Meet the Round Table Participants
Maury TognarelliChief Executive Officer Heitman
R. Scott DennisManaging Director, Chief Executive Officer Invesco Real Estate
Patrick HalterChief Executive Officer
Principal Real Estate Investors
Investors with long time horizons could do worse than look to real estate to provide an appetizing combination of income and yield, diversification and inflation protection. It's an asset class that encountered some tough times during the global financial crisis, but has since come back with a vengeance.
Today, real estate is an accepted part of many pension and other institutional investor portfolios – and not just large asset pools. Thanks to the continuing development of the public real estate markets and the formation of pooled funds on the private side, institutional investors of all sizes can take advantage of the relatively high risk-adjusted returns that the asset class offers.
As with all asset classes, it pays to do your homework to understand the market drivers, important metrics and possible pitfalls. Who better to explain the intricacies of real estate investing than three of the industry's most prominent CEOs? These seasoned investment professionals debated the best approaches to real estate investment for institutional investors, provided insight into some of their best ideas for 2014 and beyond, and considered where new opportunities are developing.
P&I: Why are plan sponsors interested in investing in real estate?
Pat Halter: Investors are in search of income and yield today, along with the need to produce a good total rate of return. Real estate is one of the key places where you can produce income and good total return, while still managing volatility. Investors are increasing their allocations to commercial real estate, across all four quadrants of our investment platform, buying public securities, whether it's global REITs or commercial mortgage-backed securities (CMBS), and private deals.
Maury Tognarelli: Real estate has been quite appealing from the standpoint of portfolio construction, not only due to income, as Pat mentioned, but also because of its role as a diversifier and its ability to protect against inflation.
Scott Dennis: Because of attributes like income, diversification and inflation protection, real estate has gained acceptance as a strategic institutional asset class with investors allocating 8% to 10% of their portfolios.
P&I: Let's discuss the public real estate markets more specifically. Why are investors interested in this way of accessing real estate exposure?
Pat Halter: Investors want to be in real estate but they also want liquidity associated with the asset class. We see more capital moving toward public investment, whether it's global REITs or CMBS. Often it's smaller pension plans that may have less of an ability to invest in private real estate because of size limitations or those looking for portfolio diversification. There's been a significant increase in investor enthusiasm for global real estate strategies, even though we do think U.S. REITs are an attractive investment.
Scott Dennis: When you talk about global REITs, roughly half of those assets are invested in the U.S., with the other half in Asia and Europe. Investors like exposure to Europe and Asia. Of the three regions, GDP growth is expected to be highest in Asia. And there's broad sentiment that Europe is a few years behind the U.S. and we're starting to see some recovery there as well.
Maury Tognarelli: When investors make the decision to allocate capital towards the public space, they are motivated by a number of objectives. Many of our clients strongly prefer to achieve their real estate objectives through a directly held portfolio. At the same time, we're finding that many investors are now seeking to increase the global exposure in their real estate portfolios. Unfortunately when you try to marry those two together, size, transparency and especially liquidity become significant issues. So although investors have a preference for direct exposure, the practicalities of constructing a well-balanced diversified global portfolio limits the number of investors that actually have the ability to execute this strategy. As a result some investors have to resort to utilizing some type of combined strategy that allows them to have some direct holdings, but also incorporates public market securities like equities or CMBS. We expect that trend to continue as the challenges of creating a directly held portfolio increase.
P&I: What opportunities are investors finding in the private real estate markets today?
Scott Dennis: Every investor has different goals and objectives, and those guide how they set up their real estate portfolio. Most investors are investing across the risk/return spectrum, which includes some core real estate exposure, some non-core and some public securities. Generally speaking most investors have roughly 50% to 65% in core investments, with the balance being in non-core.
There's a big bias coming out of the global financial crisis for wanting control, and I understand. But if the portfolio is too small and you want to do only direct deals, you aren't going to end up with any diversification. The portfolio is going to be tactical and it may not give you what you really want out of real estate.
