The signs are clear: Annualized returns of more than 25 percent in the public market over the past three years. Clients rushing into your offices with news of six-figure profits on some private deal down in Florida. Add in a white-hot residential market--fueled by low interest rates--that has burned for nearly a decade, and anyone should be able to hear the warning bells. The real estate market is overheated and ready to blow. The easy money has been made, and it's time to take your profits and run for cover. The only problem with this alarmist scenario is that it, too, is overheated.
Yes, real estate has had a tremendous run-up in recent years. The NAREIT benchmark index from the National Association of Real Estate Investment Trusts boasts a five-year annualized return of 19.08 percent through 2005, compared to just 0.54 percent for the S&P 500 over the same period. And house values have finally slowed their steep climb, a sure sign of a long-awaited softening in that market.
On the commercial side, though, real estate is just getting started, says Matthew Gilman, CEO and portfolio manager of Starwood Real Estate Securities, a real estate hedge fund launched by international behemoth Starwood Capital Group in 2004. "A lot of people are concerned that the real estate markets have come to an end, but I would say there is a difference between stopping the appreciation and a bubble," he says. "In commercial real estate we're not even close to that."
The fantastic run-up in the REIT market--both public and private--over the past five years is credited in large part to the break in the equities markets and those low, low interest rates. Investors looking for any sort of real return over the last five years have had to move into alternative asset classes, and real estate--hard assets generating real income--looked like a safe bet after those dot-com shells that blew up the equity market.
Cash has poured into commercial real estate over the past five years, pushing up prices and driving down cap rates. The key measurement in the industry, the cap rate is the discount rate used to determine the present value of a stream of future earnings. Like bonds, the more you pay for the property, the lower your percentage return on the income it generates. With cap rates in prime real estate markets such as New York dipping below 5 percent this year, returns are starting to brush against the bond market, typically a signal that this market, too, is beginning to turn.
But the more likely scenario is that instead of outstripping their fundamental market values with their recent growth spurt, commercial real estate stocks, particularly REITs, are just now reaching their true potential. Investors ignored the market for too long and have been playing catch-up. Over the next five years, earnings will propel the market, generating continued steady, albeit probably slower growth, says Joe Betlej, vice president and manager of the real estate securities portfolio for Advantus Capital Management.
"What you have going forward is very strong earnings leverage," he says. "We're set up for an earnings growth cycle, with occupancy and rental rates climbing in just about every market."
It all comes down to supply and demand, says Tom Donahue, chief executive of International Capital Partners in Phoenix. ICP is a privately held real estate company that manages portfolios for institutions and high-net-worth investors. New construction in commercial real estate has ground to a halt in some of the most sought after regions in the country, stopped short by the sky-high prices on basic materials. Meanwhile, rental rates that have been basically flat for nearly two decades are starting to move back up.
"Seventeen years ago rents in Southern California were about $24 a square foot," Donahue says. "That's about where they still are today. But nationwide, and globally, office vacancies are plummeting. You will see rates go up and values continue to increase."
Fundamentals in the commercial real estate sector, across every property type and geographic area, are stronger than they have been in seven or eight years, Gilman says. The economy is solid, job growth is strong, and interest rates are still relatively low. Historically, this is the point in the cycle when new construction would be picking up to absorb the rising demand, but the high prices of commodities are keeping the speculative builders out of the market. U.S. developers can't compete with the demand from China and India for steel and cement, so they are sitting on the sidelines waiting for rents to climb high enough to cover the cost of construction.
"It's a good time to be a landlord," Gilman says.
Well, it is if you are already a landlord. Investors looking to move into the market now, or those who have taken some profits and need to re-deploy those assets, need to be a little more careful about their selection and a little more conservative with their expectations, says James Blair, a principal of the Moneta Group Investment Advisors, a St. Louis-based advisory firm that manages more than $4.5 billion in assets for high-net-worth clients. Based on recent performance, he's preaching caution to his clients.
"REITs may go higher, but our focus is on wealth preservation and managed growth, not timing the market," he says. "If you have a diversified portfolio, you have real estate in your portfolio. If you bought in a long time ago, you're enjoying it now. But I don't know if it's time to increase that allocation."
That's the question hounding high-net-worth investors and their advisors these days. No one is questioning the importance of a long-term allocation to real estate. As a diversification tool it offers critical ballast against the more traditional weightings of stocks and bonds inside diversified portfolios. The question now is where to find the best opportunities in an already highly appreciated market.
