Institutional investors are expected to return to core real estate as the credit markets wreak havoc with the riskier portions of their portfolios.
Core real estate, the least risky property investment, has been out of favor for years. Investors searching for returns concentrated their real estate dollars in value-added and opportunistic real estate.
With the access to credit tightening and returns in riskier real estate expected to drop, pension fund investors will become more interested in stable properties with current rent streams, investment managers and consultants say.
I think there will be a shift to core, said Alan Billingsley, director and head of research for RREEF Real Estate North America, New York. Its a flight to quality and its a flight to current income.
Whats more, with debt less available and more expensive, pension funds no longer will be shut out of plum deals. A buyer who can plunk down cash is more prized than a buyer with a higher but debt-laden offer, Mr. Billingsley said. Thats similar to the situation in 2002, when investors were moving allocations to core real estate and demanding fee concessions from opportunity fund managers because of sagging returns.
Longtime real estate investors and their investment managers have been sitting out much of the hot potato real estate market this year, said Gary Koster, director of the national funds practice at consulting firm Ernst & Young LLC, New York.
They chose not to compete with buyers who were able to pay high prices by using 80% to 90% leverage. Many of these buyers were in it for a quick sale, betting they would not be holding a huge portfolio of highly leveraged properties when the market changed, Mr. Koster explained. Opportunistic portfolios are rife with these properties, which will bring down returns now that the debt market has tightened.
Investors have not yet begun their shift to core. That wont happen until value-added and opportunistic funds stopped meeting investors high return expectations, said Scott Farb, managing principal with real estate consulting firm Reznick Group PC, Bethesda, Md.
We sold a lot
Investors who will have the most performance problems have been in the asset class for a number of years. Many have properties that their managers have owned for a while, with stagnant income prospects that will have to be sold despite the poor market conditions.
We sold a lot of property earlier this year, Mr. Billingsley said. I wish we would have gotten more out the door.
Investors such as the $242.7 billion California Public Employees Retirement System, Sacramento, sold as much of their core portfolio as they could over the last few years.
Having a portfolio comprising only core investments has insulated the $1.9 billion Santa Barbara County (Calif.) Employees Retirement Systems real estate portfolio from the ravages of the credit crunch, said Oscar Peters, retirement administrator. Still, system officials wont end their plans to add value-added and opportunistic real estate.
We will take several years to get this done and wont take vintage year or market risk by investing the bulk during a particular year and time in the market, Mr. Peters said. We will use a structured process and invest at a deliberate pace.
Even so, institutional investors are edgy about future real estate returns. Prices for properties in areas of the country with little or negative growth are declining. Institutional investors consider commercial real estate returns that are depressed by the lack of credit to be the biggest threat to their portfolios, according to a survey of institutional real estate investors released in August by Real Estate Research Corp., Chicago.
While it has not happened yet, RERC executives expect to see an increased demand for stable properties instead of building all of ones investment hopes on the capital markets and low interest rates, Kenneth Riggs Jr., president and chief executive officer of RERC, said in a report accompanying the survey results.
As the economy goes
What happens in the economy at large as a result of the credit crunch is also likely to have a negative impact on real estate portfolios.
All investment styles will be affected, and operators using overly aggressive leverage or those who lack fundamental real estate experience will be flushed out of the system, noted Dan Vene, associate at C.P. Eaton Partners LLC, a Rowayton, Conn., placement agent.
Plus, a drop in consumer spending will hurt commercial real estate, Mr. Farb said.
Consumer spending (largely from people borrowing against the equity in their homes) has been steamrolling the economy along, and a decline will have a pervasive impact on real estate, Mr. Farb said.
For now, much of the pain will be felt in opportunity funds, which are mainly structured as private equity-type funds. Those managers use the most leverage between 70% and 90%. A good deal of mezzanine-type and other adjustable-rate debt was mixed in with the fixed-rate debt, Mr. Farb said.
What happens when the interest rate on this debt is adjusted upward? he asked. It will undoubtedly have a negative impact on investment returns.
Properties of lesser quality or in less desirable areas also will suffer. Until recently, investors had not demanded concessions for higher-risk properties, said Ron Greenspan, senior managing director, corporate finance, with FTI Consulting Inc., New York.
The market is re-evaluating the risk premium and whether the risk premium was appropriately priced in the last few years, Mr. Greenspan said.
Over the last few years, investors received much of their return from property appreciation as prices flew skyward. In times of higher risk, investors place a higher value on cash flow than on prospective property appreciation, Mr. Greenspan explained.
It may push more investors back to the current cash flow model with less consideration given to future appreciation, he said.