Most of the capital in the private markets today is going into commingled vehicles, two-thirds, versus one-third into separate accounts. The commingled vehicles have been huge beneficiaries and each of our three firms have very successful core strategies in the U.S. We also have core strategies in Europe and Asia.
There is no question, though, that investors are also rotating into higher return strategies. Core returns have been very strong since the end of the global financial crisis – double-digit-plus returns in the last four years in the U.S. Cap rates are also now at or near their all-time lows. That has some investors worried about where core returns are going to go in the future.
Pat Halter: The only point I would add here is that I think there continues to be a very strong interest in commercial real estate, even with the tremendous experience that we've seen over the last three to four years. Some plan sponsors that haven't been in the asset class are now moving into real estate and playing a bit of catch up. This is a source of new flows into the asset class. But I would agree that it's a very risk-controlled environment, even risk-averse. Core will continue to be the main way that new capital will access the asset class.
More experienced plan sponsors are moving into opportunistic and value-added because they feel there are some more interesting risk-adjusted returns available. So it's a strong buy in terms of core, but also significantly more interest in value-added and opportunistic investment strategies.
Maury Tognarelli: Activities in the private real estate markets are governed by the size of the plan. For several years now, many of the largest pension plans and sovereign wealth funds have been deploying capital into the real estate sector and have established portfolios. These investors are adding to their portfolios as opportunities present themselves, whether in North America, Europe or Asia. Investors with size constraints generally access the private markets through communal funds, such as a club format or other entity. The objective is to get access to private market opportunities and we help create these opportunities.
It is necessary to create well-balanced portfolios, which can also mean investing in both the public and private markets to create the right shaping of a portfolio and the right diversification mix for a client. With the guidance of an experienced investment manager and a disciplined approach, this can be achieved.
The opportunities between regions are vast, as are the opportunities between sectors. At Heitman, we have a bias that office should be underweighted in the construction of a real estate portfolio. And though we may take tactical positions in office, we typically build portfolios with this underweight. Opportunities in office are quite prevalent in North America, Europe and Asia-Pacific, so it requires discipline to keep this underweight.
P&I: Could you explain the divergent performance between public and private real estate returns last year – and whether this should worry plan sponsors?
Scott Dennis: Over long periods of time, REITs and other public real estate securities act like private real estate, because the returns are linked to the performance of the underlying properties. But in the short term – and over one year and sometimes even two years – that performance can be very different from private real estate just because capital flows in and out very quickly.
The REIT market is very small, roughly $1 trillion in market capitalization. So the top three companies in the S&P500 are larger than the entire real estate securities market combined. So capital flows tend to drive the performance in the short term.
Pat Halter: We look at the relative value equation and that's a constant dynamic. The returns over the last six months or the last year don't matter that much. What matters is our view of fundamentals, technicals, capital flows, investor interest in the asset class, money flowing in and out of the asset class, and liquidity. We're constantly looking forward relative to those dynamics and what that means in terms of relative value, whether it's public or private, debt or equity.
P&I: Where are you seeing opportunities in 2014 and beyond?
Scott Dennis: We see a range of performance in private market sectors, which is an opportunity for investment managers to overweight and underweight different sectors. For example, multi-family has performed very well since the global financial crisis as home ownership rates have decreased. Supply has been constrained and there has been tremendous demand for apartments. Rents have increased and performance has been very good. But now new supply has come on the market and the opportunities for apartments to outperform are probably not what they were a few years ago.
Like Heitman, we have a long-term underweight to the office sector, but in the short term, we think that the sector will outperform, so we are actually overweight the office sector today. That's primarily because we are seeing very little new construction in office. We're seeing tenant demand increasing so occupancy is increasing in specific markets – markets driven by industries like energy, tech, healthcare and new media that are doing well in the U.S.
