Real estate perspectives: portfolio considerations across the risk spectrum
Brian: Welcome to the Center for Investor Excellence.
Anne: Great. Thanks for having us!
Eric: Happy to be here.
Eric: So I’m going to jump right in and ask what you are thinking about the broad real estate market based on where we are in the cycle. What is the current market environment in your view and what should investors be thinking about?
Anne: I’ll take that one first, Eric. We would say that the broad commercial real estate market feels relatively solid. We are thinking about the fundamental picture that’s out there as you look across the landscape - vacancy rates are at 30 year lows and we’re seeing relatively modest new supply coming into the marketplace. So those two metrics make us feel good.
While we’re not seeing such stellar corporate earnings as we look into 2019, they’re still positive. So the backdrop is we’re still seeing is the continued demand out there broadly across the space and that’s setting up the stage for relatively solid fundamentals.
On the other side from, a transaction perspective, we’re not really seeing froth in the market, particularly when you think about what was happening in 2006. Today there’s enough transaction activity to make the market liquid, but you’re not seeing this excess amount of capital coming into the market that’s creating pricing that makes you feel uncomfortable.
We’re still seeing relatively appropriate spreads from a risk premium perspective for where you’re pricing core real estate relative to the 10-year treasury it’s at 300 basis point range. That’s the kind of historical norms and certainly why the rumors started in 2006 where it was much more narrow and closer to about 150 basis points.
Overall, I think we would say the fundamentals and the transaction side of the equation feels okay.
Brian: Okay. Eric?
Eric: I would just add to that, that the debt market is very, very liquid. It’s not difficult to find debt for transitional assets or for core assets. I think the broad capital market prices so forth is stable. You know there’s not a lot of volatility in the price. I think if you had to look at want to really be aware over the next 12 to 24 months is leasing.
I think it’s really important to start focusing on where are the holes in my building? Which holes are tougher to lease and make a decision and lease the space? You’ll be happier you leased it today than I think you will be two or three years from now.
Brian: And you say that because of your concerns about the length of the cycle or...?
Eric: I’m worried about it because the cost to build a building is so high today and even though rents have been following that trend, I’m not bullish on a tremendous performance in rent growth. I would rather have the space, lease it at today’s markets and be wrong by 3% or 4% in 18 to 24 months than to have the space vacant in 24 months.
Anne: And I’ll just add to that is that you know I think that we are at the mature point in the cycle. I think it’s certainly late cycle, mature point in the cycle, so to (Eric’s) point is you don’t want to sit on vacancy and think that it’s going to get better a year or two years from now, you lease it today. You think about the kinds of assets that you want to invest in today’s environment. Think quality, think quality of assets and quality of markets.
The later in the cycle you are, the less inclined you should be to take that excess amount of risk and take that debt on - can I build an office building and be able to get at least three years from now. So you really need to think about where you are taking the risks and how you are taking your risks given the later point in the cycle.
Brian: So if I were to summarize. You simply said pricing is not frothy, debt markets are very liquid, but you’re still saying tie things up now. Is that about right?
Anne: I think that’s fair.
Brian: So why don’t you talk about given those parameters, what’s interesting to you now in terms of investment opportunities? You gave me a different perspective so what’s interesting from a core and a non-core perspective?
Eric: Well I will take a little bit of a different view on the office side of the opportunity world and the reason is that new buildings are making older buildings ever more obsolete. And as a consequence, your new building really competes now in a much smaller universe.
Buildings that were built in the last two or three years, buildings under construction today, 10 year old buildings, 20 year old buildings are becoming far less competitive. And so if you can find the right location, you can still be rewarded for building an office building. Having said that, my preference would be at this point would be to build an office building or to renovate an office building to what would be considered Class A modern space with some pre-leasing.
I would love to have maybe 20-25% of my space leased and sometimes PMs ask for things that they can’t have, that would be one of them.
Brian: So a little contrarian about a new office in saying I want to have some of this tied down.
Eric: I want to have some of this tied down.
Brian: All right, Anne?
Anne: Yes. Sure and I think that’s fair. Where we’re seeing some interesting opportunities is really on the industrial side and doing development on the industrial side. You know we’ve certainly seen the secular change in that sector, given the way that consumers are spending dollars and the growth in ecommerce and the growth is really driving a secular shift and a precedent amount of demand in the industrial space. And we’ve certainly seen that over the last five years.
We’re starting to see some of that supply catch up with the space. Where we see an interesting opportunity is where we can leverage off of some of our partnerships and access land and where we call those in-sale markets that are close to the debt populations to those rooftops where the ecommerce retailers, logistics operators needs have quick access to that consumer base and yet there’s a limited amount of supply.
And so again we’re seeing opportunities to build in that market where we see a good underlying fundamentals for continued levels of rent growth that we see being somewhat strained when you go out to more land - areas that have more plentiful supplies of land. Where you are starting to see the catchup funds - supply catching up with demand.
Brian: Both of you said building going into industrial, one in office, just very quickly talk about multifamily and retail. Just a sentence or two.
Anne: Sure. I think multifamily is interesting. I mean we do like the core multifamily space but what’s been interesting that there’s isn’t a significant amount of supply coming into the multifamily market particularly in the more urban areas and that’s really been putting a headwind on supply.
Where we like buying core today is in more suburban markets where you’ve got, again you’ll hear the theme of land constrained environments and you’ve got the demographic shifts of millennials moving more out to the suburbs as they get married and start having kids and settling where there are good schools but still commutable to employment.
