❖ Inflation, Deflation, Stagflation –
Implications for Real Estate Investing
The developed world’s central bankers clearly fear deflation, as evidenced
by their concerted effort to lift asset prices—and risk inflation—by pumping
over $5 trillion of liquidity into global markets since 2008. Record fiscal
deficits have fanned the inflation fears while global deleveraging and excess
capacity portend continued deflationary pressure. Although inflation and
deflation garner the most attention, stagflation should also be feared. For
commercial real estate investors, each of these three scenarios represents a
different threat. Two key questions need to be answered when developing a
portfolio strategy amidst this uncertainty. First, which commercial real estate
strategies are exposed to the potential outcomes and which might benefit?
Second, how might commercial real estate investors best prepare and use the
current environment to produce opportunistic returns?
Dan Heflin
Founder & Chief
Executive Officer
Inflation
Of the three environments contemplated, inflation is the devil most people
know best—their money buys fewer goods over time. Price levels can rise as
firms pass along the cost of a drop in productivity or rising factor inputs such
as commodities or labor (cost-push inflation). Alternatively, an increase in
aggregate demand brought on by rising wages or high economic output can
also lift prices (“demand-pull” inflation). An increase in the money supply in
excess of nominal output growth can feed both types of inflation. For example,
with every new round of Quantitative Easing, major commodities have rallied
in dollar terms; in fact, the various QEs’ inflating of dollar-priced commodities
is a textbook example of more money chasing the same amount of goods.
Looking forward, the interplay of wages and prices (the wage-price spiral)
implies that cost-push inflation can only occur with a tight labor market and
limited excess capacity. However, with unemployment at 8.1%, LFPRadjusted unemployment 1 at 12%, and final demand sluggish, wages are an
unlikely culprit to drive unexpected inflation 2. The more likely candidate is
the swollen money supply’s impact on nominal GDP and the prices of
commodities and assets.
For commercial real estate (“CRE”) investors, inflation erodes real returns
most at the top of the capital stack (fixed-rate first mortgages) and less at the
equity level. Historically, portfolios of institutional-quality core CRE equity
investments have held their own against moderate inflation. If equity is
levered with fixed-rate debt, higher unexpected inflation can lead to higher
real returns, provided the unexpected inflation doesn’t lead to credit issues at
1
LFPR=labor force participation rate. The average LFPR from 1990-2007 was 66.5%. In March 2012 it stood at 63.8%. If
the 66.5% average LFPR were applied to the current population and employment numbers in the BLS survey, unemployment
would be 12%.
2 Unexpected inflation is the amount by which realized inflation exceeded investors’ expectations as reflected in surveys
(e.g. Conference Board inflation expectations) or market technicals (e.g., the Treasury/TIPS breakeven rate).
Torchlight Investors LLC
Real Estate Investing – 2012
the lessee level (discussed further below). Middle
areas of the capital stack, those that offer high
absolute returns and equity participation (e.g.
mezzanine debt or preferred equity), can balance
inflation insurance while providing more downside
protection than equity.
Stagflation
Stagflation, the ugly sibling of inflation, is a rare
occurrence, in part because of the lessons learned
when it last occurred. From 1974 to 1975 the U.S.
suffered average inflation of 10%, average
unemployment of 7.1%, and a contraction in real
GDP, a seeming paradox. In retrospect, we learned
that for high inflation and economic stagnation to
coexist, a series of events must coincide. These
events include: a supply-side shock to major factor
inputs such as oil, wage-push inflation typically
brought on by labor having the upper hand over
owners, a fall in productivity, and a derailing of
inflation expectations. Looking ahead, supply-side
shock is a real risk, yet labor’s negotiating power
today pales in comparison to the 1970s when 2025% of workers were unionized compared to 11.8%
in 20123. Globalization of labor and the surge in
part-time domestic employment has also weakened
labor’s leverage4. In addition, the 1970’s stagflation
was a catalyst for change in monetary policy,
memorialized in the Humphrey-Hawkins Act of
1978 which set the Federal Reserve’s cross hairs on
stagflation by prescribing the dual mandate of price
stability and full employment 5. Finally, the Fed’s
conscious effort to increase communication has
helped tether the public’s inflation expectations.
Stagflation’s impact on the CRE investor is
similar to that of inflation with the added risk that
the accompanying economic contraction spells
more downside for equity, especially in cyclical
properties like hotels and retail. Studies have
shown that the inflation-hedging characteristics of
core CRE failed to perform in episodes of
unexpected inflation 6. In this environment, being up
the capital stack in mezzanine or b-notes would
protect against downside while offering key control
rights to navigate the property and protect the
investment.
Deflation
Deflation is far trickier than inflation or
stagflation. As one central banker put it, “we don’t
know how deflation works.”7 Broadly, deflation is
simply a reduction in the general level of prices, the
opposite of inflation. Part of the confusion arises
out of the difference between productivity-driven
deflation and debt deflation. Productivity growth or
new efficiencies can reduce production costs and
thus prices—be it labor-driven from globalization
of manufacturing, technology-driven (William
Dudley’s iPad 2 versus iPad 1 comparison), or an
innovative solution to an old problem such as shale
gas drilling. All of these have caused beneficial
price deflation. Debt deflation, on the other hand,
accompanies the fallout from over-investment in
levered assets. In these cases, a popping bubble is
not a deflation in the sense above, but rather an
unavoidable price correction based on fundamentals
and exacerbated by a lack of liquidity, increased
fear, and hoarding—the debt-deflation spiral Irving
Fisher elucidated in his seminal work8. As Fisher
reasoned, without liquidity and reflation of the
currency, falling prices of leveraged collateral leads
to fire-sales and a liquidity trap which slows the
economic engine and spills over into the general
price level, spiraling down, further slowing
economic growth and raising the real burden of
debt. Fear of this spiral explains the coordinated
liquidity programs central bankers have instituted
worldwide since 2008; it’s their attempt to convert a
blowout into a slow leak.
The Great Depression is often to blame for the
fear of deflation and since that time many experts
have linked deflation with depression. While that
was the case in the 1930s in the U.S., historically it
3 Union Members Summary, Bureau of Labor Statistics
4 In addition, people forced to work part time because they can’t find full-time work is now at 5% of the labor force, it was 3.8% in 1974, a sign of further slack in the labor force.
5 Prior to this the Fed’s primary mandate was on real output and unemployment.
6See for example, Hartzell & Webb, 1993. “Commercial Real Estate and Inflation During Periods of High and Low Vacancy Rates” Real Estate Research Institute; or Brueggeman
et al, 1984. “Real Estate Investment Funds: Performance and Portfolio Considerations” AREUEA Journal.
7 Adam Posen, Monetary Committee Member, Bank of England as quoted in the Wall Street Journal, July 26, 2010.
8Irving Fisher, The Debt-Deflation Theory of Great Depressions, Econometrica, 1933.
Inflation, Deflation, Stagflation – Implications For Real Estate
has been the exception, not the rule. In a study
spanning 17 countries and nearly 150 years, the
Minneapolis Fed determined that although 73
episodes of prolonged deflation have occurred
across the globe, just 8 were accompanied by
negative GDP growth 9. In fact, there were three
times as many periods of depression and inflation
than depression and deflation. The bottom line is
that in deleveraging cycles, CPI deflation may
occasionally arise as a symptom, but it is not a
cause (barring a bumbling monetary policy10).