Pat Halter: We are big believers in looking at ways to manufacture core, whether it's through buying or leasing properties that may have leasing, vacancy or ownership issues, and
developing these properties. We think that the fundamentals of some markets are giving us the confidence for investors with fortitude to take on these opportunities. Many of our clients still want to be in core real estate for the long term. This is a way for us to enhance that objective though the client does need a higher risk tolerance. There is more leasing or development risk involved. We expect this will be an increasing part of our activity as we go forward.
Relative to private debt, we think there's a lot of opportunity in mezzanine financing. This is the ability to provide financing behind first mortgage lenders in order that properties can be levered at a little higher leverage point than what banks or life insurance companies are willing to offer. On a risk-adjusted basis, it facilitates the ability of an investor to provide some gap financing. There are equity investors who would rather leverage out their properties at 75% or 80%, allowing a mezzanine investor to provide gap financing that bridges from 60% loan-to-value to 75% or 80% loan-to-value. It's an opportunity that can meet some of the actuarial return assumptions of pension plans – generally between 7.25% and 8%. We like this high yield strategy because it's conservative when compared to other high yield strategies.
Frankly, we also like the public markets. We think there's some very good value in global real estate securities. Year-to-date performance is in the 4.5% to 5% total return range for global REITs, relative to the S&P500 or Dow Jones Industrial Average, which is between -1% and 1%.
Maury Tognarelli: We agree that there is significant opportunity in the debt space. Private market capital has been rewarded for structuring and taking positions in debt, both in the stretch senior secured and mezzanine segments of the market. The total returns are equal to, if not somewhat greater than what can be achieved on the equity side, and in a lower risk area of the capital structure. These investments are attractive to investors because a large part of the total return is income and the supply of capital is in better relative balance to demand in this market segment. That being said, more capital is coming in each year, so asset selection is critical. I think the opportunity will continue in 2014 and beyond.
We are also observing outsized rewards used for the creation of prime real estate. This includes the development of multi-family residential, office and industrial properties, though less so for retail. If normal rewards to capital for developing were about 15% to 20% in the past, we're seeing considerably larger rewards today. This is a timing situation, where the fundamentals are strong yet there isn't a lot of supply being created. It's an area that attracts a select group of investors.
We are also taking advantage of interest in the CMBS market, where we believe the traditional fixed income investor operates at a disadvantage. They simply don't understand the strength of the underlying collateral to those securities. We've been implementing a strategy with a fixed income specialist for the last 12 months, using our real estate expertise to assess the underlying collateral. This provides our partner with insight into those assets that it then uses to establish the best entry point for the securities. It's a combination of new issues and existing securities. The goal is to deliver a result that exceeds that of a traditional CMBS portfolio on a better risk-adjusted basis. Although there is improvement in the new issue market, we see underwriting standards that we think will allow us to continue to take advantage of mispricing in this space.
P&I: Are there any regions that are particularly attractive at the moment?
Scott Dennis: The U.S. is still the best economy in the world right now so we are going to continue to invest prudently here, especially when it comes to core. Many investors already have core exposure in the U.S. and in Europe. They are interested in having similar exposure in the gateway cities of the Asia-Pacific: Tokyo, Sydney, Melbourne, Hong Kong, Singapore. Income returns are roughly similar to those in the U.S., but expected growth in Asia is significantly stronger than the U.S., so total returns should be stronger. We expect to see continued interest and good opportunities in Asia.
P&I: P&I: You have all mentioned the capital flows into this asset class. Are there enough deals to put this money to work effectively?
Scott Dennis: Certainly many people are chasing their allocation target for real estate. When there are tremendous flows of capital into real estate, investment managers need to stay disciplined and look for the best relative value in the market. It's competitive, yes, but you still need to be in the market to know what it is providing. You can't put your pencil down and just say, 'OK, it's all overpriced and we're not going to buy anything.' We may be buying a lot, but we're also selling a lot.
Pat Halter: The transaction volume in the market has accelerated. The amount of capital trying to deploy into the industry is a bit more aligned with the volume of opportunities. Last year we saw $320 billion of transactions and over the next few years, we expect that to reach $400 billion. This gives us comfort that there will be opportunities to pursue.
