In cooperation with the National Association of Real Estate Investment Trusts (NAREIT)
After a rocky end to 2008 and a tumultuous market environment through first quarter 2009, individual and institutional investors worldwide are closely examining their portfolios—assessing losses, identifying opportunities, and looking for signals from the marketplace as to what may be next. Despite the looming credit crisis, equity markets have improved, and there have been optimistic whispers that the worst may be behind us. But what is going on in the real estate market?
Commercial Real Estate: Private and Public Markets
When referring to real estate for portfolio allocation purposes, it is safe to assume that one is talking about commercial, or income-producing, real estate as opposed to the residential housing market. There are two markets for commercial real estate—the private market and the public market. The private commercial real estate market is much larger than the public market and involves the purchase of commercial property through direct investment or private equity pools on the equity side, or the purchase of credit derivatives such as commercial mortgage backed securities (CMBS) on the debt side.
Unfortunately, the performance of private commercial real estate is still rather dismal as fundamentals across all property types remain poor. With high levels of unemployment and weakening demand from consumers, income from rentals has been declining and vacancy rates have been increasing. Hotel properties have also experienced significant pressure on revenues with record low occupancy rates. The current credit crisis, with banks unwilling to lend and the CMBS market basically closed, has made financing (and refinancing) of real estate properties nearly impossible. As debts mature this illiquidity has forced distressed sales and hurt property values.
Publicly listed commercial real estate consists of real estate companies that own and manage properties and list on public stock exchanges. Real Estate Investment Trusts (REITs) are the most common example of this type of real estate. As in the private real estate market, investors can gain exposure through debt and/or equity. They can purchase these companies’ stocks or bonds directly or through mutual funds. It is relatively easy for investors move in and out of such holdings because they are tradeable, whereas private property investments are highly illiquid. Because of listed real estate’s inherent liquidity, its performance tends to lead private real estate both on the way down and in recovery.
The “Lead/Lag” Relationship
This is what is often referred to as the “lead/lag” relationship between public and private commercial real estate. According to Meredith Despins, Vice President of Investment Affairs and Investor Education at the National Association of Real Estate Investment Trusts (NAREIT), “Returns in the private real estate market lag behind returns in the publicly traded REIT market by an average of 15-18 months, although the lag is not constant at all phases of the market cycle. REITs tend to complete their downturns very quickly and recover quickly, while private property values take a long time to reach their bottoms and a long time to recover from them.” Specifically, Despins explains that the private market tends to reach its peaks roughly 12 months after the REIT market, but tends not to reach its troughs until about 30 months after the REIT market has bottomed out. For example, during the last major commercial real estate recession, Equity REIT prices peaked in August 1989, troughed in October 1990, and had recovered fully by March 1991. Meanwhile, private prices peaked in the third quarter of 1990, didn't trough until the fourth quarter of 1992, and didn't recover fully until the second quarter of 1995.
There are four reasons for the lead-lag relationship. First, REIT investors anticipate future developments in the underlying real estate market, just as the stock market anticipates future developments in the general economy. Second, even after buyers and sellers in the private market negotiate a transaction price for a property (on the basis of their current information about the real estate market) it is generally several months before the transaction is finalized. Third, after transactions close there is another lag of several months before data on comparables are incorporated into appraised values of non-transacting properties. There is also a final reporting lag: the NCREIF Property Index (NPI), for example, doesn't appear until roughly six weeks after the end of the quarter that it values.
Positive Performance
What is happening now may very well be the beginning of a recovery for the REIT market. Listed real estate stock prices are currently rising and have shown dramatic improvement after having lost 73% in total returns since their previous peak on February 7, 2007. As of market close on June 23, 2009, U.S. equity REITs have gained almost 51% from hitting their trough on March 6, 2009. Across all major geographic regions, including Europe, the Middle East, Africa, Asia-Pacific, and most notably North America, share price of public real estate companies have risen over 25% since March. The FTSE EPRA/NAREIT Americas Index, which includes Canadian and U.S. REIT giants such as Riocan REIT, Brookfield Properties Corporation, Simon Property Group and PublicStorage among its top constituents, posted a 33% recovery since the second quarter. Listed properties in the Asian region have realized close to 27% increases on average since the beginning of the year.
Another positive signal beyond stock price recovery has been the $18.6 billion in new capital raised this year by REITs. This includes fifty secondary equity offerings totaling $15.7 billion and two new REIT IPOs. The market is rewarding these equity offerings, as REIT gains have totaled 1.25 percentage points on average in stock price on the day of secondary equity offerings, relative to what the rest of the publicly traded REIT market did on the same day. This recapitalization means that REITs have been able to tap the public equity markets and use the funds to pay off debt and strengthen their balance sheets. It also puts them in a good position to take advantage of the sale of distressed properties, something the private side of the market cannot easily do. So while it may be too soon to say “comeback,” there are encouraging signals from the publicly listed real estate market.
Institutional Investors’ Perspectives
The average allocation to real estate in an institutional portfolio ranges from about 8% to 15%. The size of these allocations is enough to suggest that real estate, although often thought of as an “alternative” investment is actually treated as a core asset class in these portfolios. Of this average 8% to 15% allocation, about 6% is currently allocated to public real estate globally.
Many of the larger institutional plan sponsors view commercial real estate as a core asset class and one that has historically contributed diversification and solid long term investment returns to their portfolio. Jean-Louis Ponce, the director of risk management and quantitative analysis in the Pension Asset Management Group at Quebec-based Bombardier, Inc. is among these. He uses REITs to access the global real estate market and measures their performance against the FTSE EPRA/NAREIT Global Real Estate index benchmark. The purpose, he says, is diversification—to improve the risk/return ratio by adding an asset class that protects against long-term inflation.
Ryan Kuruliak, a vice president with Proteus Performance Management in Toronto, says that of his clients who invest in real estate, the majority use pooled (private) vehicles. “We have seen some concerns from plan sponsors regarding the drying up of liquidity in some investment products which have direct holdings of real estate,” he says. “On the other hand, although publicly listed real estate may be more transparent and liquid in comparison, it also has a high correlation to the overall equity market, which can diminish its diversification benefits.” He advises that pension plan sponsors and endowment and foundation investment committees considering real estate investment become educated about the unique characteristics and constraints of the asset class, including the fundamental difference between public and private real estate.
Cautious Optimism
News of the private market will most likely continue to include weakening fundamentals, illiquidity and distressed property sales. However, public market real estate companies are in a unique position to lead future recovery. The ability to raise equity capital and access U.S. Government relief programs such as the Term Asset-Backed Securities Loan Facility (TALF), will allow listed real estate companies to improve their balance sheets and to take advantage of growth opportunities in the market.
As investors review their asset allocations in light of the current difficult economic environment, real estate will continue to provoke attention. Many investors have taken time to consider how their portfolios should be repositioned based on lessons learned from the credit crisis, including how to tactically capture new opportunities owing to financial market dislocations. Recent industry news has indicated that a number of plan sponsors have increased their allocations to commercial real estate from a strategic standpoint, and also to capitalize on current values in the marketplace. Of the $600 million in new investment mandates awarded in the first quarter, 15% were allocated to public REIT strategies. Even among those with capital to invest, however, a cautious “wait and see” approach has been the norm.
For further information about FTSE and the FTSE EPRA/NAREIT Real Estate Index Series, please visit www.ftse.com/realestate.
For further information about the National Association of Real Estate Investment Trusts® (NAREIT), please visit www.reit.com.
