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By Richard Westlund
For institutional investors there’s a lot to like about commercial real estate. Office, industrial, retail, multifamily, hospitality and other types of income-generating properties can add significant diversity to traditional portfolios, deliver a steady flow of cash with the potential for appreciation and provide a long-term hedge against inflation.
“Commercial real estate in the developed world has been proven to offer attractive returns on investment capital,” says Martha Peyton, global co-head of research and head of portfolio management, mark-to-market funds, TIAA-CREF Global Real Estate. “As a result, the flow of investor dollars into real estate has become larger and more globalized in recent years.”
Historically, real estate was included in the alternative or real asset class. But that categorization is changing quickly, according to Brian Ward, president of capital markets and investment services, Americas, at Colliers International. “Today real estate is almost in the core bucket,” he says. “It’s a critical component of almost every institutional investor’s portfolio.”
However, the growing demand for real estate properties in the U.S. and around the world has also pushed up valuations, making it more difficult to find bargains, especially in “hot” metropolitan areas. As a result, some institutional investors are broadening their criteria beyond the office market to include hospitality, retail, industrial and self-storage properties as well.
“Investors in core real estate will look at markets that have quality, stabilized properties,” says Peyton. “In a lot of emerging markets, the opportunities lie in development rather than in holding these types of core assets. So an investor with an appetite for the potential returns and higher risks associated with development can go to a wider variety of global markets.”
Listed or private assets?
Long-term institutional investors have a wide range of real estate strategies, including direct ownership, participation in a private fund and buying shares in a publicly traded real estate investment trust (REIT).
“In the past ten years, the allocations to listed real estate have increased as a result of desire for liquidity, not because one is better than the other,” says Stephen Dunn, executive vice president and director of institutional marketing at Cohen & Steers. “In fact, the strategies complement each other, and the exact allocation depends on the specific investment objectives of an institution’s capital pool and liquidity needs.”
Typically, about 80 to 90 percent of the real estate investments by corporate defined benefit plans, as well as those of endowments and foundations, has been invested in private rather than listed real estate, says Dunn. He adds that, in general, public defined benefit plans and corporate funds have higher allocations to listed real estate because of their need for liquidity. In addition, listed real estate is increasingly being added to defined contribution plans, either as a stand-alone option or as a sleeve in custom target date funds.
In recent years the number of listed REITs has grown around the world (see chart). Now there are more than 400 listed real estate companies in developed and emerging markets, according to Jon Cheigh, executive vice president and global portfolio manager for Cohen & Steers’ real estate securities portfolios. “Today there are good opportunities in the listed market, where companies are trading at discounts from underlying real estate values,” he says. Other trends include a pickup in M&A activity in real estate companies, including acquisitions by private equity firms.
“We are neither early nor late in the development cycle,” adds Cheigh. “However, investors should be more cautious about allocating to private real estate, because that capital might not be invested for several years, which will likely prove to be a more challenging vintage. With liquid assets you’re invested the day you decide to get in and can withdraw your funds if you decide to get out.”
Karen Whitt, president of investor services at Colliers International, notes that investors considering taking on development risk—either directly or through a joint venture—should take a close look at rising construction costs. “If the development is not getting out of the ground soon, it may not meet the pro forma financial projections,” she says.
Diversifying into global markets
Investors seeking to diversify their real estate assets should consider a global strategy, says Alice Breheny, global co-head of research at TH Real Estate in London. “In recent years the various sectors in each market, such as office or industrial properties, have become more closely correlated,” she adds. “Therefore holdings in different locations can provide greater diversification benefits to investors looking outside their own markets.” Cohen & Steers’ Dunn says that some institutional investors that already have U.S. exposure are interested in increasing their allocations to global real estate. “However, the U.S. is the most mature listed real estate market, with more REITs and less regulatory risk than Europe or Asia,” he explains. “The decision to acquire assets in Europe or Asia depends a great deal on how comfortable the investor and consultant are with a global real estate strategy.”
In the U.S. the top real estate markets include Boston, New York, Washington, Seattle, San Francisco and Los Angeles, says Colliers International’s Ward. “These metro areas are white hot right now because of the high growth of technology and ecommerce,” he says. “The Millennials are powering these regional economies just as they are in other major developed countries.”
Looking at international markets, Whitt notes that central London is priced out and capital is moving north to Birmingham and Leeds. Investors are also looking at properties in Madrid and Warsaw, which is seen as a safe haven for Eastern European capital. “Hong Kong has issues regarding its relationship with China but has more market diversity than Shanghai,” Whitt says. “The core markets in China are okay, but tier-two markets will have problems, as there are so many uncompleted or unoccupied properties.”
Elsewhere on the Pacific Rim, Whitt says Singapore’s market is slowing, but Sydney and Melbourne are still going strong. “Tokyo is showing some strength, and we are keeping an eye on opportunities in that market,” she adds. “But the favored global market remains the U.S. because of its strong fundamentals.”
Although office remains the favored class globally, it’s hard to find core properties at an attractive price because of high demand and limited supply. “When I meet with large institutional clients, the conversation is always about the office market,” Whitt says. “We are also seeing continued interest in multifamily deals as well as more consideration of the industrial and retail sectors.”
In the U.S. market, Cheigh says, multifamily rentals and self-storage properties are attractive. “Apartments are benefiting from ongoing job growth, as well as a demographic preference among Millennials for renting versus owning,” he adds. “Self-storage is a less-established real estate sector in the U.S. and U.K. It’s not flashy or exciting, but it does generate cash flow, and there are noneconomic barriers to competition, as most neighborhoods don’t want these facilities in their own backyards.
Regardless of product type, local knowledge and research still provide the foundation for a successful real estate strategy. As TIAA- CREF’s Peyton says: “There are important demographic differences shaping real estate demand. Because metro areas also vary, you have to apply key trends on a very local basis.”