Japan’s so-called lost decade gives a good
example of debt deflation deterred by innovative
policy response. Japan’s asset and property bubble
burst in the early 1990s and asset values tanked (the
Nikkei 225 fell 75% from 1989 to 2001), but CPI
deflation didn’t set in until 1998. From 1998 to
2010, Japanese CPI fell 3.3% cumulatively or just
0.3% annualized, hardly a losing proposition for
business or consumers; in fact over the same time
period, Japan experienced three full business cycles
and overall growth in real GDP11. So although
economic growth slowed, it wasn’t lost. What Japan
lost was inflated asset prices: in addition to the fall
in the Nikkei, property values fell between 60 to
80%. Japan’s monetary policy response laid the
groundwork for the Fed’s strategy today; the Fed is
simply doing it sooner and with more intensity.
Policy Response
The concerted effort of worldwide monetary
authorities to battle deflation has left the world
awash in liquidity. Yet uncertainty remains. The
sustainability of the U.S. recovery, austeritybacklash in Europe, questions about China’s growth,
civil unrest in the Middle East and nationalizations
in Latin America are just a few of the headline
topics driving volatility. Excessive liquidity and
uncertainty have pushed money into asset classes
perceived as the safest, perversely inflating values
across the spectrum, be it Treasuries and Bunds in
sovereign space, or trophy office properties in
commercial real estate. The Federal Reserve alone
has accounted for over $2 trillion in liquidity from
its two rounds of quantitative easing and its swap
lines with foreign central banks. This liquidity has
lifted the money supply (M2) as a percentage of
GDP to record levels (from 53% in 2008 to 63% in
2012). If commercial banks’ excess reserves parked
at the Fed are included, the value jumps to 74%12.
This ratio represents the simplest definition of the
cause of inflation: growth in money far outpacing
growth in goods. However, with weak aggregate
demand it’s reasonable to consider inflation a
medium-to-longer-term threat. And although a flood
of liquidity did cushion the blow from the U.S.
deleveraging cycle, the question of how we reverse
course remains.
In CRE, the deleveraging and re-pricing process
has been underway for years via a combination of
Since 2009, through the combination of QE1, QE2
re-financings or re-capitalizations for trophy
and Operation Twist, the Federal Reserve has altered
properties, and default followed by either
its balance sheet to such an extreme it resembles
modification/extension or write-off for the rest.
some of the institutions it has bailed out over the
While further price correction is possible, ironically decades. While monetary authorities write the rules
it may well occur in the re-inflated trophy
and aren’t required to mark-to-market, it is telling of
properties. Deflation in the general price level may
the risk transferred from private to public that a 100
be beneficial to lenders in real terms as they are
basis point rise in the yield curve would effectively
repaid in more valuable dollars than they lent; the
blow through the Fed’s equity, as shown in Exhibit 1,
impact on CRE borrowers is the opposite. However, on the following page. This is even more daunting
the severity of deflation could create credit issues
considering that half of their 8-year duration book is
depending on the mix and quality of tenants and
“funded” with overnight deposits in the form of
leases, as discussed later.
excess reserves.
9 Atkeson & Kehoe, 2004. “Deflation and Depression: Is There an Empirical Link?” Federal Reserve Bank of Minneapolis Research Department Staff
Report 331.
10 Much of the deflation of the Great Depression was the result of Fed policies. Milton Freidman and Anna Schwartz showed that a 33% contraction in the
money supply between 1929 and 1933 resulted in a 25% drop in prices.
11 Shirakawa, Masaaki (Governor of the Bank of Japan), 2010. “Uniqueness or Similarity? Japan’s Post-Bubble Experience in Monetary Policy Studies.”
12 Excess reserves, over $1.5 trillion in March 2012, are included in the monetary base but not broad money measures such as M2. However, as they are
demand deposits, they essentially represent shadow money supply.
Real Estate Investing – 2012
Exhibit 1
Federal Reserve Balance Sheet, 2008 and 2012
Consolidated
Leverage
Excess
Average Asset
Dollar Value
Assets
(Asset to
Reserves
Duration
of 100 bps as
($billions)
Equity)
($billions)
April 2008
896
22
2
4.6 years
70%
April 2012
2,870
53
1,510
8.0 years
371%
% of Equity
Source: Federal Reserve release H.4.1 (Factors Affecting Reserve Balance) April 12,2012 and April 10, 2008.
Asset duration estimated as median period of each asset maturity bucket listed.
What stands out about these numbers is the onus
they put on the eventual exit strategy. Should
inflation expectations change, or a supply-side shock
arrive, or a full-blown recovery take steam, the Fed’s
traditional inflation-fighting open market policy tools
will put them in the precarious position of an overinvested hedge fund whose cover is blown. They
have acquired two trillion dollars in Treasuries and
MBS since the crisis, and unwinding those positions
will certainly raise rates, but falling Treasury prices
and a rising risk-free rate may wreak havoc on
financial investments if the unwind is not handled
carefully and assuming no unintended consequences
rear their heads. And since excess reserves are
effectively demand deposits, in order to keep them
out of the money supply (where they would feed
inflation) the Fed may need to pay more in interest
than it receives on its asset book (which it would
likely do by printing more money). The unwind will
be the latest uncharted territory for the Fed and the
implications for inflation and interest rates should not
be ignored. For CRE equity investors, a surge in
capitalization rates could take years to recover from.
Implications for CRE Investors
The Fed’s battle against deflation and management
of inflation is particularly relevant for assets
associated with inflation hedging capabilities such as
CRE. A study of whether a portfolio of CRE
effectively hedges inflation is beyond the scope of
this paper, but the short answer is: it depends. What it
depends on are the variables that will determine how
a single property or property portfolio will perform
under any of the three scenarios considered here 13.
Returns from CRE broadly depend on two variables:
property performance and position in the capital
stack. On a more granular level, each of these
variables has several drivers and understanding and
optimizing them is the best way to prepare for
uncertainty and capture opportunistic returns.
Property performance in CRE begins with the
lease and the lessee. When someone declares that
CRE hedges inflation, in large part they’re saying
leases hedge inflation. That in turn will depend on
the terms of the lease—for example, its length, the
existence of CPI adjustments, a share of gross sales
in retail leases, and/or the ability to pass rising costs
through to the lessee via triple net rents. However in
a scenario of prolonged deflation, a bout of
stagflation or extreme inflation, what might matter
most is not which properties were most correlated
with CPI, but which properties and what positions in
the capital stack survived. For example, a tenant’s
ability to fulfill its corporate credit obligations,
including real estate lease payments, will depend on
the company’s sensitivity to the three scenarios
contemplated here. An office building whose largest
tenant is an oil company or a pharmaceutical
company will prove more resilient to stagflation or
inflation than an office building serving as the
13 It also depends on the choice of CRE return benchmark and whether or not such benchmark represents an actively traded portfolio or a primarily
appraisal-based index such as the NCREIF National Property Index.
Inflation, Deflation, Stagflation – Implications For Real Estate
headquarters for a major airline or a commodityreliant goods manufacturer. Likewise, in a
deflationary environment, retail lessees face
increasing real lease payments just as the prices of
their goods or services are declining—it’s easy to
see how this could devolve into a credit issue. Being
thoughtful about tenant mix and avoiding
concentration is mandatory for downside protection.
