Technical factors outside of commercial real estate (CRE) – QE-induced liquidity measures, low real rates and a shortage of highly rated assets in structured credit – have created a wedge in CRE asset pricing, as capital has disproportionately flowed to CRE assets that are perceived as “core.”
These technical factors are CRE’s equivalent of a new boyfriend or girlfriend – they may seem great at first, but they may also disappear when something better comes along. Considering the capricious nature of technical factors, PIMCO finds better relative value in the “non-core” sectors of CRE that haven’t yet caught the eye of technicals-driven capital, including debt and equity investments in non-stabilized assets and CRE-related structured investments.
The migration of capital to CRE is sensible – leases provide “real yield,” and principal is at least partially secured by a tangible asset. To date, however, new capital has disproportionately flowed to assets that are in major markets or have in place cash flows that meet commercial mortgage-backed securities (CMBS) debt coverage tests. For example, Figure 1 implies that CRE prices in “major” markets have rebounded to within 11% of peak 2007 prices, whereas non-major market CRE assets remain 27% below peak (a level that is more consistent with the S&P/Case Shilller Home Price Index).
Despite the recent outperformance of core CRE assets, we caution that even shiny buildings bought in major markets are susceptible to downside risks. In our view, the total return profile of a core CRE asset priced at a historically low cap rate is skewed to the downside when the elixir of low real rates has reached its zero bound. Conversely, we believe attractive investment opportunities will arise in sectors of CRE that haven’t yet caught the eye of technicals-driven capital, including debt and equity investments in non-stabilized assets and CRE-related structured investments.
The divergence of CRE asset prices and rental growth is not without precedent. Through 2007, CRE prices diverged from fundamentals as an abundant supply of senior and subordinate debt allowed borrowers to finance their purchases at increasingly higher advance rates.
Today, the source of demand for CRE arguably stems from low real rates as opposed to low vacancy rates, as both major and non-major markets have yet to demonstrate any material improvement in vacancies or rental growth (see Figure 2).
While low real rates may help sustain CRE asset pricing for the cyclical horizon, Figure 2 should serve as a reminder that today’s liquidity should not be confused with downside protection. On the other hand, to the extent low real rates eventually lead to capital migration along the CRE risk curve, non-core CRE assets are better positioned to appreciate in value given their relatively higher potential cash flows.
Equity is enamored
REITs have clearly benefited from the search for real yield in a low real rate environment. Public REITs raised over $37 billion in equity capital and non-listed REITs raised over $8 billion in 2011, according to NAREIT. On the private side, core or gateway markets have been especially popular, with pricing for well-leased assets in the top five markets essentially back to 2007 peak levels.
Buyers for these types of assets rationalize acquisition decisions at 2007-like prices because the spread between the property’s initial yield (i.e., capitalization rate) and the 10-year Treasury yield remains 50 to 100 basis points higher than the historical average (see Figure 3).
But relying on a relatively wide spread between cap rates and metrics like the 10-year Treasury or BBB bond indexes ignores the other key ingredient in determining cap rates – growth. Simple intuition would say that robust rent growth and low real rates are negatively correlated, so cap rate spreads to fixed income barometers should be wider than their historical average to reflect implied lower rental growth.
We believe the supposed cap rate cushion will do little to protect core CRE assets or even REIT investors in cases where changing technical conditions aren’t the result of positive economic conditions that drive rental growth.
Fixed income doesn’t have many dating options
Commercial real estate asset prices also have benefited from the fixed income market’s demand for commercial mortgage-backed securities. But once again, this demand arguably comes from a lack of alternatives as opposed to any sort of inherent belief in rental fundamentals. Specifically, the fixed income market’s fondness for CMBS has been prompted by a lack of alternatives such as highly rated credit assets. In 2011, for example, total issuance of securitized assets was $135 billion, compared to approximately $1 trillion of issuance in each of 2005, 2006 and 2007 (see Figure 4).
Given this backdrop, the $33 billion of newly issued, multi-borrower conduit CMBS in 2011 enjoyed little competition from other securitized products.
This affection for CMBS comes at a time when CRE’s linkages to CMBS are stronger than ever. Though CMBS only represents less than a quarter of the $3.1 trillion U.S. CRE debt universe (as of 4Q11, according to the Federal Reserve), CMBS is among the only relief valves in the current CRE debt system. This is due to the fact that regional and local banks, the traditional suppliers of over one third of the debt capital in CRE, remain largely on the sidelines due to underperforming legacy loans. Additionally, many European banks are exiting the U.S. CRE loan market.
