As the era of cap rate compression draws to a close, how can institutional investors maintain the outsized returns they’ve enjoyed for over a decade?
Over the past 15 years, the growing popularity of real estate in institutional investment portfolios has increased against the backdrop of a sustained decline in yields, called cap rate compression. Property brokers, vendors, purchasers and, ultimately, investors have all benefited enormously from this trend, which was has been exaggerated by a global systematic dynamic that has delivered outsized returns.
Before the 2008/09 financial crisis, many in the industry would point to the summer of 2007 as the peak of the market. Market conditions were frothy. Acquiring real estate with risk commensurate returns was a challenge, even with relatively lax terms of lending.
But after the crisis hit, seasoned real estate professionals, who were psychologically burned by the recession in the early 1990s, suddenly experienced déjà vu. The notoriously cyclical nature of the asset class was once again affirmed. Though the commercial real estate market paused following the 2008/09 financial crisis, the broader financial services industry was saved by central banks’ concerted efforts to keep interest rates artificially low in an effort to stimulate an economic recovery. Real estate investment trusts, the early beneficiaries of low interest rates due to publicly sourced equity, helped recapitalize the Canadian market and did much of the buying from vendors who were willing to dispose of stabilized income-producing properties.
The 2012 sale of Scotia Plaza was considered a high water mark for core real estate in downtown Toronto. Back then, some wondered if this was peak pricing. Yet cap rates are even lower today.
Everyone looks smart when investing on the downward slope of a cap rate trend. In real estate, investment managers are often tasked with adding value by leasing space (preferably to strong covenant tenants), making routine capital improvements and investing in markets with potential for above-average rent growth.
If a property is properly underwritten and sufficient expertise is brought to bear, an asset manager should be able to add value as a matter of form. Things don’t always go according to plan.
Underperformance is always possible due to careless underwriting, short-sighted strategic planning and poor execution. However, underperformance has been masked by the steady decline of cap rates. For more than a decade, buying real estate and maintaining the status quo often resulted in double-digit rates of return. This luxury can only be in a world awash in liquidity, the result of expansionary monetary policy.
Separating the wheat from the chaff
To quote a very astute former client, “Cap rate compression is not a birthright.” These words should be top of mind for anyone investing in real estate today.
Going forward, investment managers won’t be able to rely on cap rate compression to offset operational underperformance or generate total returns well in excess of their hurdle rates.
Attention will now fall almost squarely on net operating income, a function of the leasing market and improvements made to the property. The stratification of advisory talent will become more obvious to institutional investors such as pension funds, life insurance companies, trusts and endowments.
Carrying out modest capital improvements and implementing a proactive leasing program won’t be sufficient to achieve returns that even remotely resemble the returns of yesteryear. Net operating income — the driving parameter of value in a pro forma — must be ramped up sufficiently to realize competitive exit multiples as interest rates ascend due to inflationary pressure. Though direct real estate has historically been a hedge against inflation, the need to increase NOI through value creation will come into sharper focus.
Relying on value creation
Value creation refers to the active management of real estate resulting in economic improvements to deliver above-benchmark returns for investors. This strategy is often carried out in two distinct investment styles mandated in a real estate fund’s governing documents: value-added and opportunistic.
The value-added investment style sits around the middle of the risk reward spectrum and typically involves executing improvements to non-core real estate assets through proactive leasing, capital improvements and redevelopment strategies where they’re opportune.
Typically, this strategy employs leverage at approximately 60 per cent of property value. The opportunistic investment style is more aggressive — it occupies the space further along the risk-reward frontier. This approach entails more aggressive strategies that require heavier outlays of capital.
The range of improvements depends on an investment team’s creativity, experience and tolerance for risk. Relatively conservative active management can involve the reconfiguration of space to accommodate large format tenants, the aggressive lease-up of existing or near-term vacancy, capital improvements to maintain institutional quality and proprietary research to invest in markets with strong growth prospects. More aggressive strategies can involve re-purposing a property to cater to local demand pressures and ground-up development to generate additional recurring income.
The amount of leverage employed is even higher and development expertise more vital when the scope of improvements is more ambitious.
Risks of value creation
Achieving anything beyond the bond-like return of core real estate entails additional risk. In the absence of standard deviation to examine the return on a risk-adjusted basis, investment teams must rely on collective experience while factoring scenario and sensitivity analysis to understand the downside risk if market conditions change or property-specific assumptions fail to materialize. Investment managers should have this competency embedded in their teams as their performance depends in large part on the effective monitoring of third-party service providers that implement strategic at the property level.
Value creation initiatives can fail to achieve because of systematic and non-systematic risks.
With respect to the former, higher construction costs due to sharp increases in commodity prices can throw a project off-budget. Market dislocation at the time of disposition can nullify capital appreciation derived from past improvements. The higher cost of capital due to mortgage refinancing rates can narrow cash yields.
With respect to non-systematic risks, the list is more exhaustive. A development opportunity on a site with heritage attributes can severely limit the original vision. A contamination plume originating from a former drycleaner and encroaching upon acquired property may be worse than realized following a detailed site investigation. A covenant review can fail to identify embedded put options on a tenant’s outstanding debt that precipitated a bankruptcy filing. A disposition can fail due to a purchaser’s inability to obtain investment committee approval.
Looking forward against a challenging backdrop
It has been said the coronavirus pandemic is less of a change agent and more of an accelerant, bringing forward events that would have transpired a decade in the future to the present.
The prospect of rising interest rates makes value creation an important consideration going forward. It is worth mentioning that this imperative in the industry predates COVID-19. However, the pandemic has brought the need to create value into even sharper focus.
The confluence of events, namely rising rates, the pandemic’s impact on commercial real estate and structural changes in the industry due to technological shifts will make active management that much more challenging — and interesting — for years to come.
Managers and investors alike should continue to be mindful that the playbook that has served them well for so long is in need of revision and a higher level of scrutiny will be placed on specific skills needed for value creation to effectively deliver excess returns.