U.S. Real Estate: Priced for Perfection?
Deciding whether to buy, hold or fold.
November 1, 2011
With disappointing results in the public markets, pension plans naturally are looking for alternatives. Real estate and infrastructure beckon, not only because of their lack of correlation to public market returns, but because of their coupon yields.
But is real estate, particularly in the U.S., built on a stable investment foundation? Before the real estate bust, investors were pushing yields below the 6% range. Clearly no longer a bargain price for a long-term asset.
Floris van Dijkum and Elysia Tee, respectively managing director and vice-president in BlackRock’s Real Estate Investment Group highlight that issue in a paper entitled “U.S Real Estate: Buy, Hold or Fold.”
“Coming out of the most devastating CRE downturn in history, pricing for well-leased, stabilised properties in most US markets is strong with capitalisation rates in the 4% to 6% range,” they note. (That implies a p/e ratio of 17% to 25%.)
Still, it’s all relative. A 6% cap rate in a 5% T-bond market isn’t very compelling. But with sustained low yields as the U.S. Fed battles deflationary pressures, the picture looks a little bit different.
“With expectations of subdued economic growth over the next decade, BlackRock forecasts unlevered core US CRE to deliver between 6% to 7.5% average annual returns during the same period. Although these returns are lower than historical averages, they are higher than the expected returns for fixed income. Additionally, core US CRE appears attractive when compared to the expected returns for stocks (which are leveraged) over the next decade. As a result, CRE offers a compelling investment option among investors seeking yield, particularly in light of the 10-year Treasury yielding around 2%.”
With that analysis, however, they are not advocating an overweight position. Moreover, the “bulk of the return is expected to come from income, rather than capital gains.” Mind you, they are subdued about the prospective capital gains in equity markets too.
That’s for private real estate equity – direct investments in open or closed-end funds. Joseph Harvey, president and chief investment officer at Cohen and Steers, in his own white paper, is less sanguine about private real estate investing. In “The Truth About Real Estate Allocations (Part I), he writes:
“As the commercial real estate sector in the U.S. transitions from collapse to recovery, we believe that institutional investors are re-evaluating the composition of their real estate allocations. In our view, the historical performance of private real estate funds does not justify the high allocations to direct property typically found in corporate and public pension plan portfolios. Notably, investors have not been compensated for the costs or risks of illiquidity. The recent real estate downturn has illuminated those costs, and has demonstrated why listed real estate, through REITs, provides a superior investment vehicle for core and value added real estate allocations.”
Looking at the data, he finds REITs outperform in both the short and long term, compared to core real estate funds. “Over the past 30 years, which encompass two commercial real estate crashes (1989-1992 and 2008-2010), REITs have outperformed diversified core funds by 470 basis points annually. Over the past 10 years, REITs have outperformed core funds by 560 basis points annually.”
Thus, he concludes: “These results, to us, do not justify the fees paid for most private funds, nor do they justify the cost or risks of illiquidity that private investment vehicles require.” And illiquidity raised the gates in 2007-2009 period. It was buy and hold – when the pension plan wanted to or not.
So why go with a core fund instead of a portfolio of publicly traded REITS. Harvey suggests that “There are fund-of-funds managers who add value in private fund investment management, but the alpha is derived from strategy, property type and fund manager selection at a point in time, and from advisor oversight of strategy and governance—rather than from portfolio rebalancing throughout the cycle. Lack of liquidity for private funds precludes the same style of active portfolio management REIT investors enjoy.”
Which brings to mind a variation on the old real estate meme: liquidity, liquidity, liquidity.