The cautious money is still concentrated in the public REIT market, specifically in a handful of REIT mutual funds such as Cohen & Steers, which manages more than $2 billion in its C&S Realty Shares fund (CSRSX). That's where Vincent Cannillo, principal and senior wealth manager at The Baron Financial Group in Fair Lawn, N.J., keeps most of his clients' real estate dollars.
"We are asset allocators, allocating 8 percent to REITs," he says. "And within the REITs, there is no residential property owned."
Cannillo is looking for diversification, both geographic and by property type. But mostly he is looking for active management. Cohen & Steers has consistently outperformed the NAREIT benchmark over the past 10 years by focusing on brand-name properties with predictable cash flow, such as Host Marriott, Boston Properties and Vornado Realty Trust, the biggest landlord in New York City.
Looking forward, that is exactly where investors want to be, says Betlej, of Advantus.
"We're in the part of the cycle where you want to emphasize companies that can provide rent growth--hotels, offices and apartments," he says. Especially in markets with clear constraints in new supply, such as coastal areas where it is very hard to find development sites, but people want to live there.
The downside is that this is where all the money is going. While the stocks in the public REITs continue to climb, their internal returns on investment have been eroding over the past five to 10 years because of too much money chasing good deals, Betlej says. As a result, investors need to start dialing down their expectations. Over the intermediate term, investors should look for returns in the high single digits, with about half of that coming from income. Still, that's more than most analysts are expecting to see from either the broader equity or the fixed-income markets.
"Add in diversification, and [real estate] is still a wonderful asset allocation tool," Betlej says.
Investors willing to take on a little more risk are still finding some impressive returns in the private markets, says ICP's Donahue. Of course, since private investments are--well--private, no hard data is available to compare performance numbers between the private and public sectors. The key to this market is in understanding the fees and knowing exactly what you're getting into, because in this case, past performance is the only measure for future returns.
ICP pools money into private placement funds that then purchase and manage three or four commercial properties. Investors receive a quarterly dividend from the rents, and once 100 percent of their original outlay is returned, the properties are sold and the profits are divvied up. That can take several years, though, depending on the strength of the market. In the meantime, that cash is tied up.
Most real estate investment managers look to return 6 percent to 8 percent a year in annual dividends to their investors, after taking their 1.5 percent to 1.75 percent management fee, Donahue says. Once the original capital is paid back, the properties are sold, with management taking another 20 percent to 40 percent off the top. The net yield to investors averages an annualized 12 percent to 15 percent, Donahue says.
"Is that sustainable? If you had asked me that question a year ago, I would have said 'no,'" he says. "But when you look at construction costs rising so quickly, rental rates are rising because the national vacancy rate is only 12 percent to 13 percent. So I think those yields are sustainable now."
Starwood is a private fund that invests in public REITs. With a $1 million minimum investment, it qualifies as a hedge fund for regulatory purposes because Gilman and his team may short stocks if they see an opportunity. His focus is on two of the most dearly priced markets in the country--New York City and Southern California--with a heavy emphasis on office buildings, buying stocks like SL Green Realty (SLG), Boston Property (BXP) and Vornado Realty Trust (VNO).
"Vacancies are 6 percent, and there is very little new construction space coming," he says. "Rents are going to have to move up 30 percent to 50 percent over the next four or five years to encourage new development, and then it will take a couple of years after that to get them built, so you have good visibility."
As with the equities market in general, though, investors looking for continued double-digit growth in real estate are going to have to look outside the United States, says Sam Lieber, co-CEO of Alpine Woods Investments and portfolio manager of Alpine US Real Estate Equity Fund (EUEYX) and Alpine International Real Estate (EGLRX). He points to the recent surge in international real estate fund offerings. (See "Passport to Profits," page 60.)
Kensington Funds and Goldman Sachs both launched new publicly traded international REIT funds in the first half of 2006, and another half-dozen private money managers are putting together international offerings, Lieber says. But the real signal that the international market is starting to grab U.S. attention is that pension funds and other institutional investors have suddenly come calling. "This recent interest reflects two things--the strength of international stocks in general, and the fact that international real estate stocks are outperforming the international index," he says.
Lieber expects the dollar to continue to ease against major currencies around the world, pulling more capital into countries with strong economies. As companies across the European continent streamline operations, looking to get real estate off their books, they create tremendous opportunities for new REIT initial public offerings. And in Asia, booming economies continue to drive demand for real estate.
With strong economics as the backdrop, Lieber projects annualized returns to stay in the low- to mid-teens for the foreseeable future. "If we do our work right, we'll do 20 percent total returns over the next few years," he says.
Rebecca McReynolds (rjmcr@att.net) is a freelance writer who has written for Wealth Manager on a wide range of topics.
