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PwC: LPs to be less core-focused in 2014

 Amid an anticipated rise in exit cap rates, institutional investors are expected to shift their emphasis to non-core real estate strategies in the US in their continued search for yield.   

Interest rates in the US are expected to rise next year and that is to have a major impact on where real estate investors search for returns in the country over the coming years, according to a survey from tax and consulting firm PwC and the Urban Land Institute (ULI), published late last week.

“2014 is forecast to be the year that institutional investors reduce their emphasis on core properties,” PwC’s Andrew Warren, ULI’s Anita Kramer, ULI’s Stephen Blank and Michael Shari wrote in the 2014 Emerging Trends in Real Estate report, which reflected the perspectives of more than 1,000 industry participants. “In the expectation that core investments with fixed-income-like streams might struggle with valuations as exit cap rates begin to rise, their future equity investments should reflect a search for higher returns in value-added and opportunistic investments in secondary locations, with development focused in only the strongest markets.”

The key change will be a focus on fundamental performance rather than cap rate compression. With interest rates anticipated to rise moderately in 2014, income growth in real estate instead is expected to come from rising occupancy or rising rents. “This marks a significant shift from a dependence on cap rate compression for appreciation growth that has become ingrained in investment strategies across property types,” the authors noted.

The investors consequently are expected to put greater emphasis on improving cash flows to enhance returns, and that means more attention on asset management. Therefore, more attractive property investments could be those which have prospects for improving value, a change from recent trends where investors favored assets with high occupancies and were considered safe bets, the authors said. The report also predicted a growing confidence in secondary markets for investment in 2014 outside of core gateway markets Boston, Chicago, Los Angeles, New York City, San Francisco and Washington DC.

But the timing and pace of interest rates hikes will remain the key risk for real estate investment. Citing one property investment advisor, the report noted it was uncertain how dramatic the increases would be, and that rising rental rates in supply-constrained markets would offset some of the cap rate increases that would result from interest rates climbing.

The report noted a widespread belief that an orderly increase in interest rates would not cause a major disruption to the recovery of the US real estate market. That said, “the potential for rising rates leaves a lingering shred of uncertainty and discomfort over higher interest rates, which will muddle the exit strategy for investors if cap rates rise,” the authors said.