A more obvious factor in property returns is the
entry price. A low basis provides upside and
flexibility whereas a high basis limits returns and
provides little room for error (and for those
seeking an inflation hedge, overpaying for it
defeats the purpose). Certain CRE markets and
properties have fully reflated while others
occasionally offer rationalized pricing and a low
basis. In the last few years, fully-leased trophy
office properties in primary markets have priced at
cap rates as low as 4.0%. That doesn’t leave much
room for upside if inflation arrives or interest rates
spike since cap rates move swiftly while net
operating income catches up slowly. And although
such properties may take on the deflation-hedging
qualities of low-yielding Treasuries, if leverage is
applied at the property level, the investor is left
with an increasing debt burden in real terms and
potential credit issues depending on lessee types.
diversification is not as prudent as economic
diversification. A portfolio of hotels located in Las
Vegas, Orlando, and Atlantic City is an obvious
example of a well-diversified portfolio
geographically, but a poorly-diversified portfolio
economically. Far subtler examples exist, and
incorporating submarkets at the portfolio level can
help further diversify the credit and concentration
risks inherent in all the scenarios.
After identifying the ideal property, for CRE
investors in uncertain times, position in the capital
stack becomes the primary driver of risk-adjusted
returns. Debt is a natural hedge against deflation as
lenders are repaid with more valuable dollars than
they lent, resulting in higher real returns. For debt
to outperform against inflation or stagflation,
however, an asymmetric return profile must exist.
Returns must be high enough to exceed inflation,
while downside must be protected against credit
deterioration that stagflation or runaway inflation
can cause. Opportunistic debt investments can fill
this role, stepping into distressed situations that
offer rationalized market prices, flexibility in
creating investor protections, and attractive returns
for those who can price risk and evaluate collateral.
Alternatively, mezzanine loans and preferred equity
can perform a similar function, leaving the first
wave of unanticipated lessee, property, and market
Property performance also encompasses property risks to the equity holders while retaining equityspecifics and sub-market dynamics. This is an area
like features of high returns or upside participation.
where sharp risk-averse investors can find one-size- Within the securitized market, various CMBS
fits-all solutions to the three scenarios. For instance, structures can provide similar opportunistic or
regardless of the economic environment that
mezzanine-type characteristics, often with added
unfolds, investing in best-in-class property
value through optionality. For example, certain
characteristics such as location and access,
interest-only securities (“IOs”) have proven an
amenities, age, and barriers to competitive entry
effective hedge against deleveraging-induced
will serve as the best insulation at the asset-level
property value declines in the current environment.
because such properties tend to be price makers,
The practice of extend-and-pretend has often
even in secondary and tertiary markets. However,
substituted for outright sale or foreclosure in the
the sub-market itself is key because the interplay of CRE market since the crisis began; the ironic twist
the property and the sub-market will drive the
is that extending troubled loans also extends the
returns. Simply put, CRE won’t outperform (let
payments on IOs past the expected maturity date.
alone hedge inflation) in any of the scenarios if it’s This position in the CMBS capital stack, then, can
located in a market with excess supply of space or
outperform in drawn out deflationary environments.
above-average economic contraction. Furthermore,
on a portfolio level, submarkets also come into play Market uncertainty rooted in the nebulous nature
based on their similarities to each other; geographic of the U.S. recovery, a new election cycle in the
Real Estate Investing – 2012
Eurozone, and continuing financial pain and social
unrest arising from worldwide deleveraging have
forced central bankers to choose their poison and
fight deflation with inflation. Trouble is, they’re in
uncharted territory and exit from the historic
stimulus may leave the patient with a different
disease. Geopolitical risks in commodity-producing
countries and embargoes in the Middle East keep
the threat of stagflation alive and when combined
with the other uncertainties, give investors pause.
Volatility spikes have become all too common, and
have left many investors more focused on return of
capital than return on capital. The strategic theme is
clear for all CRE investors: low basis, protective
leases, resilient tenants, submarket surveillance and
economic diversification can protect the downside
and enhance returns. Opportunistic debt and
alternative CMBS exposures can further insulate
the downside while providing avenues to
unconventional returns.
Certain statements in this paper represent the
opinion of Torchlight Investors and may be subject
to change. The sources of facts and figures above
will be provided upon request.
Dan earned his M.S. from the London School of Economics, his B.A. from Texas Christian University, and
is a Certified Public Accountant in the State of New York.
❖ How Leverage Adds to the Risk of
Real Estate Investments
❖
“When you combine ignorance and leverage, you get some pretty interesting results.”
Robert J. Negrelli
Warren Buffett
Leverage is complicated. Although the overuse of leverage was definitely
an issue for many real estate investors, particularly value-add and
opportunistic funds, the absolute amount of leverage was only one of the
problems during the real estate recession. Numerous investors overlooked
complicated leverage structures in an effort to close transactions. Given the
high velocity of transactions prior to the downturn, many of the leverage
structure characteristics were not scrutinized by investors. These details,
incorporated within the loan covenants, included recourse, prepayment
penalties, cross-collateralization, and other terms that ultimately created
problems for investors. Many of these covenants increased the risk of leverage
by amplifying the loss for poorly performing transactions. Additional leverage
issues resulted from complicated senior/subordinate borrowing structures,
CMBS loans, and a lack of attention to the debt refinancing restrictions.
Ultimately, investors have realized that not all leverage is created equal. Two
similar properties with equal leverage levels may have significantly different
return outcomes depending on the loan structure and covenants. Managers that
were proactive with structuring their leverage and that focused on borrower
friendly covenants inherently reduced their leverage risk.
History: Investors Lose Focus on Leverage Details
The run-up in the commercial real estate market was fueled in large part by
historically low interest rates, which led to aggressive lending practices by
financial institutions. In absolute terms, the level of commercial and
multifamily mortgage debt outstanding more than tripled, from approximately
$1.0 trillion in 1995 to over $3.4 trillion in 2008. Commercial and multifamily
mortgage debt outstanding as a percentage of U.S. GDP correlates with the
boom-bust cycle of the real estate market. After reaching a trough in the
previous real estate cycle, the ratio increased from approximately 13% in 1996
to nearly 25% in 2008 (currently stands at 19% as of March 31, 2012) 1, Exhibit
1 on the following page.
1
Federal Reserve Flow of Funds as of March 31, 2012.
Consultant
Courtland Partners, Ltd.
Real Estate Investing – 2012
U.S. Total Debt/GDP
Exhibit 1
Ratio of Commercial & Mutifamily Debt to U.S. GDP
Commercial real estate transaction volume
exploded in 2005, 2006, and 2007. As indicated in
Exhibit 2 and 3 on the following page, in 2007
there was $494 billion of real estate transaction
volume in the U.S. 2 A significant portion of the
capital flowing into real estate was driven by the
availability of commercial mortgage-backed
security (“CMBS”) financing. Domestic CMBS
issuance for 2006 totaled $203 billion, and the
market peaked in 2007 with $230 billion of
issuance. Demand for the high loan-to-value
financing, combined with the low cost of CMBS
debt, fueled the continued expansion of leverage.
The market was flooded with capital as
inexperienced investors entered and risk premiums
diminished. Investors acquired long-term real
estate positions with a short-term trading mindset.
Equity returns were engineered through slicing the
capital structure into multiple layers of leverage.
Finally, underwriting standards deteriorated, both
2
Real Capital Analytics, CMSA, Commercial Mortgage Alert.
at the property level and on the loan structures. As we now know, the aforementioned
conditions resulted in an inevitable correction in
the market. Spurred by the subprime crisis and
accelerated by the corporate credit market, the
credit crunch spread throughout the capital
markets.The result of the aggressive borrower
practices became evident over the subsequent
years, and many investors came to regret their
structuring decisions that had increased the risk of
their leverage.
Restructuring: Fallout from Aggressive Leverage
Since 2008, the results of poor leverage
structuring have become apparent. The leverage
structures, which were glossed over by investors
during the height of the market, became key
concerns during the downturn and subsequent
leverage restructuring process. Investors that
How Leverage Adds to the Risk of Real Estate Investments
Exhibit 2 Exhibit 3
Annual U.S. CMBS Issuance ($bn)
structured leverage inappropriately have taken
larger losses and are having a more difficult time
recovering capital from investments. Listed below
are some of the common leverage structure
mistakes that increased investor risk and,
ultimately, losses during the downturn.
