Report: Opportunistic returns are not viable

Forget the high teens and low twenties returns that were expected of higher-risk real estate strategies in the days before the global financial crisis – much lower yields are what’s realistic today, according to a new report released by PwC and the Urban Land Institute.

These days, annualized return targets of more than 15 percent on a commercial real estate fund are “bordering on fanciful,” according to their Emerging Trends in Real Estate 2013 report. Managers cannot achieve such projections today without taking on a lot of leverage – which is still challenging to obtain – and a lot of risk.

“Added value and opportunistic returns pegged to pre-crash expectations just do not appear viable,”  according to the 34th edition of the annual report. “That is bad news for all the general partners and high-growth managers trying to resurrect their fund management businesses and earn generous promotes off their optimistic appreciation scenarios.”

As large amounts of capital are likely to be tied up in deleveraging and refinancing through at least the middle of the decade, return expectations are changing, and “real estate looks more like ‘the income vehicle’ it was meant to be,” the report stated. In general, three-quarters of real estate returns are derived from income, while only one-quarter are from value gains.

“Any return in the 6 percent to 10 percent range looks particularly attractive in 2013 when compared to interest rates and inflation, not to mention against stocks and bonds,” according to the report. In addition, debt investments are likely to generate better risk-adjusted returns than equity as a result of high loan-to-value ratios and realistic valuations that together would act as a buffer against downside risks.

Moreover, the high yields targeted by opportunity funds could be particularly difficult to achieve in commercial real estate markets with improving but still weak fundamentals.  In such markets, it will be challenging for managers to earn promotes, but that is far less of a concern to megafund managers, which can earn huge fees just based on their assets under management, than for smaller general partners that rely on promotes to survive.

“Because finding good opportunistic investments in the current environment is difficult, more opportunity funds ‘will be forced into development’ to have any chance of realizing satisfactory performance bonuses,” the report stated. The obvious obstacle, however, is that many fund managers lack development expertise and would need to team with experienced local operators.

Meanwhile, “expectations for returns decrease on paper, but investors still push for higher yields than may be possible or reasonable, especially given the insipid economy and ongoing political intransigence,” the report said. Pension plans are grappling over strategies and return expectations, as they try to balance the need for alpha to fill funding gaps with the need for steady income to meet current payout requirements.

In response, fund managers have struggled to come up with products that can meet investors’ aggressive return parameters. After all, pension capital was first drawn to real estate because of return prospects of 15 percent or greater, but those projections have not panned out, one survey participant noted.

Emerging Trends, written by real estate forecaster Jonathan Miller and PwC director of research Charles DiRocco, Jr., includes interviews and survey responses from more than 900 leading real estate experts, including investors, fund managers, lenders and consultants. This year’s interviewees included Thomas Arnold of the Abu Dhabi Investment Authority, Sam Zell of Equity International, John Kukral of Northwood Investors and Steve LeBlanc of White Stone Associates (formerly with the Teacher Retirement System of Texas).