“Working Around the Edges” For Strong Risk-Adjusted Returns
By Robert J. Dougherty
With U.S. commercial property prices having broadly surpassed previous peak the discerning investor is asking how long this pricing rebound can continue. Given corresponding declines in commercial real estate yields, where can interesting returns be earned in the current climate? How is capital protected and how are profits best insulated against a possible market correction?
This paper will examine how a secondary market strategy, which avoids investing in overpriced gateway cities, could offer strong returns as well as a high degree of safety. It will illustrate how trends in capital flows and supply/demand dynamics are continuing to provide strong support to property pricing and may counter any upward movement in cap rates in the near term. Lastly, it will present a case for strong risk-adjusted returns existing in the “middle market” segment, defined as properties valued at $25 million to $75 million.
Play to the Edges for Better Returns
Appreciation has been uneven
Looking a little deeper into commercial real estate’s post-recession price boom reveals that not all markets are created equally. In fact, any perception that real estate may be over-valued appears to be driven substantially by the dramatic appreciation of trophy assets in gateway cities such as New York, Boston, and San Francisco.
These are frequently the markets where institutional investors first venture forth from the real estate cycle bottom, so they usually lead commercial real estate out of its recessionary trough. This cycle appears to have been no exception.
The first chart illustrates how much greater price appreciation has been in the major markets of Boston, New York, Washington, DC, Chicago, San Francisco, and Los Angeles as compared with “non-major” cities.
Similarly, dissecting the broader price indices reveals that the highest-value properties, which tend to be office and multifamily projects located in gateway cities (particularly in their urban cores), have appreciated significantly more coming out of the global recession than have the lower-value properties.
As illustrated in the chart below, the gap between the value-weighted and equal-weighted indices is at an all-time high. Since the value-weighted index is concentrated toward the highest-value properties and markets while the equal-weighted index neutralizes property values, the gap implies real estate price growth since the recession has been concentrated in the high-value properties, leaving the lower-value properties (i.e., those in the middle market) under-valued. This trend points to value in the comparatively under-appreciated secondary markets – cities such as Denver, Phoenix, Dallas, and Southern California’s Inland Empire.
Among the major property types, this spread is the widest for office properties, reflecting the dramatic and disproportionate appreciation of core buildings in the gateway markets. This suggests that office buildings in secondary markets may represent the most under-appreciated asset class.
Enhanced yield in secondary markets – the first leg up
An arbitrage opportunity seems to be presenting itself, offering the savvy investor the chance to buy in non-major markets and in non-core properties. This trend often plays out in the real estate cycle, as safety-minded investors flock together and drive up prices for trophy real estate. Then, as the economy improves – as it has been – their emphasis on seeking shelter should diminish and they will grow dissatisfied with the low yields available in the primary cities. As they branch out to secondary markets in search of more interesting returns, the gap may narrow and investors in secondary cities could reap the benefit.
Value-add investments – the second leg up
The positive influence of these capital flows can be augmented if properties that are not presently considered core investments can be repositioned into the core investment channel. Value-add activities that can serve to reposition properties in this fashion include lease-up, renovation, portfolio aggregation, retenanting, rebranding, and other actions that serve to increase cash flows and
diminish risk. Such repositioning activities offer the chance for today’s investor to realize a “double lift” from value-add properties in these secondary markets.
Follow the jobs
Apart from the latter being more fully priced, the primary story in favor of the secondary markets is employment. Of the nation’s Top 20 cities in terms of office-using job growth (those that added 10,000 or more jobs for the 12-month period ended 12/31/15), non-gateway cities outpaced the gateway markets markedly in terms of percentage job growth (the San Francisco Bay Area was the primary exception, but prices there are approaching all-time highs). Notably, many of these second-tier cities are also boasting strong job growth in absolute numbers (e.g., Dallas, Atlanta, Phoenix, and San Diego). It should also be noted that the Western U.S. accounts for a disproportionate share of these high employment-growth markets.
Middle Market Properties Priced Less Efficiently
We believe strong risk-adjusted returns can be earned by segmenting the market based upon asset size in addition to geography. Recent capital raising can be broken down in a similar fashion to the price appreciation segmentation, and doing so reveals a corollary trend. A disproportionate share of capital has been raised in the post-recession cycle by $1+ billion “mega-funds.” The trend towards mega-funds symbolizes institutional investors’ desires to invest with the largest managers. It also reflects a move towards efficiency on the part of many investors as they are consolidating more capital with fewer managers. This concentration of capital has already manifested itself in the rapid appreciation of the highest-value core U.S. properties. With so much capital to deploy, these $1+ billion mega-funds must remain focused on the larger transactions, and this skews the balance of capital flows towards $100MM+ properties. A similar bias towards larger transactions is also starting to play out with foreign investors who are re-entering the U.S. market. The outgrowth of this larger-is-better trend is that comparatively less capital is seeking assets valued at less than $75MM. With less competition, pricing is less efficient for lower-value properties.