Capital Stack/Mezzanine Debt: Numerous
investors utilized complicated senior/subordinate
debt structures to maximize leverage proceeds. In
many cases, these investors would layer multiple
levels of mezzanine loans on top of the first
mortgage. The multiple lender structure created
difficulty when attempting a workout because of
the number of parties involved. Also, many
investors discovered that the mezzanine position
immediately senior to the equity was often sold by
the original holder to a hostile group. Negotiations
with this new mezzanine owner proved to be
difficult as the new owner would have a lower
basis and attempt to foreclose on the asset.
Recourse/Cross-Collateralization: Many
investors structured debt with recourse by
guaranteeing the repayment of the debt through
the fund, portfolio, or other collateral. After the
downturn in the real estate market, these investors
U.S. Commercial Real Estate Transaction Volumes
had difficulty negotiating with the lender because
the lender had more security that the investor
would repay the loan. In addition, investors often
chose to put more money into a property to
restructure the debt, rather than making an
optimal decision to walk away from the loan,
because the recourse or guarantees eliminated
that option. Also, in extreme cases, the investor
was forced to liquidate an entire portfolio of
properties or call additional capital from limited
partners to meet recourse obligations.
CMBS: As indicated above, CMBS loans were a
popular form of debt during the height of the
market. Unlike traditional loans, CMBS loans are
held together in a trust and managed by a loan
servicer. CMBS loans are often carved into
multiple tranches based on loan-to-value.
Consequently workouts are difficult because of
the number of parties involved with potentially
conflicting incentives. Also, primary CMBS
servicers are very limited in their ability to
modify loans. As a result, investors can have
difficulty negotiating forgiveness of loan
principal, a reduction of an interest rate, or a
maturity extension prior to a default.
Real Estate Investing – 2012
Maturity Defaults: During the height of the
market, investors had a short-term trading
mentality for real estate investments. These
investors did not consider the need for long-term
debt financing on their properties, and, as a result,
many of the loans were short-term and without
extension options. When these loans matured,
investors had difficulty meeting the loan-to-value
requirements based on new appraisals.Additionally,
lenders were requiring lower loan-to-value ratios
on new loans. Consequently, although investors
could continue to make the payments on the loan,
many had issues with maturity defaults because of
an inability to refinance or extend the loan.
Result: Reduced Investor Appetite for Leverage
The leverage mistakes have reduced the
investor appetite for debt in their institutional
portfolios. Notably, in an environment of
particularly low cost debt, investors are favoring
real estate investments with low leverage. This
trend is most evident in the open-end fund
universe. As of June 30, 2012, the open-end fund
with the lowest leverage had the largest investor
entry queue on an absolute basis and as a
percentage of net asset value (indicated in the
chart below, Exhibit 4). Perhaps not
coincidentally, the only two funds with
redemption queues are at the higher end of the
leverage spectrum. Even if the highest entry
queue fund is removed from the graph, the linear
trend is still downward. Although more difficult to quantify, the lower
leverage trend is also anecdotally evident in new
strategy targets for value-add and opportunistic
investments. For value-add funds, which
typically had leverage targets of 60% to 70% in
2006 and 2007, the new fund guidelines are often
in the 50% to 60% range. Similarly, opportunistic
funds, which previously had leverage targets
Exhibit 4
Investor Queues and Leverage (Q2 2012)
How Leverage Adds to the Risk of Real Estate Investments
exceeding 70%, have now reduced targets to 65%
and 70% maximums. While the absolute amount
of targeted leverage is being revised, investors
have yet to devote significant attention to the
specific leverage structures (i.e., recourse, crosscollateralization, mezzanine debt, etc.) and the
subsequent impact on investment risk.
Conclusion
Investors often contribute poor investment
performance to high levels of leverage; however,
poor loan structuring can also significantly
increase the risk of loss. It is important that
investors not make wholesale abolitions against
leverage, but rather understand the structuring
differences. When utilizing leverage, there are
structuring pitfalls that should be avoided. A
ten-year amortizing mortgage is very different
from a CMBS loan or a floating rate loan with
mezzanine debt. Appropriate structuring to
reduce complexity should reduce the risk of
leverage in value-add and opportunistic
investments.
Robert has his Bachelor of Science in Finance from Miami University.
❖ Real Estate Income Strategies
❖
The income generating potential of real estate is one of the primary reasons
pension funds invest in the asset class. Simply put, income pays benefits. This
paper surveys the landscape of real estate investment products that are billed as
“income” strategies and are designed to give an investor a purer income play
compared to mainstream core real estate private equity (e.g., core open end funds)
or long only publicly traded REITs. These products include income oriented REIT
portfolios, farmland, net lease strategies, and assorted debt related products.
Income Oriented REIT Strategies
Income oriented REIT strategies include high dividend common shares,
preferred shares, common shares and debt securities issued by REITs and real
estate operating companies. The investment premise of these strategies is
increased income and decreased volatility relative to long only REIT portfolios.
The volatility claim holds for the universe tracked by Callan; however, investors
are cautioned that the data is thin and many of the track records are short. In
addition, when the data is disaggregated, Callan is struck by how closely some
track typical REIT strategies, suggesting limited portfolio benefit when added to a
portfolio. In other words, the Risk/Return Chart at the end of this paper puts
REITs in a more favorable light than is warranted. With regard to the income
claim, some income REIT managers are shifting the focus of their income
products to a total return focus due to low prevailing yields.
Managers offer these strategies in a funds and separate accounts. A significant
segment of the universe was formed after 2005 and track records are relatively
short. The funds are generally small ranging from a few million to several billion;
however, they can be capacity constrained as they grow, particularly if they are
targeting REIT preferred securities (according to Security Capital, as of March 31,
2012, preferred equity issued by U.S. REITs was estimated at $22 billion).
Additional drawbacks include relatively high volatility and high correlations with
equities and long only REIT portfolios.
Farmland
Farmland has historically offered competitive returns anchored by a solid
income component with similar total return volatility compared to private real
estate. (Exhibit 1, following page) The opportunity set for farmland is seemingly
huge at $1 trillion; however, institutional ownership has been stuck at around 1%
since the mid-2000s. Barriers to investing include a small universe of qualified
managers and a long time frame to implement. Strategies are available in separate
Sally Haskins
Senior Vice President,
Real Assets Consulting
Callan Associates Inc.
Real Estate Investing– 2012
Exhibit 1
NCREIF Farmland Index Annualized Returns as of March 31, 2012
Asset Type
Income Total Total
Last 10
Appreciation Last
Income
Appreciation
Last
Years
Last 10 Years
10 Years
Last 15 Years Last 15 Years 15 Years
Farmland Total
7.9%
7.3%
15.5%
7.1%
5.0%
12.3%
Row Crops
4.6%
9.0%
13.8%
4.8%
6.7%
11.8%
Permanent Crops11.6%5.1%16.9%9.8% 2.6%12.4%
Private Real Estate ODCE
6.3%
0.2%
6.4%
7.1%
1.2%
8.4%
Private RE NCREIF
6.6%
1.6%
8.2%
7.3%
2.1%
9.4%
Source: NCREIF Farmland Index and NCREIF ODCE
accounts and funds. Separate accounts are viable at
$100 million compared to $500 million for core real
estate. There are no funds specifically targeting
higher income; most funds offer a diversified
approach. Investors wishing to implement an
“income agriculture” strategy would need to do so
through a separate account where the manager
might purchase properties only with certain types of
leases such as cash or cash/flex leases or invest in
permanent crops which have offered higher income
compared to row crops but also have higher
volatility.
