Financial prospects appear bright but risks lurk around every corner

Even though returns are expected to slip in 2020, real estate could provide a relatively safe haven in the event of economic squalls because of its income component.

But investors should beware of taking on more risk to maintain returns and relying on the liquidity of trophy properties in their portfolios.

The low-economic-growth environment is leading asset owners to continue investing in real estate for the income as well as some property appreciation, industry experts say.

"Going into 2020, the environment looks more attractive for real estate, at least for the short term, than we would have anticipated," said Lee Menifee, Madison, N.J.-based managing director and head of Americas investment research at PGIM Real Estate, which has $175.9 billion in assets under management.

But there are caveats, he said.

For example, overall foreign investment — dominated by Canadian investors — in the U.S. dropped in 2019, which raises concerns for the liquidity of larger properties in gateway cities, he said.

Foreign investments account for 10% to 15% of transactions in the U.S. overall but foreign investment is higher in gateway markets, Mr. Menifee said.

Overall, cross-border transactions fell worldwide fell to 26% in the third quarter from 38% at year-end 2018, according to a PGIM Real Estate global real estate trends report.

"Institutional investors' target allocations to real estate remain firmly above 10%, and many continue to expand their allocations," said Nancy I. Lashine, New York-based managing partner and founder of placement agent Park Madison Partners LLC.

Currently, investors' average target real estate allocation is 10.2%, larger than all other alternative investment allocations except for hedge funds (13.2%), according to Preqin. By comparison, asset owners worldwide had an average target private equity allocation of 9.9%, private debt of 6.3%, natural resources of 5.6% and infrastructure, 5.5%, Preqin data shows.

What's more, 51% of global institutional investors surveyed by the London-based alternative investment research firm in June expect to commit the same amount of capital to real estate and 28% expect to commit more capital to real estate in the next 12 months than they did in the previous 12 months. The remainder expects to invest less.

"In 2020, the big picture is that we continue to live in a lower-for-longer environment and real estate looks attractive," Ms. Lashine said.

Some investors are looking for real estate with a value-added component, she said.

Indeed, more global asset owners think that value-added and opportunistic real estate offer the best investment opportunities, opposed to core and core-plus, Preqin's survey results show. Some 46% think that value-added and 44% consider opportunistic properties the best real estate bet compared with 27% for core-plus and 24% for core.

Even so, fundraising remains competitive across all strategies, she said.

The number of real estate funds in the market seeking capital is at an all-time high while the number of funds reaching a final close continues to trend down, Ms. Lashine said.

The number of real estate funds being raised has been increasing steadily since January 2015, Preqin data shows.

As of October, there were 856 real estate funds in the market worldwide, seeking $251 billion in total commitments. By comparison, in January 2019, there were 634 real estate funds in the market attempting to raise a total of $219 billion.

In the first three months of 2019, 188 real estate funds closed raising a combined $121 billion, according to Preqin.

One reason for the competitive real estate fundraising environment is that real estate investors and many managers expect lower real estate returns going forward.

Real estate will produce a return more modest than the annual 8% to 10% investors have been earning over the last 10 years, said Jacques Gordon, Chicago-based global head of research and strategy at real estate manager LaSalle Investment Management.

Investors will end up with returns this year in the mid-single-digits for core real estate, he said.

What's going to happen is that asset owners will ask their managers how they can keep delivering the same returns as before, he said.

Managers will have to stretch. They will have to get creative, take on more risk and all of that will be happening in a slower economy, Mr. Gordon said.

Property sector returns in the U.S. will continue to diverge, Mr. Gordon said. Starting around 2009, the difference in performance of the major property sectors in the U.S. converged to about 2 percentage points between the highest-performing and lowest-performing property types, he said. However, in recent years, a gap began to form, with the highest, logistics, outperforming the lowest, retail, by an ever-growing amount.

Over the last three years, retail has plummeted from the top-performing sector "to everyone's least-favored sector by a lot," Mr. Gordon said.

This performance gap is growing, he said. "It has not run its course yet," Mr. Gordon said.

The same dynamic is happening in other countries, he explained. It is more severe in the U.K. where everyone's favorite property segment is logistics. Office properties held up in London but not outside London and retail in the U.K. showed negative appreciation at the end of 2019, meaning that the loss of capital value will be greater than the property's income.

The specter of logistics wins and retail losses is most pronounced in the U.K., followed by the U.S. and then Australia, he said.

Going forward, LaSalle executives say investors' portfolios would do well to tilt toward more office properties in Europe, logistics in the Asia-Pacific region and multifamily in the U.S.