Suburban Properties Are Safer Investments Right Now
With higher-value urban properties “priced to perfection,” there is a much greater margin for error in lower-valued properties that tend to be located in “edge cities” and other suburban environments. According to a recent survey by Dr. Peter Linneman utilizing national data from Cushman & Wakefield, central business district (CBD) office rents are 10% below average 2007 peak rents nationwide, while suburban office rents are still approximately 25% below their prior zenith. Notably, suburban rents are still below their 20-year historical real average (while downtown rents remain above this average), and suburban rents achieved their prior 20-year high not in 2007 but during the early 2000s technology boom. The latter is noteworthy because recent space demand studies have revealed that a very high degree of the current office reabsorption in this cycle has been fueled by technology companies, with financial services companies, attorneys, and accounting firms still in their shells.
This time around, however, this growth has been more balanced between downtown and suburban office buildings, reflecting the preference by millennial workers for 24/7
environments. However, the urban/suburban tilt is actually a pendulum. As the millennial worker ages, has children, and seeks to buy an affordable home, this pendulum should swing
back in favor of suburban locations. While the pendulum may not tip back to the suburbs to the same degree as in prior cycles (reflecting a true demographic value shift) affordability
metrics for companies and their employees alike may cause it to swing back to some extent.
Employers may soon favor more affordable suburban locations
The widening rental gap between downtown and suburban properties has, in turn, spawned two additional trends that should also favor non-CBD investments over the next several years. First, tenants are finding their options increasingly limited and expensive in the nation’s downtowns and, thus, are beginning to absorb more space in the suburbs. This has led to rapidly declining suburban vacancy rates as evidenced in the chart below. This trend is likely to accelerate if economic growth slows because companies will face less competition for workers and, therefore, may be less pressured to offer higher cost urban work settings. At the same time, a stagnating economy will cause employers to become increasingly cost conscious, again favoring suburban environments.
Suburban locations face less supply-side risk
CBD office rents have been escalating more rapidly than in the suburbs, and, partially in response to this demand, new construction has also ramped up in many of these downtown markets. Development has resumed in this cycle and, while office construction remains below its historical average nationwide, much of the current supply pipeline is concentrated in very few cities. According to Colliers, nationwide office space under construction reached 106 million square feet in 3Q15, the largest total since 116 million square feet were under way in 3Q08. Of this space under construction, seven cities – all of which had over 5 million square feet under development – accounted for nearly half of this nationwide construction. This construction is concentrated in tech-heavy gateway markets and mostly in their respective downtowns. This increased supply threatens to dampen future rent growth prospects for the urban markets. Conversely, U.S. suburban markets are adding relatively little new supply because rents have not reached “replacement rents” – the level required to make new development economically viable. This should lead to accelerating rental growth in the suburban markets provided that the recent suburban demand trends continue.
Suburban risk premium (without the higher risk)
A look at relative cap rates indicates that the rapid compression of CBD office cap rates has caused the spread between urban and suburban cap rates to expand well beyond its historical average. Even if the next generation office worker favors an urban environment, it is reasonable to believe that lifestyle considerations of the employee and cost considerations by the employer will cause space utilization to swing back in favor of the suburbs, narrowing investors’ perceptions of the risk differential between these environs. This cap rate spread should narrow over the next several years as suburban cap rates move towards CBD cap rates, reflecting a reversion to the more normalized historical gap.
Expect Commercial Real Estate to Continue Generating Solid Risk-Adjusted Returns
When benchmarked against Treasury yields, the spread between average cap rates and the 10-year Treasury bond remains relatively attractive, certainly when compared against the minuscule risk premium during the 2006-2007 bubble. The status quo will most likely continue with prices remaining strong and yields remaining relatively low for commercial real estate generally, absent some forces that jolt the market out of its current track. Cycles tend not to expire. Instead, some disrupting force usually causes them to shift. However, there are many factors at work that we believe should cause property prices to remain strong and, even if yields moderate, property returns will continue to look attractive versus other investment alternatives.
FACTOR ONE: Supply/Demand Fundamentals Contributing to Improving Property Income
Strong post-recessionary demand
Strong market fundamentals are expected to continue to buoy investments over the near term. Most U.S. markets and property types are exhibiting favorable trends with positive net absorption, declining vacancy rates, solid rent growth, and limited new supply.
For example, in the U.S. office sector, strong employment gains coming off the recession have led to very healthy net absorption.
