The battle between public and private real estate is on, at least among pension plan executives that remain committed to the asset class.
Real estate managers in 1997 will continue their quest to get a piece of the business of managing public real estate securities, as clients seek greater liquidity and higher returns than they had investing through commingled funds.
"We'll see an increasing amount of major runs being made on portfolios at commingled funds," said Paul Saylor, managing partner of Chadwick-Saylor & Co., a real estate investment bank in Atlanta.
"We have eight or 10 potential transactions where unsolicited and hostile offerings are being made for undercapitalized REITs and commingled funds. This stuff has really geared up."
"REITs, opportunistic funds and some real estate managers have so much capital. The only assets available in any kind of volume are in these commingled funds. We'll see a ton of more action in buying units to control assets or buying the assets directly," Mr. Saylor said.
Activity heated up in recent weeks with the Utah State Retirement System attempting to buy out its fellow investors in Metric Institutional Apartment Fund and Everest Properties' foiled attempt to acquire interests in Aetna Institutional Investors I L.P.
Jacques Gordon, managing director and head of investment research of LaSalle Advisors, Chicago, noted that despite the overbuilding of the 1980s, returns from private real estate averaged almost 8% from 1979 to 1995 and the sector was correlated negatively with stocks and bonds. Over the same period, public real estate produced an average annual return of 13.6%, about midway between stocks and private real estate. Mr. Gordon expects the correlation of real estate investment trusts to other stocks will continue to decline as the market grows.
Joseph Azrack, president and chief executive officer of AEW Capital Management, Boston, said securitization is the wave of the future in real estate. "This is a sea change and we're positioning the firm to be a leader in REITs and commercial mortgage-backed securities. Twenty percent to 50% of client portfolios will be in securitized investments, passive or active, or strategic investments, buying significant block interests in a company."
He said clients in real estate, like most asset classes, continue to reduce the number of managers and are demanding more service for lower fees.
Mr. Gordon, agreed. "The key thing we're seeing and recommending is that clients add securities programs to their existing real estate allocation."
Yet he has seen very few funds make an effort to integrate the two.
Funds need to look at "what markets securities managers and private managers are exposing them to and they or their consultant can play traffic cop," said Mr. Gordon, noting LaSalle is in talks with clients about such an assignment.
"We scoured our universe of commingled funds. Virtually every manager of every (closed-end) fund is looking to restructure, remediate or divest their funds so investors can take advantage of the new structures out there. Managers recognize the need to take steps," said Mr. Saylor.
"I'm convinced existing portfolios of properties will be restructured, traded, some securitized, sliced and diced both in the public and private markets. There are a lot of other ways to gain liquidity and improve risk-adjusted returns besides hard assets," Mr. Saylor said.
Rather than hire an adviser for a fee, some pension funds are forming joint ventures with REITs that allow for co-development and acquisitions with the option to convert ownership of the assets to REIT shares, he said.
The $4.5 billion Crow Investment Trust, the investment arm of the Trammell Crow Co.,is seeking similar deals.
Last February it teamed up with Prudential's PRISA fund in a $160 million joint venture in which operating income from Crow's portfolio of warehouses and $100 million in cash from PRISA will finance the construction of new industrial parks in recovering distribution markets.
Crow also is contributing a warehouse and its operating income to a $100 million limited partnership fund it is raising with China Merchants, a trading company, to build warehouses in China.
"The smart money is seeking experienced operators that can create value for investors out of their existing infrastructure," said R. Byron Carlock Jr., managing director.
At Allegis Realty Investors, firm officials restructured open-end commingled funds to more closely resemble private REITs in that clients can collect dividends or reinvest. The changes were in response to recommendations from a client advisory group formed two years ago, according to Jim O'Keefe, chief executive officer.
According to Mr. Gordon, LaSalle is recommending that portfolios larger than $100 million include private investments alongside public securities. Whether through public or private markets, LaSalle recommended growth-oriented investors take positions in hotel and office markets that are still recovering while income-oriented investors look to neighborhood shopping centers, state-of-the-art industrial buildings and well-positioned apartments.
Outlook by property sector
A 1997 forecast by Landauer Real Estate Counselors, New York, said offices continue to be the hot property type. Home offices and laptops have become supplements rather than substitutes for offices. Vacancies dropped 1.5 percentage points in the 12 months ended June 30 and will drop out of the teens by the start of 1997. Landauer rates Sacramento, Calif., first in quality followed by Portland, Ore., Phoenix, Orlando and Fort Lauderdale.
Major U.S. downtown markets with global business ties remain stable and well positioned for 1997, according to Arthur J. Mirante, president and chief executive officer of Cushman & Wakefield Inc., New York. Its favorite downtown office markets are midtown Manhattan, San Francisco, Boston, Miami and Los Angeles, largely because they have a "well-educated, bilingual or multilingual work force" and provide international transportation and cultural amenities, he said. Office vacancies are down in many markets, and leasing activity is increasing.
