’s irreplaceable?” asks Hourihan. “I would argue that there is an awful lot that people say is irreplaceable that really isn’t.”

Lester, meanwhile, argues that part of the reason that some offshore institutional investors are making long-term property bets in the US is because they are seeking to diversify globally and there aren’t a lot of attractive options elsewhere in the current market. “And if you sell something today, that money is sitting around for five years until you get to another buying opportunity, if you’re really planning on timing the market,” he says.

Managing risk
Meanwhile, the location of an asset remains more important than ever. McGibbon says he is staying away from any market where new supply makes up a significant portion of the real estate inventory.

“There are a lot of markets where it’s been much easier to get developments out of the ground, and if not checked by some force or event or constraint, you could see supply get out of hand and it’s going to have an impact,” says McGibbon. The 6 percent to 7 percent growth in net operating income in those markets will turn negative if new supply is added at too rapid a rate, he says.

He adds that TIAA-CREF is highly focused in terms of the US markets where it invests, which primarily include the West Coast from Seattle to San Diego and the East Coast from Boston to Miami. “We actually have a very disciplined approach, to the point where our acquisitions people don’t buy plane tickets to many non-coastal markets,” says McGibbon.

The firm also has adopted another measure for choosing geographies in the US. “It’s really simple, it’s a very scientific test,” he says. “If you’re flying into a market, and all you see for 20 or 30 minutes before you land is cow pasture, that’s probably not a good long-term total return market. Atlanta is a perfect example. If you’re flying into a market like LA and all you see is rooftops for 30 minutes before you land, that’s probably a good total return market.”

In making investment decisions, institutions ultimately are making a greater effort to assess the risk they may be undertaking in deploying capital in real estate. CBRE GI, for example, has developed an investment model to examine four different aspects and measure both long-term structural and short-term cyclical risk in a metropolitan area, as well as where the best risk-adjusted returns can be found in that particular market.

“As an industry, we have not really been good at measuring risk,” says Hourihan. “That’s one hole where real estate just hasn’t done well. Stocks and bonds, they have tons of frequencies, so they have a lot of data, and we just don’t have that.”
Meanwhile, McGibbon notes that some institutional investors – including TIAA-CREF itself – have been conducting mock scenarios with their investment committees or clients to discuss how they would act in a variety of investment climates.

“They realized that they missed out on great opportunities in 2009 and 2010,” he explains. “So it’s, how do you take what you know and apply it advantageously in today’s environment? That cycle is still fresh in most people’s minds.”