But are we also seeing excesses? We are starting to look a little more closely at possible signs of market excess. We are looking at core valuations. Are those price levels starting to exceed significantly the production cost? Are we seeing excessive leverage in the market, either from traditional lenders or CMBS? Is leverage starting to drive prices to unsustainable levels? It's about looking at the underlying assumptions going into real estate decisions and seeing whether they are reasonable, given the potential for interest rates to rise in the future.
We think that the spread of cap rates over Treasury rates seems reasonable relative to historical expectations. High quality core and very good markets are trading at 275 to 300 basis points over Treasury rates. In general, we don't think we are seeing significant excess, though there are probably pockets where there is less discipline and less focus.
P&I: How will the prospect of rising interest rates impact the development of real estate markets going forward?
Maury Tognarelli: We believe that as monetary policy tightens, interest rates will rise. What we've already observed is that spreads that were at the high end of historical ranges just 12 to 15 months ago, are now narrowing. The margin of error in terms of pricing and interest rates has changed. At this point, though, real estate is fairly valued. We're seeing plenty of liquidity and transparency, and pricing isn't changing because of concern that interest rates have increased. This is because there is a belief that the increased interest rates correlate to an improvement in the economy, and future appreciation and growth is expected to be captured from rent rolls. The more difficult question to answer is what happens if interest rates return to historical norms, as Fed policy tightens further. The implications for real estate valuations are less clear at this point in time. We continue to monitor what is a competitive and complex globally linked economic environment.
Scott Dennis: What Maury touched on is that the Fed isn't going to taper unless they see good economic growth. Good economic growth means jobs and that means more demand for office space and apartment units. Overall that's a good leading indicator for real estate, and should offset any rise in interest rates and subsequent rise in cap rates.
What would concern us is if interest rates were to spike without a corresponding gain or improvement in the economy and gains in employment. That would make the real estate asset class look less appealing and would slow down capital flows. We also watch for overbuilding.
Pat Halter: We do think that interest rates will rise going forward, but we'd want to know why they are rising. If it's because of stronger economic activity, employment growth and corporate earnings, then there's a pretty decent chance that rental increases and landlord pricing power leading to improved cash flow could outpace the natural rise in interest rates.
Strategically, though, you will want to be careful about the kinds of investments you are making. When interest rates are rising, you want to be careful as a landlord that you have the ability to raise rents and aren't tied into a very long lease or a bond-like lease structure.
P&I: How are defined contribution plans accessing real estate for their participants?
Maury Tognarelli: Initially DC plans were interested in gaining exposure through REITs because the direct investment path was challenging. What we see now are target-date funds that seem to be using both directly owned assets as well as listed REITs to offer a real estate option to their investors. We're monitoring this closely because it could be a significant change in terms of long-term capital in the market, but it's in its infancy today.
Scott Dennis: Liquidity is clearly a big structural consideration here, but we think that solutions will be found. It will be critical for those offering investment strategies to the DC channel to address the liquidity requirements. The market here is evolving and we're continuing to watch and learn.
Pat Halter: How to incorporate investments in private real estate equity in DC plans is an interesting product development initiative for the industry. We know that asset allocators are looking to use these sleeves within target-date funds and we expect it to develop in the next few years.
P&I: May I ask you each for a closing comment?
Pat Halter: The real estate investment management industry has come a long way in providing solutions to their client base. These solutions are much more specifically targeted than they were ten to 15 years ago. We expect to see a continued evolution of long-term, sustainable and risk-controlled solutions in this space.
Maury Tognarelli: I've greatly enjoyed watching and participating in the evolution of the real estate management industry over the last 30 years, Because of this experience, we as a company are much better to produce timely and appropriate solutions for clients that seek real estate exposure.
Scott Dennis: It's a pleasure to see our investors continuing to view real estate as a beneficial asset in their portfolios – and see them maintaining their target allocations through the cycles. We've seen challenges, but these provide opportunities, and we're all fortunate to work with some of the smartest and most sophisticated investors in the world.