Commercial real estate investors are keeping calm and carrying on, even though they are uncertain about what is coming next for fundamental elements affecting their business, such as the federal tax code and interest rate policy.
“It makes it difficult to plan. . . . You don’t know what the federal budget is going to be. You don’t know what the Federal Reserve is going to be,” said Bowen H. “Buzz” McCoy, who participated in the 24th annual ULI/McCoy Symposium on Real Estate Finance, held in December in New York City. Symposium rules prohibit attribution of comments to any of the 70 participants, but McCoy shared his impressions of the colloquy.
The financial system is still vulnerable to shocks—and the uncertainty exacerbates the vulnerability. However, investors still need a place to invest their money, and in an environment in which interest rates and investment yields are very low, real estate remains one of the best options available.
“The whole country is acting as if there is no problem,” said McCoy. “There is such a huge amount of available funds. It is hard for the uncertainty to have an effect on the available capital.”
Uncertainty in Washington
Federal policy has a massive impact on real estate, and important aspects of federal policy may or may not change in the near future. For example, the Federal Reserve Board, which sets interest rate policy, will soon have a new chair and several new board members.
The federal tax code is another huge source of uncertainty. At the time of the symposium, Congress was considering a sweeping overhaul of the tax code. With proposals having passed in both houses of Congress, real estate experts were analyzing the bills to understand their implications and, if possible, influence the final version of the legislation.
Even people close to the tax-writing process had a lot of questions. “The people who wrote the bill don’t know for sure what’s in it,” said McCoy. “To analyze a several-hundred-page bill takes time.”
According to reports, legislators were considering whether the interest paid on loans used to finance a business should be tax deductible. Most real estate investors rely on such loans. “I was very surprised to hear that Congress was considering the deductibility of business interest. . . . That would be a huge hit for commercial real estate,” said McCoy.
Even when Congress is finished working on tax legislation, other uncertainties will remain. For example, the two government-sponsored entities that provide financing for much of the housing in the United States have dangled in a kind of limbo since federal officials took control more than a decade ago. Fannie Mae and Freddie Mac are still in supposedly temporary receivership. Among other things, that means they cannot build up any kind of financial reserves, leaving the two secondary mortgage–market giants vulnerable.
“It’s a big messy problem that no one wants to handle,” said McCoy.
Other financial regulations also need clarification. For example, rules that govern the servicing of loans that have been securitized as commercial mortgage–backed securities (CMBS) could be improved to make it more feasible to work out CMBS packages that include loans in default. “You can’t make any money servicing CMBS,” McCoy noted.
The Hunt for Yield
Despite these uncertainties, real estate continues to draw investors. “People don’t know where to invest,” McCoy said. “The amount of investable money in the system is huge.”
Investors often have inflexible targets that their investments must meet. Pension funds, for example, must be able to pay benefits on time to pension holders. If a pension fund’s investments do not yield enough in one year, the fund will need to make higher-yielding investments in the next year to make up the difference. If the pension fund’s investments do not yield enough for several years, eventually the fund will reach a year in which it is unable to provide benefits.
“You increasingly have underfunded pension plans—you have bigger holes you have to fill up,” said McCoy. That means investors like pension plans will have to take more risks to earn a higher return on investment.
Fund managers are also feeling stress from low investment yields. “Fees are under huge pressure,” he said. Investors are even less willing than usual to share a big piece of their yield with fund managers.
The stock market has been one solution for investors hungry for higher-yielding investments. However, stocks can be volatile investments, particularly in the short term. Investors, like pension funds, often prefer to keep the percentage of funds they invest in equities at around 60 percent of their portfolio, but many pension funds now have closer to 80 percent of their funds invested in equities. They need to find other high-yielding investments to diversify their portfolios.
Solid Demand for Real Estate
In an economy in which interest rates and investment yields are very low, commercial real estate provides a relatively attractive balance of risk and reward. “The property markets are strong,” said McCoy. “Office property is in good shape. Industrial is strong.”
Investors are even finding opportunities to update retail properties, even though the retail sector is arguably the least healthy sector of commercial real estate. “The obvious outlier is retail,” he said. Retail properties have suffered from competition from online sales. As more people shop online, many companies have closed storefronts or simply gone out of business. Some commentators say this moment constitutes a “retail apocalypse.”
Taking on the risk of these investments is another way for investors to add value and earn a higher return. “It is interesting the way that retail is fighting back,” said McCoy. For example, by focusing on new kinds of retailers, as well as medical offices and lifestyle and entertainment facilities, some managers have been able to keep their properties full with good cash flow.
Industrial properties have benefited from the rise of e-commerce, providing other opportunities for investors to acquire or develop last-mile warehouse sites close to the customers who make purchases online.
Fewer CRE Deals
Because of this healthy fundamental demand for real estate and because investors need a place to put their money, investment capital continues to flow into real estate.
The volume of properties bought and sold is still relatively strong, even though investors bought fewer properties in 2017 than they did the year before.
“Investors have looked for all the easy deals and the low-hanging fruit,” said McCoy. There are relatively few giant portfolios available to buy. Instead investors are working harder to find deals with the best balance of risk and reward, he said. Prices for real estate properties continue to be very high.
“People would be very happy to have a 2018 just like 2017,” McCoy concluded.