Since hitting a valuation trough in early 2010, U.S. commercial real estate (CRE) properties have rebounded, recovering roughly half the losses they suffered during the financial crisis. Nearly four years later, the state of the market evokes both caution and optimism among investors. Devin Chen, co-head of U.S. CRE investing, discusses PIMCO’s view that many parts of the CRE market remain attractive but warns that asset selection is critical. He explains why the potential for gradually rising interest rates in the years ahead won’t necessarily mean poor returns for CRE assets, why having a flexible investment approach can help achieve optimal risk-adjusted returns and where he is finding the most attractive value in today’s market.
Q: How has the U.S. commercial real estate market evolved since the 2008 financial crisis?
Chen: Conditions have greatly improved, but not without the market first experiencing significant pain. While stocks were having one of their better years in 2009 (the S&P 500 was up 26.5%), prices were still falling in the private CRE market (see Figure 1). Only $66 billion of CRE properties traded hands that year, an 88% decline from $572 billion in 2007. Liquidity for private CRE assets was so challenged that even well-collateralized performing loans would sometimes trade at a large discount to par value.
While few were buying and selling CRE properties, another form of investment activity was occurring behind the scenes: restructurings. Many CRE investors had to address balance sheet issues such as looming debt maturities in the face of weak property fundamentals, falling values and minimal liquidity. (The commercial mortgage-backed securities market, which was the biggest source for CRE financing in 2007 with $230 billion of new issuance, was almost nonexistent in 2009.) In 2010 PIMCO estimated that $300 billion to $500 billion of deleveraging in U.S. CRE was needed – the realities of a nearly 40% decline in unlevered asset values.
The CRE market has experienced a gradual recovery in asset pricing since then. The prospect of quantitative easing (QE) induced inflation and the opportunity to buy assets for significantly less than the cost to construct them have attracted investors. CRE property values are generally up over 30% since the trough, and in some cases are even higher than 2007’s peak levels. However, the recovery has not been evenly distributed. For instance, large investors have generally gravitated toward the perceived safety and liquidity of core assets. One result has been a wider-than-usual yield gap between major and non-major markets. So despite the duration of the recovery, there continues to be dislocation in the CRE market that astute investors can capitalize on.
Q: What’s been driving this CRE recovery? Has the market primarily been the beneficiary of lower interest rates?
Chen: There’s no question that U.S. monetary policy has helped property values. Lower interest rates make CRE assets appear attractive given the strong current yield component and cheap financing available. This has particularly been true for assets with predictable income streams, so-called stabilized properties. An investor could generate a 10%–11% current yield by purchasing a property at a 7% capitalization rate and financing half the cost at 3%.
Other important and interrelated factors have contributed to the CRE recovery as well. The economic outlook is generally improving, and commercial real estate fundamentals have stabilized and are on the upswing. The ability to obtain construction financing has been limited, reducing the amount of new supply for tenants. That means less demand growth is needed to boost rental income. Investors can (i) buy assets below replacement cost, (ii) attain cheap financing to generate high current cash flow and (iii) underwrite for future rent growth. These circumstances have made CRE a pretty attractive asset class for investors.
Q: Do you expect a pullback in values, given the potential for interest rates to rise further over the next several years?
Chen: PIMCO remains constructive on many areas of the U.S. CRE market. However, picking the right assets, the right part of the capital structure and the right local operators to invest with is more important today than three years ago. In PIMCO’s view, the Fed is likely to remain accommodative for several years and keep yields from rising significantly. So while there was a sharp increase in interest rates early this summer, reducing the spread between cap rates and borrowing costs, we don’t expect a severe uptick in cap rates unless fundamentals begin to deteriorate.
Furthermore, trends in capital flows and demand for space are the key drivers of CRE performance, not just interest rates. If rates were to rise amid an improving economy, as is typically the case, demand for real estate should have a positive effect on property performance, particularly in an environment of limited new supply that is making rents and occupancy levels less dependent on increased demand. In terms of capital flows, there are two important tailwinds: Investors currently have a risk-on attitude regarding the underwriting and pricing of CRE assets, and large institutional investors such as pension funds and sovereign wealth funds are increasing their allocation to CRE to diversify their portfolios, both as a source of income and as an inflation hedge.
Q: Can the volatility in bond yields we’ve witnessed create relative-value opportunities in the CRE market?
Chen: Volatility such as the sharp rate increase in June can create dislocations in the CRE market and present buying opportunities, especially if you have flexibility in how you deploy capital. For instance, public equity REITs fell 15%–20% over the summer months (as represented by the MSCI U.S. REIT Index), primarily due to interest rate movements. Certain companies suddenly trade at a compelling discount to net asset value (NAV).
At PIMCO we cast a wide net to search for undervalued CRE assets – across geographies, up and down the capital structure, and in both private and public markets. We work closely with our analytics team to determine investment outcomes across various economic conditions. This allows us to identify the most undervalued assets, since the optimal asset isn’t simply one that has the most absolute return potential in a strong growth environment. That may mean, for instance, that at times of sudden deleveraging, buying CMBS is the better relative-value alternative than acquiring whole loans, or that mezzanine loans offer better risk-adjusted return profiles than equity. We’re able to be flexible with our investment approach because of our broad network of contacts across the financial and real estate sectors. If you have the expertise and depth of resources to analyze a broad opportunity set, along with a longer investment horizon, there is an abundance of attractive relative-value opportunities in CRE.
Q: Where are you finding the most attractive opportunities today?
Chen: We believe certain properties in non-major markets look attractive for acquisition. We are seeing opportunities to acquire high-quality assets for attractive initial cap rates in markets with improving fundamentals, at a price point that is well below peak pricing and replacement cost, and with financing that is still cheap by historical standards. These assets offer relatively limited downside risk and the potential for rent growth and capital migration into their markets. We have also been acquiring residential land on an opportunistic basis. When PIMCO analysts predicted a bottom to the U.S. housing market, we began to focus on residential land opportunities because of land’s inherent correlation to home prices. We also observed that there were many motivated sellers. Macro views certainly don’t replace robust bottom-up analysis, but in this case they helped us focus on a compelling area of dislocation.
We think this is a good time to be in the loan origination business, particularly on assets that are not stabilized. Transaction activity in the CRE capital markets is expanding the demand for floating-rate mortgages and bridge financing for so-called transitional assets. Over $1.7 trillion of CRE loans mature over the next five years and property sales are rising. Yet many banks’ capacity is still handicapped by deleveraging and regulatory forces. Dodd-Frank-mandated risk-retention rules could, if adopted, make CMBS lending less profitable for conduit programs and more expensive for borrowers. Similarly, Basel III standards increase Tier 1 capital requirements and the risk weighting of certain CRE loans for banks. Both sets of regulations could decrease credit availability and increase the cost of that credit to CRE borrowers, creating a funding gap for non-bank lenders to step in and provide liquidity at attractive terms (see Figure 2). This is especially true in Europe, where tougher and cohesive regulatory oversight has begun to speed up deleveraging in the form of bulk CRE asset sales by banks. PIMCO has increased its CRE presence in Europe in anticipation of this opportunity.