Suburban markets continue to strengthen as well, particularly in Dallas, San Francisco, Portland, Ore., northern Virginia and Boston, Mr. Mirante said.
The infusion of capital for new equipment has begun to stimulate demand for modern industrial facilities, according to the Landauer report.
Most retail properties remain a risky investment through 1997, but investment flows into the area are significant. Debt capital availability for retail properties is becoming more stringent.
The thirst for hotel acquisitions by U.S. investors is pushing up prices, especially for full-service hotels, according to a survey by the hospitality consulting group of Arthur Andersen & Co., New York.
Ninety-five percent of the investors surveyed acquired one or more hotels in the first three quarters of 1996 and the majority plan at least the same level of activity in 1997; 42% plan to invest more, according to Roger S. Cline, director. The most aggressive buyers are REITs and major hotel companies; private owners, banks and other financial institutions are the leading sellers.
The Andersen report also expects premier full-service hotels owned by Japanese banks to come on the market in the next year or two.
Landauer said hotel markets appear to have another good year ahead, although investors and operators will be challenged to find new growth niches. Landauer's top markets are Las Vegas, New York and Orlando.
Goods production has spurred a revival in demand for warehouses, light assembly facilities and research and development buildings. There is tremendous buying interest from wealthy individuals, REITs, corporate owners/users and institutional investors. Dallas tops the warehouse/distribution category followed by Portland, Ore., Chicago and Minneapolis, according to Landauer.
And the multifamily market, which was early in its recovery from recession, has plateaued, with the housing market overextended and the rental vacancy rate higher, at 8% for the first time since 1988. Still, California is an "excellent bet for multifamily investment" as the job boom continues and single-family home prices remain high, according to Landauer.
Mr. O'Keefe of Allegis - one of the largest institutional investors in apartments with 23,000 units -said pension funds, at about 15%, are tremendously underweighted in apartments, but that will change. His firm believes apartments represent 30% of the real estate universe.
"Apartments are much less volatile in many ways (than offices). Even though leases are short, the market rents are much less volatile," Mr. O'Keefe said.
The projected issuance of CMBS was expected to reach a record $25 billion in 1996. Total CMBS outstanding in June 1996 was about $81 billion, indicating about 8% of all U.S. commercial mortgages have been securitized, according to the LaSalle report.
The public REIT market has grown to almost $80 billion, according to figures from the National Association of Real Estate Investment Trusts, Washington. The percentage of REIT shares controlled by institutions has grown to more than 45% in 1996 from 25% in 1992, according to the LaSalle report. The firm projects the market will grow to nearly $110 billion by 1998.
Jon Litt, real estate analyst for PaineWebber Group, sees REITs as an alternative to utility stocks.
"REITs have lower volatility and a total return in line" with the Standard & Poor's 500. For 1996 through Dec. 6, the PaineWebber REIT index was up 23%, led by office and hotel REITs.
Mr. Litt said utilities traditionally are sought for yield and low volatility, but the industry fundamentals are deteriorating, which usually leads to lower earnings growth and potentially lower dividends.
REITs have strong yields and also enable investors "to participate in the recovery of real estate markets around the country in all major property types."
REIT mutual fund assets more than doubled in 1996 to $4.5 billion from $2 billion, while utility funds experienced $2.5 billion in net outflows, declining to $20 billion in assets through Dec. 6, said Mr. Litt, citing figures from AMG Data Services, Arcata, Calif.
Institutional REIT transactions will increase in 1997. Mr. Litt said Prudential Insurance Co. of America plans to liquidate a $5 billion real estate portfolio. It is likely to sell the properties to REITs in exchange for REIT shares. The California State Teachers Retirement System, Sacramento, is likely to do the same, with the help of AEW Capital Management L.P.
Mr. Litt thinks pension funds will prefer to receive shares rather than cash, which they would have to reinvest, for properties sold to REITs.
Mr. Saylor said opportunistic funds are enabling pension funds to co-invest. But he cautioned that with approximately 26 funds in the market, "it is increasingly unlikely to get 20% returns despite what the opportunistic funds say."
Instead, pension funds should put a small amount in these funds and seek overall real estate returns of 10% to 15% over a seven to 10 year period.
Donald Conover, chairman and chief executive officer of Greystone Realty Corp., Greenwich, Conn., expects more than $15 billion to pour into U.S. real estate from foreign individual investors before 2000.
He said current yields on U.S. properties are far higher than, say, German investments. Consequently, an estimated $7 billion to $10 billion will come from German investors with another $2 billion to $3 billion from Dutch investors.
Another $1 billion will come from Asians, who, unlike Europeans, are accepting lower yields than they can achieve at home in exchange for economic security and political stability.