So we like the core suburban story in multifamily and we’ve think there will be some opportunities in the urban core multifamily, we just don’t see enough of that yet given the amount of plot that has come in.
Eric: I would be a buyer into the chronic underperformance of urban multifamily. It’s not finished. It’s underperformance. It will continue to have a problem. I think there will be a pricing opportunity. It will be value that exists in that sector, it won’t be deep value, but there will be value there.
And if it’s reflected in your underwriting in terms of not having to underwrite top of the market rents, or maybe you can underwrite a little more free rent in a concessionary environment, you’re total return might not look spectacular, but you have to look at the basis of the asset and you can make a lot of money on basis over time.
Brian: So both of you actually staying with multifamily. The urban areas aren’t going to necessarily do great but you hope that that’s reflected in price and that gets you sort of an entry point. Nothing on retail.
Eric: Well Brian, I don’t know what to tell you about retail. I don’t how cheap, cheap is.
Anne: Great. I have a comeback. I will respond because we are investors in retail on the court side. But here again, the focus has been on quality of location and at the end of the day when there’s periods of stress, there’s always the flight to quality.
And with what we’re seeing happening in the retail environment, there’s absolutely, you know we talk about what’s happened and the benefits of industrial with regard to ecommerce - it’s been the other side of that - the flipside of that has been on the retail side.
And so we’re absolutely seeing a major disruption and it’s very hard to determine who are going to be the winners and the losers, but at the end of the day, the focus is on quality of locations where you’ve got the sort of broad tenant mix that’s attracting consumers and therefore will continue to attract retail retailers.
And when you own those kinds of centers and you can invest in those kind of centers, we’re seeing the positive outcome in terms of being able to lease to the retailers being continued to increase in sales in those types of centers.
But to Eric’s point, it’s really hard when you start going into lower quality assets to really get a sense today as to what is going to happen to those lower quality assets. And when you look at the number of them all across the country that is the majority of the number of malls.
Brian: So you think there will be less retail going forward even though you still like some retail.
Anne: There’s absolutely going to be less retail. The United States is absolutely over retail. We need probably a third of the retail that we have and I think again when you start thinking about if you only need a third, you want to be invested in that third and how do you figure out what that third is and it comes down to quality of asset and quality of location and traffic patterns.
You know creating that traffic in retail. When you can do that, you can find the opportunity for success. I think the issue is - and I think this is where Eric was going is that you know retail has already broken in the environment that we’re in trying to figure out how to invest in the next dollar in that broken retail and fix it is I think that’s a very difficult proposition.
Brian: It’s usually broken for a reason.
Eric: Well I’m not sure that we know what two-thirds of retail are about to go away.
Brian: What are some of your current concerns beyond that and what are the things that keep you up at night?
Eric: Well I’ll just touch again on what Anne mentioned earlier in a very broad sense. I’m following the stock market and corporate earnings. Those are so important to creating demand in our industry for office and multifamily retail industrial.
And then the derivative of that is obviously the valuations in the market and as we’ve seen in the past, when the stock market goes down, I think our investors are far more proactive about adjusting their real estate allocations. Now 10 or 15 years ago they were very slow to do that and I don’t think that they’re that willing to wait. They are far more disciplined about it.
Brian: Yes, we see the impact of a very weak stock market very quickly.
Anne: Well what I would say is the reason why you do is because investors today are mature in their allocations. Ten or 15 years ago they were still building allocations to real estate. Today they’ve already moved to 10% to 15% allocations to real estate and so when the stock market moves, and you’re already at or over your allocation, you are going to be quicker to make that adjustment.
Eric: Yes, I think I would add to that - that 2008 a lot of investors learned what assets that are less liquid do to their portfolios and they’re not willing to hold on to illiquid investments when there is some liquidity left in them. They’re far more willing to move out of what might be less liquid thinking about buying undervalued stocks at that point.
I mean they’re just reallocating their assets for the next marginal return on their dollar and they’re doing it far more quickly than they’ve ever done it.
Brian: So you’re concern is to the extent to which flows turn the other way quickly because of some financial market disruption.
Eric: Yes. Because that creates illiquidity for those of us who build things for a core exit. So if I’m counting on a core exit this year, hiccups in the stock market and headlines create fewer bidders and that means the prices are not as interesting and then I become disappointed and...
Brian: It’s a tougher environment than it was 15 years ago.
Anne: Yes. I would say that most investors do understand the benefits of the illiquid asset class and what it does to their broader portfolio. But as I said earlier, I think a lot of what we’re seeing is the maturity of allocations and prompting sort of that quicker response by investors out there.
Yet, when I think about what keeps me up at night it is public debt. Like Eric said earlier, it is that debt is accommodative. My concern is that there have been a lot of debt funds other than raising capital in the next couple of years.
There’s a fair amount of dry powder in that space and while they’ve been accommodative, up to this point, it still appears that they are maintained at a level of discipline, but if they become overly accommodative, we do seem to have standards, they could create some froth in the market that might cause me more concern of where valuations could go.
Eric: Yes the debt and high covenant life. They’re not really on the margins saying they’ll take a much lower debt service coverage ratio. The advance rates are still fairly disciplined which means there’s real cash equity in these loans.
Eric: But that can change. You want to watch it.
Brian: Which is what we saw before the end of the last cycle.
Eric: It makes you think here’s the sign at the end when we start like every cycle in the past - lenders have overextended in the commercial real estate business.
Brian: I think that’s a great way to end. So Anne, Eric, thank you for joining us for the Center for Investment Excellence.
Anne: Great to be here. Thanks for having us.
Eric: My pleasure, Brian!
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