After the great mortgage bust, opportunities are beginning to open in select real estate sectors. Yields are running high against 10-year Treasuries, which historically has been a good predictor of real estate fortunes – five years ahead.
“We think [it’s] the beginning of an attractive time period to invest in real estate in the U.S.,” says Laler DeCosta, a client portfolio manager at Invesco who is based in Atlanta. Real estate is down 44% from the March 2008 peak. DeCosta was speaking last week at a seminar on real estate investing sponsored by the Toronto chapter Chartered Alternative Investment Analysts Association.
In general, U.S. real estate looks promising because capitalization rates – the income versus the purchase price – have trended as high as 500 basis points over 10-year U.S. Treasuries. They’re still above 400 basis points and that historically has augured well for real estate – and the spread is well above the 100 basis points charted in 2007.
“Demand is starting to come back slowly,” he notes and supply is short because companies are unable to get construction loans. That’s different from the 1990s, although he concedes there are some high-vacancy spots.
Still, not every sub-class is attractive. In the U.S., industrial properties – warehouses essentially – have been overbuilt, notes DeCosta. In the discretionary retail sector, suburban big-box supercentres face challenges unless they are very well located, particularly as U.S. consumers pare back on consumption. But malls anchored by a strong grocery franchise should do better.
Apartments represent a sweet spot for two reasons, he suggests. One is that the prime apartment-renting population – those aged 24 to 34 – is picking up. It helps that those potential apartment dwellers can pick up lower-paid jobs than an older demographic would. At the same time, home ownership rates are also falling. “Every drop in the home ownership rate is about 1 million new renters,” he says. Unusually, DeCosta is seeing apartment demand picking up before growth in employment.
Apartments are serving as a leading indicator. That’s to be expected, DeCosta says, because leases are of a shorter duration. Offices serve as a lagging indicator, for the opposite reason. There, he expects a “roll down in rents,” because companies have laid off workers faster than they’ve shed space.” But offices located in central business districts are more attractive — they have “more larger companies that are better financed,” than their suburban counterparts.
The situation in Canada is different, says Peter Cuthbert, vice-president for real estate investments at Standard Life Canada. Apartments don’t look nearly as attractive because of rent controls. Secondly, Canadian banks were more disciplined in their lending, so the decline wasn’t nearly as severe. “It was tougher to get financing unless you had pre-leasing,” he says. “You didn’t get the same oversupply as you did two recessions ago.”
As a result, Cuthbert sees potential overbuilding only in downtown Calgary and downtown Toronto.
But real estate isn’t a game targeted at capital gains. His fund aims at a 7% coupon plus 2% in capital gains, with a bond-like volatility of 4% to 4.5%. That’s a spread of 3% to 4% over the yield on 10-year Canadas – and a healthy spread over inflation.
Still, there are a couple of issues. One is valuation policy. While rent can be counted as soon as it is deposited in the bank, valuations remain trickier. Often properties are appraised once a year. Standard Life does it quarterly, and in the heat of the market meltdown, was doing it monthly.
Another is whether there is enough real estate to go around. While Canadian pension funds have an average 10% allocation to real estate, the median is much, much lower, since the average is inflated by the giant pension plans and their managers such as Ontario Teachers Pension Plan, OMERS and the Caisse, each of which has a real estate subsidiary.
As pension plans move from being net collectors to net payers, they are seeking sources of income, particularly REITs. Cuthbert suggests that Canadian pension funds will have to return to foreign markets, even though they’ve had less than successful results in the past. This time, they will have to partner with locals who know the market.
Cuthbert notes that REITs have been raising huge amounts of capital – $51 billion globally since January 2009 – to make acquisitions. For every $1 in transactions, there’s $2 in capital looking for a home. “There’s a lot of competition for capital.”
In the Canadian local market, increased competition will likely lead to decreased yields, forcing investors to shift from “A” properties to “B” and “C” properties. “I don’t think there’s enough to go around,” Cuthbert says. That could lead to a structural repricing of real estate, he says. “We’re going to accept a lower yield.”
But a shortage of growth in private real estate by no means equates to shortage of opportunities, suggests. J.T. Straub, senior vice-president at ING Clarion. ING Clarion runs an absolute return fund that invests in publicly traded real estate equities. Listed equities represent only 11% of high-grade global real estate. “So there’s plenty of room for growth,” he believes. The publicly listed market has more that doubled over five years, so “what’s available to us as a manger has improved greatly.”
Straub adds that during the economic meltdown, REITS found a cheap way to raise capital. And were savvier than most. They were net sellers in 2006 and 2007 as the global real estate bubble swelled. Now with cash on hand thanks to equity issuance, they are net buyers.
How does that work for an absolute return fund? Private real estate has a low correlation to other asset classes, partly because of the timing of appraisals. But it also suffers from a lack of liquidity, and in 2008 “open-ended funds weren’t open.” They set up gates against redemptions.
REITs offer more liquidity. But there are additional risk factors. REITs generally pay out a fixed dividend. In times of trouble, they may be forced to cut or suspend their dividends, sell properties to maintain their dividend, or neglect capital expenditures and maintenance. Those are the REITs Straub shorts.
Good quality REITs, by contrast, make acquisitions that are immediately accretive to earnings. Unlike private real estate funds, they don’t have the luxury of investing in a turnaround situation.