Debt Strategies
Investment opportunities in the commercial real
estate debt space span the risk / return spectrum and
feature various levels of income and security of
income. Some qualifying characteristics that define
the risk/return profile include type of loan and
last-dollar investment exposure, quality of the
collateral, quality of the borrower and investment
approach. Income oriented debt strategies are those
that include origination and/or acquisition of
performing debt investments which are meant to be
held to maturity.
A common problem in the debt space is to
oversimplify the investment approach and apply
broad categories to disparate investment types and
investment approaches. Senior, secured commercial
mortgages imply greater security of income and
repayment of principal; however, higher loan-tovalue ratios, lower debt service coverage ratios,
transitional collateral and non-current payment
components may increase investment risk. Debt
financing for transitional assets, as well as
mezzanine debt investments, typically have
increased last dollar investment exposure and an
income component that is less secure. These
investments have a higher coupon payment, but
focus should be placed on the component of return
that is generated from current pay because
components of the total return may include deferred
returns such as equity participation and accrued
interest.
While real estate is the collateral for all of these
strategies; their investment characteristics fall
between bonds and real estate equity. Whole loan
strategies offer markedly lower volatility compared
to private real estate and a strong income return
(particularly in down markets) but they are highly
positively correlated to fixed income and are often
included in fixed income portfolios. Mezzanine,
participating loans, and hybrids are closer on the
spectrum to real estate equity than whole loans, the
degree to which depends on the loan structure.
(Exhibits 2 and 3, following page).
Real Estate Income Strategies
Exhibit 2
Returnes
Whole Loan Index Returns
1, 3, 5, 10 and 15 Year Period Ending March 31, 2012
The investment opportunity set for loan
strategies is immense considering debt maturities
and withdrawal of traditional debt providers. There
are a myriad of debt funds with varying strategies
and track records. It is interesting to note that there
are now whole loan strategies being offered in open
end fund formats with return targets of 7% net,
mostly from income. These funds are similar to the
dedicated real estate mortgage loan programs which
have been used in large pension plans since the
1980s, most often for the steady cash flow. Whole
loan funds can be used by large and small investors.
Large investors who have a co-lending program that
has been limited in its ability to underwrite loans
due to the co-lenders capacity could use a fund to
augment exposure to whole loans.
Exhibit 3
Returnes
Rolling Income Return – Whole Loans
Rolling 12 Quarter Return For 15 Years Ended March 31, 2012
20112012
Source: LifeComps and PREI
Real Estate Investing– 2012
Net Lease
Net lease or sale leaseback strategies invest in a
portfolio of properties with each property leased to a
single tenant. Lease structures are triple net whereby
the tenant pays rent plus insurance, maintenance and
taxes. Leases are typically 10 to 25+ year terms with
fixed or CPI linked adjustments. The tenants may be
government entities, publicly traded companies (both
investment grade credits and non-investment grade
credits), or privately held companies. Some strategies
target government entities exclusively and some
strategies feature a mix of credit and tenant types.
The income yield is based on tenant credit and
typically offers a spread over a tenant’s corporate
bond rate given the real estate and liquidity risk.
Property types are retail, office, and industrial which
are highly customized to each tenant’s needs. They
may be new construction build-to-suits or existing
properties. The specialty nature of the property is the
biggest drawback and can result in hefty re-fitting
costs should the tenant break the lease or fail to
renew; building a portfolio with staggered lease
maturities can mitigate some of this risk. Triple net
leases provide a partial hedge against inflation
through the lease, structure, asset appreciation and
the ability of the owner to pass operating expenses to
the tenant. The long lease structure can dampen the
impact of cyclical real estate markets. Callan does
not maintain a net lease database group for strategies
offered through separate accounts and funds. To
examine the current income potential, we have
examined the initial cap rate for 13 transactions
completed in 2011. The average cap rate of these
transactions was 8.3% with a low of 6.3% and high of
9.4%. The average dividend yield for the five triple
net lease REITs in the NAREIT Index Free Standing
category stands at 4.3% compared to approximately
3.4% for U.S. REITs.
In terms of the investment opportunity set, RCA
reports single tenant transaction volumes of
approximately $17 billion in 2008, $10 billion in
2009, $20 billion in 2010, and almost $25 billion in
2011 across the industrial, office, and retail sectors.
The triple net lease REITs in the free standing
category have a market cap of $11 billion. Callan
clients have invested in the sector via separate
accounts and funds.
Putting It All Together
Correlations and return statistics are shown Exhibit 4
below and Exhibits 5 and 6 on the following page for the
income strategies except for net lease.
Exhibit 4
Correlations 15 Years Ended March 31, 2012
Asset Type
Private
Real
Estate
Domestic REITS
Income
REITs
Farmland
Whole
Loans
Equities
Bonds
Private Real Estate
1.00
Domestic REITS
0.20
Income REITS
0.140.951.00
Farmland
0.11(0.01)(0.04)1.00
Whole Loans
0.110.260.26(0.23)
1.00
Equities
0.180.610.650.12
(0.07)1.00
Bonds
(0.08)(0.06)(0.07)(0.14)0.75 (0.38) 1.00
1.00
Notes: Private Real Estate is represented by NCREIF ODCE, Domestic REITS by NAREIT Equity Index, Income REITS by Callan’s Index of
Income REITs, Farmland by NCREIF Farmland Index, Whole Loans by Life Comps Index, Equities by S&P 500, and Bonds by Barclays Capital
Aggregate Bond Index.
Source: NCREIF, NAREIT, Callan, LifeComps, PREI, and Barclays Capital
Real Estate Income Strategies
Exhibit 5
Returns, Standard Deviation, and Sharpe Ratio 15 Years Ended March 31, 2012
Total
Standard Sharpe Asset Type
Returns
Deviation
Ratio
Private Real Estate
8.4%
7.5
0.73 Domestic REITS
9.6%
23.0
0.29
Income REITS
11.2%
20.9
0.40
Farmland
12.3%
7.4
1.26
Whole Loans
7.8%
3.9
1.26
Equities 6.1%
18.9
0.17
Bonds
6.4%
3.5
0.98
Source: NCREIF, NAREIT, Callan, S&P, LifeComps, PREI, and Barclays Capital
Exhibit 6
Returnes
Risk Return Chart 15 Years Ended March, 2012
Source: NCREIF, NAREIT, Callan, S&P, LifeComps, PREI, and Barclays Capital
Real Estate Investing– 2012
Observations
Incorporating income strategies into a portfolio
should consider the investor’s primary reason for
being in real estate, the return target, and liquidity
needs. The diversification power of investing in real
estate will be reduced by incorporating more bond
like investments. In other words, there is no free
lunch over the longer term. Secure income (and
lower risk) comes at a price and that price is less
diversification and/or upside return potential. For
example, whole loan strategies offer income but they
are highly correlated to bonds (0.75 correlation) and
the return is the coupon. The outlier to the “no free
lunch in the long term” is farmland. Farmland offers
a very attractive combination of income and
diversification but it’s hard to gain critical mass and
requires a long time horizon to implement.
Investors should consider that the returns offered
by the income strategies may not meet the actuarial
nor the real estate required return which may impact
which strategies are appropriate and how much to
invest. Plans that need more current income or are
implementing an LDI strategy may be strong
investor candidates for income oriented strategies.
