Real estate managers likely to ratchet up risk in search of better returns

Updated

Real estate investors are likely to dip their toes into riskier real estate investments in 2015, while high-flying core fund returns are expected to fall back to earth, industry executives say.

“Institutional investors that have fully recovered from the meltdown of 2008 are feeling really good about their asset base and stepping off the curb and taking more risk,” said Kevin Campbell, managing director and portfolio manager in the private markets group at fund-of-funds manager DuPont Capital Management, Wilmington, Del.

Core real estate funds are expected to return 6% to 8% in 2015 from about 10% now. Investors had been using the current income of core properties as a safer investment, and now they are starting to add a bit more risk. But like private equity, there's been a great deal of capital poured into real estate, which could reduce returns, he said.

More real estate managers that invest outside the popular gateway cities and that are buying properties that go higher on the risk scale in terms of lower occupancies and capital needs are expected to receive investor dollars in 2015, Mr. Campbell and other experts said.

“Both of those markets are built on the idea of inefficiencies,” Mr. Campbell said. “Whenever there is a lot of capital chasing a limited number of good deals, I worry that the markets are becoming more efficient than they should be.”

Even so, investors are expected to retain their positive view of real estate into the new year.

“Generally, there is a positive sentiment toward the real estate sector,” said Lori Campana, managing director and partner of Monument Group, a Boston-based alternative investment placement agency firm.

One of the real estate's attractions is what hasn't happened. “We haven't hit a bubble because there hasn't been overleveraging in this cycle and so nobody is expecting a big bust,” Ms. Campana said. At the same time, few investors expect real estate prices to continue increasing because they will be tempered by rising interest rates, she added.

While investors are still focused on coastal cities, some now are looking to invest in secondary markets such as Austin, Texas — driven by the technology industry — and Houston — driven by the energy industry, Ms. Campana said.

Scott D. Brown, global president and CEO of Boston-based money management firm Cornerstone Real Estate Advisers LLC, said he doesn't think the U.S. is at the end of its economic expansion, leading to continued interest in real estate investment. Core real estate in all sectors should still be interesting to investors because they can get “good return for the relative risk” compared to other asset classes, he said.

But 2015 will present more opportunities for investors “to step out on the risk spectrum and be paid for it.”

There will be increasing demand for multifamily properties and industrial space, he said. In retail, vacancy rates should decrease, especially in necessity retail — centers that include grocery stores and other necessary destinations.

“We still like the office sector ... with the work-live-play phenomenon driving demand,” he said.

Cornerstone executives expect vacancies to come down and greater upward pressure on rents for office buildings that are close to restaurants, gyms and other amenities that give workers a balanced working life, Mr. Brown said.

Indeed, “walkability” — being close to public transportation, dry cleaners, restaurants, and other services and amenities — is becoming a key part of the value equation, said Monument Group's Ms. Campana. “It's part of the demographic shift,” she said.

Millennials — people born between the early 1980s and the early 2000s — want to live and work in areas where they can walk to work or walk to retail, Ms. Campana said. “You wouldn't have heard of walkability 10 years ago. Now it's a key factor,” she said. “Even though infrastructure is in horrible shape, would you want to get into your car if you have access to a transit system?”

Jeff Furber, CEO of Boston-based real estate money management firm AEW Capital Management LP, expects the focus on millennials to continue into 2015. “It's a big, big demographic, as big as the baby boomers,” he said.

For example, AEW recently developed apartment building in Minneapolis with a view to attracting millennials. Among the amenities is a heated outside dog run.

This focus on millennials has led AEW to be “much more bullish on creative office space ... rather than traditional office space,” he said.

Mr. Furber also thinks 2015 will be a good year for real estate because supply is under control and has not exceeded demand for properties, while leverage also has been under control.

At the same time, leases signed after financial crisis in 2009 will come due, leaving room for rents to increase in 2015. “Five- or seven-year leases will be rolling way up,” Mr. Furber said.

However, he does expect returns for core real estate to fall in 2015. “Core returns have been incredibly strong and people had 10%-plus return,” he said. “Core returns will drop to 6% or 7%, where they should be.”

Supply is also key to real estate investment trusts' performance in 2015, said Vince Childers, senior vice president and real asset portfolio manager in the New York headquarters of listed real asset manager Cohen & Steers.

Rising interest rates will dampen REIT returns in the short term, but the supply-demand and underlying growth scenarios are more important than interest rates to REITs' anticipated returns, he said. There is no oversupply, and at this point, the most new construction has occurred in the office and multifamily sectors, Mr. Childers said.

Foreign capital is beginning to flow into U.S. REITs. “It's an extension of investors pursuing high-quality assets,” Mr. Childers said.

Mr. Childers also said he doesn't think real estate prices have topped out, but he does see a need for investors to proceed with caution in 2015.

“The easy money has already been made at this point,” Mr. Childers said. “It will pay to be more discerning ... going forward.”