This, in turn, is causing vacancy rates to decline nationwide and rents to rise. Naturally, certain markets are exhibiting more robust job gains and corresponding income growth than others. These cities present the most compelling investment opportunities given the strong correlation between employment gains and property net operating income (NOI) growth.
Limited development pipeline, especially for office space
At the same time, the supply of new office properties remains relatively muted compared to historical levels, suggesting that existing inventory will need to absorb most of the market’s growing space needs and helping to ensure that the favorable supply/demand balance continues to generate rental and income growth.
Notably, relative to demand, the office sector exhibits the least active construction pipeline compared with other major property types. Retailers are absorbing relatively little new shopping center space, so comparatively little is being built, and while demand is strong in the apartment and industrial sectors, developers have geared up to meet surging demand. In 2015, the multifamily sector added new supply equal to approximately 1.95 percent of its nationwide inventory while industrial deliveries amounted to a 1.27 percent addition to existing stock compared to the <1 percent office supply additions.
FACTOR TWO: Solid Capital Flows
Investor demand provides price support and liquidity According to the most recently available surveys of institutional investor sentiment (Preqin’s H2 2015 survey), 78 percent of surveyed investors plan to maintain or increase their allocation to commercial real estate over the next 12-months, as compared with the preceding 12-months. Over the longer term, only 11 percent of respondents indicated that they planned to decrease their allocation to private real estate, while 34 percent projected a long-term increased allocation.
This sentiment is evidenced in the nearly $300 billion that has been committed to private real estate funds since the beginning of 2013. Similarly, “dry powder” available for investment in commercial real estate reached an all-time high of $244 billion in 3Q15, according to Preqin.
Furthermore, the influence of offshore capital on U.S. real estate appears to be in its early innings. Foreign investment in U.S. real estate is soaring, totaling $70B for the 12-months ended 6/30/15 while it had not exceeded $30B per annum for any 12-month period from 2008-2012. Specifically, Asian investment in the U.S. topped European and Canadian investment in 2015 for the first time since the global financial crisis, and there are signs that Asian investors, particularly Chinese investors seeking a safe haven for their capital, are far from done. These increasing inflows of foreign capital should continue to stabilize U.S. commercial property prices and keep cap rates from rising significantly over the next 12-24 months.
More liberal lending environment, except for construction
Debt capital is now flowing more freely to commercial real estate investments. Mortgage origination volumes for life insurance companies and Commercial Mortgage Backed Securities (“CMBS”) lenders have trended up significantly, and overall outstanding U.S. commercial and multifamily debt reached an all-time high of $2.7 trillion as of 2Q15. However, in the current credit cycle, lenders are lending more freely for existing cash-flowing properties, while they remain far less willing to finance speculative construction due to significant regulatory restrictions. This credit environment is favoring existing properties and constraining new construction nationwide. At the same time, despite increased lending volumes, underwriting standards are also more stringent for income properties in the current cycle than before the global financial crisis. More conservative loan-to-value and coverage ratios should help prevent any credit-fueled market decline.
FACTOR THREE: Wide Spread for CRE Investments Can Absorb Interest Rate Increases
We expect U.S. interest rates to remain comparatively low, driven down by global demand for dollar-denominated investments. Even with a modest increase in interest rates, it is reasonable to believe that such an increase will not necessarily translate into rising cap rates. This is because the spread between the risk-free rate and property yields is on par with 2003 levels and roughly in line with its historical average. This suggests that, as long as economic fundamentals continue on the road to improvement, as they did in 2004-2005, investors may allow for spread compression before adjusting property pricing.
Statistical analysis tends to confirm that interest rates and commercial property capitalization rates are not closely correlated. In fact, as the chart below illustrates, several meaningful interest rate increases over the past 20 years have not necessarily translated to rising cap rates. Capital flows to various investments seem to have their own independent drivers.
In summary, we believe commercial property fundamentals are solid and are projected to remain so for some time. Barring some unforeseen exigent event that shakes up the
U.S. economy, supply and demand should remain well balanced leading to steady occupancy and rental gains over the next several years. Employment factors, domestic capital flows (both debt and equity), and the inflow of foreign capital are projected to buoy asset values and keep a lid on cap rates. Within this environment, we believe premium risk-adjusted returns can be realized over the next several years by playing to the edges. Appreciation of larger properties in gateway cities has been so dramatic that they may carry more risk of price declines than under-appreciated assets that tend to be smaller properties in secondary markets and submarkets. These smaller assets – mostly suburban office buildings – generally offer strong yields to investors, are comparatively insulated from supply risk, and present compelling rental economics to tenants. Investors in these middle market properties may find less competition on the buy side today and are likely to benefit from capital flows trending towards these secondary cities down the road. Those who reposition non-core assets in secondary markets into core-quality investments may also realize a “double lift” by combining income gains with increasing buyer demand.