The biggest opportunities today, in terms of
quantity of transactions and risk/return, are found in
mortgage strategies followed by net lease. In the
shorter term, it may be appropriate to incorporate
these strategies if the expected return is more than
the risk profile suggests, due to market dislocations.
REIT income strategies suffer from the same
issues as long only REITS, including volatility, high
correlations to equities and to mainstream REITs. In
addition, their dividend profile is not as strong as the
income offered in private strategies.
As with any investment, investors reviewing
individual strategies would benefit by quantitative
analysis to insure the investment thesis is sound.
The historical results may not support the claims
and/or the investment strategy promised may have
more risk than is apparent.
Sally has her B.A., Magna Cum Laude and Phi Beta Kappa, St. Olaf College, 1986 and her M.S., Real Estate
Appraisal and Investment, University of Wisconsin, Madison, 1989.
❖ Global vs. Domestic REITS
❖
Introduction
The trend toward global REIT investing over the last decade seemed
natural enough in the face of spreading REIT enabling legislation and,
therefore, increased opportunities for U.S. institutions to deploy capital. The
arguments also seemed uncontroversial – increased diversification, access to
different economic drivers and a growing pool of potential opportunities. As
we can see from Exhibit 1, the capital flowed in a significant way during the
peak years, in part perhaps because U.S. core pricing looked rich and an
alternative looked attractive. Many investment managers were encouraging
investors to consider global REIT programs, and on the private investing
side, a move to global investing had already occurred for more opportunistic
style investing with good success.
Christopher Lennon,
CFA
Director of Analytics
The results so far have been less than encouraging for many overseas
Exhibit 1
The Townsend Group
Source: Lipper US Fund Flows and BofA Merrill Lynch Global Research
Real Estate Investing – 2012
REIT programs. Exhibit 2, shows the performance
of regional REIT indices going back over 20 years
– as long as the existing regional indices will
permit. We note that the ‘modern era’ of the global
REIT is far shorter, perhaps measured up to a
decade, or perhaps slightly less. When we
consider shorter time periods for the analysis, we
arrive at the same result – that the U.S. REIT
market has far outpaced it overseas counterparts.
This is not a surprising result given that, in the
aftermath of the Global Financial Crisis there has
been a flight to quality assets which has benefitted
the U.S. Add to that fact that Europe has been in
the eye of the most recent economic storm, and
the fact that U.S. performance has been the recent
winner isn’t very surprising. One hypothesis may
be that any point-in-time performance analysis is
highly dependent upon the time at which the
analysis is struck, and that multiple market cycles
are needed in order to come to any real
conclusion about what the historical data is
indicating. This wouldn’t be an unreasonable
position to take with the limited amount of data
available today relative to a typical real estate
investing cycle.
However, investing professionals are rarely
content to wait a full market cycle (let alone
several) before attempting to read the tea leaves
of the performance story. While many Investment
Managers were making the ‘bullish case’ for
overseas REIT programs which promised to
Exhibit 2
Global Public Market with EPRA NAREIT Series (USD)
Global vs. Domestic REITS
deliver them higher fees, there were few who were
naturals to make the ‘bearish case’ which would
be for the U.S. investor to favor the home markets.
Since the performance has turned sour for the
Ex-U.S. Investments, there have been a few
research houses that have come out with their own
version of the case against going global for public
market programs that offer some substantive
points about the structural differences between the
U.S. REIT market and its overseas analogs. In our
own discussions with public market investment
managers with global programs, many managers
themselves concede there are a number of
important differentiators which favor the more
mature U.S. REIT market, and offer the hope that
some of the key differences will dissipate over
time. It could well be that some portion of the U.S.
outperformance is due to the global flight to
quality while the balance is caused by other more
permanent factors.
costs (such as Prologis driving down the cost for
industrial roofs through bulk buying). On the
other hand, Pan European REITS often operate
across multiple property sectors, which spreads
the focus of their efforts. In addition to being
intuitively appealing, we have also seen
additional evidence of this effect in research
which we have done for private investing in
opportunistic closed ended vehicles globally.
Specifically, we found that investment specialists
with a narrow focus for their investment mandate
outperformed the global allocators.
The next most significant issue is that
corporate governance, broadly speaking, is better
in the more mature U.S. market than it is on
average across the globe. This involves situations
ranging from self-dealing from closely held
names (mostly in Asia) in which the advocates for
the minority shareholder rights are not as
numerous or as vocal as they are in the U.S. In
The Case for a US Home Market Bias
addition, not every country has bankruptcy
systems as strong as in the U.S. which lead to
In making the case the U.S. investors should
particularly dilutive recapitalizations during the
favor a home market bias in the construction of
GFC which occurred most notably in the U.K. and
their public market real estate portfolios we
Australia. Finally, the internally-managed REIT
categorize the reasons into two categories: (i) high structure which serves to align interest so well
level conceptual difference in the REITS
between management and owners is not
themselves, which will be evident from reviewing universally embraced in each country. Japan, in
the market indices and (ii) challenges at the
particular, still uses an externally managed REIT
portfolio implementation level which have real
model which separates the management company
world implications, but not be reflected in the
from the real estate holdings. Though this may
existing indices.
change in the future, it is still an issue today.
Structural Differences
Finally, the overseas REITS embrace a higher
risk investment model including higher leverage,
The most significant challenge leveled against
more development, and a propensity to look
the overseas REITS is that the individual
beyond their national borders when they feel that
constituents are considered generalists while their
opportunities look better elsewhere. In a recent
U.S. counterparts tend to specialize within one
missive, Green Street Advisors reminded
property type in which they can build an expertise,
investors of the admonishments of famed real
which provides them with a competitive
estate investor Sam Zell that investors should
advantage. These advantages often manifest
focus on income producing investment and use
themselves on the revenue side through better
leverage only sparingly. In that piece, GSA notes
leasing opportunities through strategic
that half of the REITS in its universe failed to
relationships (such as Simon Properties bundling
generate share level income growth in excess of
locations for large national chains) to reduced
Real Estate Investing – 2012
their unleveraged real estate holdings. They
believe that overly aggressive balance sheet
activity including property debt and development
mainly served to detract value and add to
volatility. We include a graph on page 5, Exhibit 4,
which shows the leverage levels over time for a
series of real estate indices.
Implementation Challenges
All of the items listed so far could reasonably
be expected to impact the share price of the
constituents of the various global indices and,
therefore, be reflected in the index differentials
which we have cited in the earlier graphs. There
are a number of additional real world
implementation challenges which effectively
occur ‘below the line’ when an individual investor
would seek to implement an investment strategy
– perhaps in a separate account. We approximate
these impacts in the following table:
■ U.S. tax exempt investors will be penalized by foreign withholding and stamp tax –
some of which is recaptured through treaties,
but not all (~15 bps)
■ Manager fees are frequently higher
(~15 bps)
■ Trading costs are higher overseas, though
trending down (~10 bps)
■ Custodial costs are higher overseas, and not
always reflected in the numbers (~5 bps)
■
There is likely a higher internal administrative
burden for US based investors in terms of
back office complexity of overseas
REITS (~ ???)
A Lesson Learned and Opportunity for New US Index?
The existing REIT indices are all ‘supply’
based meaning that they capture all of the
available issues meeting a set of criteria (such as
legal structure etc). In addition, many of them
have adopted a number of similar features such
that the performance going forward will likely be
very similar among them. Our belief is that there
might be a use for a ‘demand’ based index which
seeks to replicate a risk return profile which
investors seek to achieve for their portfolio. This
Exhibit 3
Global vs. Domestic REITS
new index would be part of an industry wide trend
toward ‘smart beta’ in which specific investment
styles are targeted instead of broadly defined
categories.
