Institutional investors will not be abandoning real estate as an asset class in 2010. Instead, they will be retrenching, rethinking, and carefully dipping their toes back into the water.
More than $1.4 trillion in commercial real estate loans will be maturing over the next five years and, clearly, there will be a shortage of equity to fill the underwriting gap when most of those loans come due. The problem is values have dropped far below those originally underwritten, while underwriting standards have tightened considerably.
Over the past 20 years, one of the largest and most important sources of equity for real estate investment has been the pension, foundation, and endowment fund sector, which, together with other institutional investors around the globe, collectively own well over $5.1 trillion in real estate holdings.
While unleveraged or low-leveraged core assets make up the majority of these investors’ portfolios, higher-leveraged value-added and opportunistic investment strategies targeting domestic and offshore markets have attracted the majority of new capital invested over the past five years. Consequently, most of these investors’ portfolios are leveraged to the tune of 40 percent or higher. (Some 20 years ago, the typical tax-exempt investor’s portfolio was leveraged to the tune of 20 percent or less.)
Not surprisingly, the recent downturn in the markets has had a severe impact on portfolio values and returns. Total returns for core open-end funds over the past 18 months at the end of September, as tracked by the National Association of Real Estate Investment Fiduciaries (NCREIF), for example, were down 37.23 percent. Value-added fund returns declined 29.87 percent, and opportunity funds 60.82 percent.
Since it is generally accepted that the appraisal-based NCREIF returns tend to lag the property markets, it is likely that fourth-quarter 2009 and first-quarter 2010 returns will show further declines.
Given so much hurt, it would be reasonable to expect that institutional investors like these would be pulling back from real estate in 2009 and 2010. They did reduce their investment activity—radically— to less than $24 billion in 2009, down from the $42 billion invested in 2008 and the $46 billion invested in 2007.
But while investors are not expected to ramp up their investment activity dramatically this year, 52 percent of investors surveyed recently reported that they did plan to make some new commitments to real estate in 2010—at least $34 billion of new capital commitments, collectively. That number is in addition to the roughly $64 billion in committed capital from prior periods that was still sitting on the sidelines waiting to be called at the time the survey was conducted. This means at least $98 billion of new equity capital will be available for recapitalizing existing investments as well as capitalizing new ones in 2010.
Investors are able to commit new capital this year due to a variety of factors. First, as previously noted, their real estate portfolio values have been written down. Perhaps more important, however, the recovery in the equities market has boosted overall portfolio values.
Since equities of all types make up as much as 60 to 70 percent of most institutional investor portfolios, this lift in equity values has reversed the denominator effect. Investor positions in real estate now equate to roughly 9.16 percent of total portfolio holdings, against targets averaging 10.19 percent of total assets (relatively unchanged from the prior year, when targets also were at 10.2 percent of total assets).
Multifamily properties are expected to remain the most attractive property type on a relative basis this year, although all property type categories were rated lower in relative attractiveness in 2010.
Most investors will be seeking to purchase core assets at discounted pricing. Some also will be pursuing niche investment opportunities like seniors’ housing, student housing, or medical office buildings, where underlying fundamental demand is considered to be stronger.
Two years ago, investors were paying up for vacancy. Today, vacancy is free. Tomorrow, investors reason, vacancy will be discounted. When it is, that is when most investors will be reentering the value-added and opportunistic space.
Investors also have been taking a serious look at their leveraging strategies. Their initial response to the global asset pricing meltdown of 2008 and 2009 was to question the effectiveness of global diversification. (Several of the largest fund failures of the past two years were focused exclusively on either Asian or European markets.)
In retrospect, however, in almost all cases where fund managers have found themselves under crushing pressure, it has been due more to the debt load than the quality of underlying collateral. Furthermore, the fact that some markets, like Canada and Australia, were less affected by the global financial market meltdown than others, and some regions—like Asia—have rebounded much more quickly than others, suggests that the case for global diversification actually will emerge from the wreckage of this last downturn stronger than ever.
What will be called into question is how best to diversify globally. Should U.S. investors expect to earn returns in offshore markets superior to returns expected by most local investors? Given the potential for value loss due to normal economic cyclicality, how much leverage can be prudently placed on a given asset in a given market?
Meanwhile, U.S. investors and their investment managers will continue to have their hands full managing the assets already in their portfolios. Most investors—74 percent of those surveyed—expect that it will take another 12 to 24 months before the United States is likely to see significant job growth.
Until that happens, leases will continue to mature and roll over at lower and lower rental rates, undermining what in many cases already was fairly weak debt-service coverage. As more loans shift to nonperforming loan status, lenders will be hard pressed to continue to extend terms.
The better loans will be sliced into performing and nonperforming tranches, with the nonperforming tranches sold off at discount. The intermediate-quality loans will be sold at discount as well. The worst loans will be foreclosed and then dumped onto the market.
All of this reshuffling of loan portfolios should continue to place downward pressure on valuations, even if new capital does begin to flow into the market. The bottom line here is that pension, foundation, endowment, and other institutional investors will not be abandoning real estate as an asset class. Rather, they will be retrenching, rethinking, and carefully dipping their toes back into the water in 2010. But the temperature of that water is expected to remain cool throughout the year, and probably will remain fairly tepid until 2012— and perhaps as late as 2013.
(Many of the data presented in this article are from Institutional Real Estate, Inc.’s 14th annual Tax-Exempt Plan Sponsor Survey, conducted during fourth-quarter 2009 by Kingsley Associates.)