Investors may flirt with riskier real estate strategies in 2014

Spoiler alert: Real estate investors might be edging into riskier strategies in 2014.

Other trends predicted for the new year include that multifamily properties might fall off of investors' must-have lists, construction investment could pick up and foreign investors are expected to continue to scoop up trophy properties in the U.S.

“Looking ahead, I would fully believe investors would take advantage on value added and opportunistic strategies instead of focusing on core,” said Brad Morrow, senior private markets consultant in the New York office of Towers Watson & Co. The riskier strategies appear to be a better opportunity because of the risk-return spread between them and core.

Mr. Morrow does not expect a wholesale switch of capital out of core for value added and opportunistic real estate. Instead, he expects investors to begin using riskier strategies with a little more return potential “at the margins.”

As for the real estate markets, Jim Sullivan, managing director, REIT research, of Green Street Advisors Inc., a Newport Beach, Calif.-based research firm, said real estate market projects are “tied at the hip with any investor's view of interest rates.”

One camp's view is that interest rates might go up because the economy will be recovering at a robust pace, Mr. Sullivan explained.

“A higher cost of capital is bad for real estate investing but a robust economy is great for real estate,” he said. Another view is that if interest rates go up unaccompanied by strong economic growth, it will be bad for real estate because it is an industry that is capital intensive, Mr. Sullivan said.

Meanwhile, multifamily real estate investments may no longer be the darling of real estate investment community in the coming year.

Apartments — and the multifamily sector as a whole — have been extremely strong for several years, but it won't be as hot going forward, Mr. Morrow said.

The net operating income might start to come down as new multifamily development projects that are in the pipeline are completed, he said. Indeed, there might be oversupply of multifamily properties in certain markets.

“I don't see the growth opportunity we've seen in the past,” Mr. Morrow said. “Apartments might become less desirable.”

It could be a completely different story in the apartment real estate investment trust sector, Mr. Sullivan said.

Apartment REITs were red hot in 2011 and 2012, but underperformed the rest of the public markets in 2013, he said.

“Our view is the market overreacted to the decelerating growth,” Mr. Sullivan said. “Apartment REITs look cheap going into 2014.”

There will be a similar story with mall REITs, he added. In 2013, the mall sector significantly underperformed as investors anticipated a decline in consumer spending and a tax increase.

As a consequence, high-quality malls look cheap in the public real estate market, Mr. Sullivan said.

“Investor angst in relation to investor spending is legitimate but the mall sector was overly discounted,” he said.

One really big-picture item in 2014 is that the pace of new construction is starting to pick up.

“The commercial real estate party … usually ends not because of the lack of demand but because of excess new supply,” Mr. Sullivan said.

New construction, which had been at generational lows, is starting to change “in a pretty meaningful way,” he said.

The pace is picking up the quickest in multifamily, industrial and niche strategies such as student housing and data centers.

“The good news is that there is demand to meet the new supply,” he said.

The increasing supply is not enough to ring any alarm bells, but it is the first time in two or three years that observers will be watching out for oversupply.

One trend that sprouted in 2013 and might take firm root in 2014 is an increase in co-investments in real estate. While co-investments are fairly common in private equity, real estate deals have not been large enough for co-investments.

Real estate managers that can't raise a large blind pool closed-end fund are looking to new ways to raise capital including seeking co-investments.

Managers may be more open to it in 2014 as fundraising continues to be a challenge, said David M. Sherman, president and co-chief investment officer of Metropolitan Real Estate Equity Management, Carlyle's newly acquired real estate fund-of-funds business, and head of the real estate fund of funds group in Carlyle Group's solutions subsidiary.

“Managers that need to stretch the remaining equity in a fund may co-invest, even if their deal sizes are manageable, during the latter half of a fund's lifecycle,” Mr. Sherman said. “A manager of a new fund may seek co-investment because fundraising is going slowly. Some managers utilize co-invest in between fund raises.”

A big theme in 2014 is expected to be continued investment by foreign investors in U.S. real estate, said P.J. Yeatman, head of private real estate for CenterSquare Investment Management, a Plymouth Meeting, Pa., real estate manager. In a flight to quality, foreign investors have been buying up trophy assets in the U.S., leading to the overpricing for these properties, Mr. Yeatman said.

“We (the U.S.) became the flight-to-quality market,” he said.

These investors consider U.S. core real estate to be akin to fixed income, Mr. Yeatman said. What's more, many of these buyers purchase properties on the basis of “perception,” he added. “The perception is that New York is a fortress and it is worth paying anything for New York real estate,” Mr. Yeatman said.

He added: “I don't expect (foreign purchases of U.S. property) to stop” in 2014.

Astute investors will begin investing in value added and opportunistic real estate in order to sell into the overheated core market.

“The smart money will recognize the arbitrage opportunity between creating income streams to sell into the overheated market vs. buying income streams,” Mr. Yeatman said.

Another huge investment opportunity will be European real estate debt, said Joe Valente, managing director and head of real estate research and strategy in the London office of J.P. Morgan Asset Management.

Some €400 billion ($546.7 billion) of distressed European assets will be coming to the market, Mr. Valente estimated. “Half will be in core European markets where investors don't have to take macro risk,” he said.

As for the year just ended, one of the big surprises was that the capital markets rebounded stronger than many real estate investors expected.

“I expected it to be strong, but it was stronger than I had expected,” said Gary M. Tenzer, Los Angeles-based principal at real estate investment banking firm George Smith Partners Inc.

Even though prices were at very high levels, in many cases around the pre-financial crisis levels, cap rates were very low, he said, noting that investors were chasing yield.