In order to more appropriately define the
opportunity set, we reviewed the institutional
portfolios in the marketplace and undertook a
consultation in order to determine the
characteristics that investors expected from the
real estate portion of their portfolios. Generally,
we found that institutional investors prefer real
estate companies which have longer term focus
and can demonstrate durable income streams as
core investments. Therefore, the Core REIT
Index is designed to (i) limit the property types
of the constituent companies to those that are
focused on longer term rent generation and
remove shorter lease term focused REITS such
as hotels (ii) screen out the REITS with lesser
quality portfolios and/or balance sheets that do
not match the holding criteria which is typical of
an institutional investor and (iii) screen out
REITs which maintain a strong focus on
development in lieu of managing a portfolio of
income producing assets. Exhibit 3 previous
page.
After employing the selection screens, we
were left with a universe of 25 to 30 REITs over
the prior 10 year period. We would expect that the
number of constituents in the index to remain at
approximately that level over time. In addition,
the constituents of the index were generally the
larger, more liquid names. The weighted average
market capitalization for the existing US REIT
Exhibit 4
Real Estate Investing – 2012
Exhibit 5
CORE REIT U.S. Less DJ U.S. Select Index
indices ranges from $4.7 to $7.8 billion while the
Townsend Institutional Core U.S. REIT Index
average is $10.7 billion. In addition, the qualities
of the Core REIT Index are more closely aligned
with those of the private market as it relates to
portfolio leverage as shown in Exhibit 4, below,
and property types.
Though the index was not designed with the
intention of providing outperformance relative to
any of the existing indices, our back-testing of the
criteria does show performance over time which is
higher than the original index from which the
constituents were selected. Exhibit 5 above.
CONCLUSION
success of overseas REITS. What we have seen
recently may be purely a function of the flight
to quality to the U.S. produced from the GFC or
it may be the result of structural deficiencies of
the less mature overseas REIT market which
may or may not resolve themselves over time.
In addition, the higher costs for implementation
will likely persist for many years, but likely
lower in magnitude slowly over time. We
believe that some if the items that have made
the U.S. market behave differently over time
can inform the creation of a new index which is
designed to address the characteristics that some
investors desire from the core portion of their
real estate program.
The final chapters have yet to be written on the
Christopher has his B.S. in Finance from Wharton School, University of Pennsylvania with Magna Cum
Laude distinction. He also, has his BS in Mechanical Engineering, School of Engineering and Applied
Science of the University of Pennsylvania also with Magna Cum Laude distinction. Christopher
❖ Stalemate or Crisis? Examining the
European Real Estate Deleveraging Debate
❖
The European sovereign debt crisis continues to dominate the outlook for the
global economy and financial indicators reflect a world still coping with systemic
risks, volatility and political instability. European banks continue to hold vast
amounts of loans originated at the top of the cycle, in many cases at marks above
what the market would pay for them, and deleveraging of the European sector is
taking longer than expected. All of this is having a major impact on the real estate
industry in Europe, presenting opportunities as well as challenges. LaSalle
Investment Management has witnessed structural (and arguably long term) shifts
in the make-up and depth of European commercial real estate (“CRE”) debt
capital markets. As these structural changes continue to take shape, the scale of
the European debt crisis remains enormous. The questions remain how large is
the magnitude of the problem, how long will the deleveraging process take to
reach a sustainable level of bank CRE exposure, and which market participants
are available to fund the sizeable gap left open by a retreating banking industry.
Michael Zerda
Director
Evolution of European Debt Capital Markets
In the decade prior to the near financial collapse of 2008, the European real
estate market experienced strong growth in capital market activities which led to
an active commercial mortgage backed securities market, expanded lending from
foreign banks and domestic non-banks, and significant balance sheet expansion
for real estate lending from the major domestic banks. The boom created massive
debt bubbles across Europe. (Exhibits 1 and 2 on the following page) The U.K.
saw its commercial real estate debt mortgage market rise five-fold in less than a
decade to £250bn ($400bn) billion in 2008. Spain’s CRE mortgage market
increased ten-fold to €100bn ($124bn) during a similar time period (or
€320bn/$400bn if you are to include construction debt related to residential
development and land loans). Unlike in the U.S. where alternative sources
accounted for 50% of CRE lending, European lending was almost entirely
concentrated around banks (making up 90%+ of all CRE lending in Europe).
This meant two things: that majority of stock purchases in the lead up to the
financial crisis were driven by an enormous supply of cheap financing and that
Europe’s risk concentration was firmly in hands the banking sector.
Following Lehman’s collapse, there were three distinct phases of debt market evolution:
Phase 1: Panic (September 2008 – December 2009) the events of 2008 led to a
deer-caught-in-the-headlights panic in the banking market. The European
banking sector held its collective breath and quietly took time to assess balance
sheets, hire in-house work-out teams, prepare restructuring or sale plans, and
LaSalle Investment
Management
Real Estate Investing – 2012
Exhibit 1
Growth of U.K. CRE Debt Balance
UK CRE Debt Outstanding*
Exhibit 2
Growth in Spanish Residential Development & Construction
Funding Outstripped Other Business Lending Over the Last Decade
Source: De Mount fort University
hope for the best. There were a number of loan sales
reported during this period but not to the extent that
many predicted. The banks that could take pain, did
(notably U.S. investment banks whose substantial
post bailout 2009 earnings helped insulate huge
markdowns on loan books sold during the period)
while European commercial banks with massive
over-exposure to European real estate adopted an
“extend and pretend” strategy to their loan books that
for the most part allowed these banks to avoid
realisation of embedded losses.
Phase 2: Denial (January 2010 – July 2011) By late
2010, the market seemed to hold a sanguine view on a
sustainable market recovery. Fuelled by a comforting
sense that the European banking industry would be
able to address its issues without outside assistance,
banks and buyers alike participated in a fragile loan
market recovery. There were comforting moments
that Europe was on track for a sustainable recovery.
Europe’s first post-crisis CMBS was issued.
Provisions on legacy loans were generally accepted
and the bulk of peak loans originated in 2007 still had
a few years to go before their ultimate maturity. Real
estate investors in turn began to invest more regularly
as price volatility gave way to market price recovery
in core sectors of many markets. The general
perception was that Europe could soon be out of the
woods and a re-opened credit market would provide
much needed liquidity to the property markets. This
Source: Bank of Italy, Morgan Stanley Research
perception faded quickly as the summer of 2011
turned into fall.
Phase 3: Acceptance (August 2011 – Today) August
2011 brought with it volatility and shocks to the credit
capital markets. Senior unsecured yields across the
banking sector skyrocketed as it became clear that
outside assistance would indeed be required to
preserve sectors of the European banking systems.
Many European economies were now almost destined
to double-dip and central banks continued to cut rates
to curb deflation. Banks soon found that the
combination of stricter regulations, higher internal
cost of capital needs, and continued market value
deterioration on their non-core portfolios was too
much to bear and many began to scale back loan
extensions, pull back from new business lending, or
shut down operations in their entirety. The banks that
remained in the market faced a new lending practice
that combined two clear elements: significantly more
conservative lending levels and inflated margin levels
(that by mid-2012 had achieved near historic highs in
the U.K.). See Exhibit 3 on the following page.
Over the course of the last year European banking
sector CDS remain at or near record highs, bank
liquidity is severely damped, and sentiment across
European markets has been one of accepting that the
debt capital markets in Europe have undergone a
fundamental structural change. Many in the market
Stalemate or Crisis? Examining the European Real Estate Deleveraging Debate
Exhibit 3
New Senior Debt Financing Core Office Properties in the U.K.: Higher Costs For Lower Risk
expect LTVs to remain low and margins to continue
to increase, especially for secondary properties.