Ronald Dickerman, New York-based founder and president of real estate firm Madison International Realty, agrees that returns in real estate will be more difficult to produce.

Madison has $5.6 billion in AUM.

"I think people feel good about 2020," even though rental growth expectations are measured and it will be more difficult to earn returns, Mr. Dickerman said.

Most of the metrics needed for successful real estate investment are there, including job creation and GDP growth, he said. The ingredient that will be difficult to achieve is rental growth, Mr. Dickerman said.

Madison International Realty invests in property sectors and geographic locations that have higher growth such as industrial and Class A multifamily, Mr. Dickerman said.

"You can buy income or growth but you can't buy both," he said. "If you invest in property with income, odds are it doesn't have a lot of (rental) growth."

Madison International is investing more heavily in multifamily and industrial, while remaining underweight office and very cautious with retail investments, sticking to grocery-anchored retail, he said.

His firm is underweight office because the most popular office properties have measured rental growth, Mr. Dickerman said.

"We also would consider affordable housing, notwithstanding regulations" because there is bigger supply-demand imbalance, he said.

The office sector in the U.S. has been disappointing throughout its cycle, said PGIM's Mr. Menifee.

The last downturn in the U.S. office sector was steep but the recovery since then has been weaker than in prior cycles, he said.

"We have not seen the rent growth … and the cost of tenant improvements has been high," Mr. Menifee said.

He does not expect this situation to improve in 2020.

"In the last three years, co-working companies have been a source of demand and that business model is under pressure, taking away that incremental demand," Mr. Menifee said.

There is opportunity in office but the sector going into 2020 will be weaker because of co-working companies like We Work that are prompting companies to lease less space per employee.

Additionally, companies are continuing to pack more employees into less space.

"Tenants are very cost-sensitive," he said. "The more you pay to employ and pay people, the less you have to pay for real estate. It may explain the expected slow office growth in 2020."

Industry insiders expect investors to continue to invest in real estate debt because real estate can produce attractive returns with a risk profile that differs from equity real estate, a LaSalle report said.

Mr. Menifee agrees. While PGIM executives expect the supply of commercial real estate across sectors to remain low, the supply of debt will continue to increase with a diversified group of lenders that are competing against each other, he said.

"It's a good year to be a borrower," Mr. Menifee said. "Lenders are competing for lending opportunities and are competing across the risk spectrum," Mr. Menifee said.

There are not only traditional lenders such as banks and insurance companies but also real estate debt funds that have raised a significant amount of capital, estimated to be $20 billion in 2019, he said.

"There are a number of funds with a lot of dry powder to deploy," Mr. Menifee said.

Ryan Krauch, Los Angeles-based principal at real estate debt firm Mesa West Capital, echoed that real estate debt sector has become competitive.

"As a lender, I may not like that because of lot of people are going into the same deals I am and there are deals that should not be done … but those are the exception," Mr. Krauch said.

While there are some trends in the way loans are being structured that are going in the wrong direction, "we are nowhere where we were in 2006 and 2007," he said.

Even so, in 2020, Mesa West executives will push to lend to the more conservative end of the spectrum with a loan-to-value in the 50% to 60% range, down from the typical 60% to75% loan to value range.

Mesa West executives expect to compete with banks and insurance companies, which are more conservative lenders. They are also looking to longer-duration loans because some investors are concerned that interest rates could go down, possibly to negative interest rates.

Niche sectors in real estate are also being considered as a way to eke out some returns and as a defensive strategy in 2020.

In its annual real estate report, LaSalle Investment Management is again recommending investing in real estate investment trusts in niche sectors including cell towers/infrastructure, health care, data centers and self-storage.

Much of the niche exposure is in REITs. Some 4% of the NCREIF Fund Index - Open End Diversified Core Equity universe of core open-ended funds is in niche property types, with the remainder in the four main real estate sectors of office, apartments, retail and industrial. Meanwhile, 53.2% of the FTSE NAREIT All Equity REITs index was in niche property types as of Dec. 31.

Niche REITs have generally performed better than core property-type REITs in the 10 years since the global financial crisis, the LaSalle report said, with U.S. niche property-type REITs earning an annualized return of about 15%, outperforming core REITs by about 2 percentage points per year, according to the LaSalle report.

What's more, LaSalle tested the strategy of adding niche REITs to a mostly core portfolio using three-year rolling returns over the 20 years and found that all combinations tested — 25%, 33%, and 50% public niche — would have produced higher returns with lower volatility than a purely private core real estate strategy, the report said.