2011 – Loyalty to CRE comes into question
2011 revealed the extent to which fickle technical factors can dramatically alter pricing across capital structures and assets nearly instantaneously. Through mid-2011, new CMBS deals enjoyed increasing levels of demand, and spreads generally tightened with each new offering. In short order, conduit platforms ramped up activity and passed the spread tightening to borrowers through lower rates, which in turn allowed yield-starved borrowers to pay increasingly more for leased assets to achieve the same target leveraged yield.
In August 2011, however, negative headlines – ranging from increasing risks of default in Europe to rumors about impending structured credit asset sales from distressed financial institutions – suddenly changed the supply/demand dynamics for credit assets and demand for CMBS quickly reversed. Within days CMBS spreads on new deals widened by 50 basis points to 100 basis points according to Commercial Mortgage Alert. As a result, conduit lending platforms quickly scaled back and some even exited the business.
At the property level, borrowers found their cost of capital increased dramatically in the course of a month. By the end of the year, numerous deals fell out of contract and the general level of optimism in commercial real estate turned noticeably down.
The nearly overnight widening in senior CMBS spreads (from 50 basis point to 100 basis points) experienced in August 2011 should serve as a reminder of how fleeting technical conditions can easily impact cap rates for all sectors of CRE.
Similarly, while this affection for core real estate may persist for the low-real-rate cyclical horizon; new investment alternatives could easily reorient the adoration of equity or fixed income investors over the longer term. Bias may shift from income back to growth, new alternatives may arise in the rated credit space or, quite simply, investors may finally realize that even core markets like New York and Washington, DC aren’t immune to shifting employment dynamics. These types of risk are arguably most acute for seemingly safe core assets since their return profiles are relatively more reliant on cap rates versus cash flow.
Risks and opportunities: How to find “the one”
Fickle technical factors are not the only headwinds facing the CRE market. Deleveraging, regulatory uncertainty and weak fundamentals also add further pressure. This creates additional risks for core assets.
Deleveraging pressures for both domestic and foreign financial institutions increase the downward pressure on values for all sectors of the U.S. commercial real estate market. We believe many regional and community banks continue to rely on appraisals that are significantly overstated to survive; but over the coming years increasing pressure and vigilance from shareholders and regulators may finally force these banks to reduce exposure. Pressure to reduce exposure to both public and private real estate exists across the pond as well, driven by changing capital requirements.
Regulatory changes also could have an enormous impact on the CRE industry. Many of these issues will not be resolved in 2012; however, lingering concerns about risk retention, capitalization levels and Dodd-Frank could force traditional players to eliminate their CMBS or private equity platforms.
Finally, while the multifamily sector has benefited from the collapse in the housing market and changing demographic trends, the office, industrial and retail sectors continue to face persistent headwinds due to limited job growth, improved productivity and the increasing market share of e-commerce. Limited new supply in these sectors has been one clear positive this cycle but it has yet to offset anemic tenant demand.
At the same time, deleveraging and fickle technical factors create opportunities for flexible platforms that can invest across asset classes and capital structures.
Today for example, the disproportionate migration of debt capital to assets with in-place cash flows that satisfy CMBS debt-service ratio tests may create attractive relative opportunities to provide bridge capital to high-quality transitional CRE assets that don’t quite meet this hurdle.
Through the origination or acquisition of senior or subordinate debt positions on these less-admired assets, investors may achieve returns that are comparable to core equity returns but with better seniority in the capital structure.
Similarly, debt or equity investments in less fashionable markets or asset classes may provide relatively higher return potential if there is a reversal in the historically large divergence between primary and secondary market CRE asset price inflation. Even in a low real rate environment, these assets will benefit as capital moves to other markets and asset classes in search of higher yields (see Figure 5).
Additionally, forced balance sheet adjustments may provide opportunities to acquire CRE assets at discounts to underlying collateral value from U.S. banks; but the opportunity set is not limited to U.S. bank loan portfolios. European banks, defunct mortgage REITs and 2006/2007-vintage CRE debt funds also hold CRE exposure via subordinate debt positions and legacy CMBS or collateralized debt obligation (CDO) positions. Considering the nature of these sellers and their propensity to sell securities when technical conditions force liquidity needs, investments in select CMBS or CDO positions may offer better relative return potential than private loan pools or bank-owned real estate, even after adjusting for the control and transparency tradeoffs.
Like any new courtship, today’s relationship between technical factors and CRE is likely to change as the two sides get to know each other. For CRE investors, an open mind and flexibility is essential to avoiding heartbreak in the long run.
Carrie Peterson contributed to this article.