The Current State of the Debt Market: A Sizeable Funding
Gap Exacerbated by Regulations
At a time when demand for liquidity is at a
generational high, new regulations are being
implemented that could potentially require banks to
further re-assess internal risk models (many already
have, pre-emptively). The resulting margin
premiums have created an increase of interest from
oversees lenders, debt funds, pension funds, and
insurance companies looking to capitalise on the
opportunity. The main regulatory movements that,
along with balance sheet legacy loan issues, are
creating a sizeable funding gap in Europe are
summarized below:
Basel Committee on Banking Supervision – “Basel
III”: Impacting the Banks
Basel III is a global regulatory standard on bank
capital adequacy, stress testing and market liquidity
risk which was agreed in 2010 by the members of the
Basel Committee on Banking Supervision.
Under the proposed Basel III regulations,
regulators of member countries have imposed a
framework for the banking sector that requires lenders
around the world to hold a “tier-one” capital ratio of at
least 9% of their risk weighted assets. The medium
term impact of Basel III is broadly expected to be that
bank lending spreads will increase as banks pass the
rise in bank funding costs (due to higher capital
requirements), to their customers.
Basel III is expected to have negative
consequences for the property finance market as
property lending accounts for a significant portion of
the risk-weighted assets of many banks, thus requiring
those banks to allocate a greater proportion of capital
to be maintained in reserve for such loans. Various
research firms and consultancy groups predict the
impact of new Basel III rules would be equivalent to a
20-25% reduction in their balance sheets ($250300bn) if no new capital is raised.
Local Regulatory Pressures
Outside of Basel III, certain banks are now faced
with increased pressures borne in the home
jurisdictions. Although these will likely end largescale forbearance trends, many of these regulations
Real Estate Investing – 2012
could have further sizeable impacts on their
respective banking industries’ ability to lend. For
example in the U.K., the Bank of England and U.K.’s
Financial Services Authority issued risk modelling
guidance in December 2011 on a portion of U.K.
CRE lending. If following a review by the FSA, U.K.
banks are deemed “not compliant” (ie. not setting
aside enough capital to cover risks), the FSA can
impose its own “slotting” regulation to banks’
internal models. Although not fully implemented,
this new slotting regulation could lead to even higher
capital requirements for U.K. banks (according to
one source, in the range of tens of billions). Similarly,
proposed new write-down requirements in Spain
should impact asset sales and debt restructuring, but
this remains to be seen.
Solvency II: Potential Impact on Insurance Companies
and Pension Funds
Insurance companies on the other hand are
considered by the market to be better placed than
financial institutions to absorb these structural
changes. Although focused on longer duration loans
(many 10+years), many insurance companies have
entered the European lending markets of late. Unlike
many banks, they have few legacy sub-performing
loans, different capital adequacy requirements, no
Basel III requirements, and cash available to invest though they will be subject to the provisions of
Solvency II.
While Solvency II is expected to impact capital
reserve requirements in connection with real estate
related investments of insurance companies (possibly
even make debt investment more attractive), there are
still areas of significant uncertainty as to what rules
will be introduced pursuant to Solvency II, which will
come into effect in January 2014.
The Resulting Funding Gap
Limited lending levels, conservative loan-tovalue ratios, and high margin requirements have
impacted traditional senior debt providers in the U.K.
and other core Western European markets. Loan-tovalue ratios in the U.K. secured against a typical core
office property have come down significantly since
2007, falling from circa 85% to a maximum 60% in
the first half of 2012. Exhibit 3 (previous page) the
impact of this conservative underwriting together
with increased regulation, declining capital values
and a decreased number of active lenders is
illustrated in the following example:
Illustrating The Funding Gap
Assume a good-quality property located in the
U.K. has an appraised value of £100 million and was
financed with a five year interest-only loan in 2007 at a
60% Loan to Value ratio, Exhibit 4. Accordingly, the
property has £60 million of debt coming to maturity in
2012. Assuming that capital values have fallen by 25%
since 2007, the property is now valued at £75 million.
As such, the investor only has £15 million of equity).
With a debt of £60 million, this would equate to an
increased Loan to Value ratio of 80% (£60 million as a
percentage of £75 million). As the property is now
valued at £75 million, it would be plausible in the
current market to raise senior debt of £45 million
(being a Loan to Value ratio of 60% on the reduced
value of £75 million) of the £60 million required in
debt financing. This leads to a gap of £15 million. This
gap is referred to as the ‘funding gap’. Two very different situations
Prime
/ Good4Quality
Exhibit
£120m
£120m
Asset
Value:
£100m
£100m
£80m
Equity
£40m
25% Drop in
A
Asset
t Value
V l
£100m
Asset
Value:
£75m
Asset
Value:
£75m
Equity
£15m
Equity
£15m
£60m
£20m
£0m
£80m
Equ
£40
£60m
Senior
Debt
£40m
Ass
Valu
£100
Funding
g Gap
£60m
0-60%
LTV
Pre-Crisis
Senior
Debt
£60m
0-80%
LTV
Funding
Gap
New
Senior
Debt
£40m
£60
£45m
(Covenant
Breach)
0-60%
LTV
Post Crisis
Today
Sen
De
£20m
£0m
0-60
LT
Pre-C
Stalemate or Crisis? Examining the European Real Estate Deleveraging Debate
For a secondary or tertiary property, the
availability of finance is significantly diminished and
thus the size of the funding gap much more
pronounced, see Exhibit 5 on the following page. With
a significant decline in both value and occupational
demand in many cases erasing any value for the
property owner, the original lender is facing a
defaulted loan. In this example, with the property
now valued at £50 million and an uncertain income
profile, the asset is un-financeable in the current
ituations
Exhibit 5
Secondary / Tertiary
£120m
Asset
Value:
£100m
unding
g Gap
£100m
Asset
Value:
£75m
£80m
Equity
£40m
Equity
£15m
£60m
£40m
Today
NonPayment
Default
Asset
Value:
£50m
Senior
Debt
Market
Value
£60m
£45m
0-60%
LTV
Significant
Income Loss
Loss
Funding
Gap
New
Senior
Debt
50% Drop in
Asset Value;
£50m
£20m
£0m
0-60%
LTV
Pre-Crisis
Underwritten
Under
ritten
Recovery
NPL
Sale
Price
£42m
0-120%
LTV
Post Crisis
Loan Sale
climate, creating a £50 million funding gap.
Depending on the profile of the property (cash profile,
location), the choice for the senior lender is to either
take enforcement action or package the loan for sale,
in both cases crystallizing significant losses for both
property owner and bank.
When aggregated using statistical information on
available funding levels, current LTVs, and asset
impairment measures, this can be used to
quantitatively measure the funding needed in the real
estate sector that cannot funded through sales or debt
finance. Of the worldwide funding gap reported,
DTZ estimates that early 85% of the $216 bn global
figure will be in Europe over the next two years. The
impending regulatory measures proposed pursuant to
Basel III and the European Banking Authority are
expected to more than double last year’s estimate to
approximately $182 billion for 2012-2013 alone.
Morgan Stanley forecast in May 2012 that the
commercial real estate industry faces a $400-750bn
financing gap primarily from European banks
deleveraging, which includes a $125bn estimate
attributable to future CMBS outflow.
The funding gap has offered an opportunity for a
number of new entrants to gain exposure to good
quality real estate with significant downside
protection via the provision of preferred equity,
mezzanine, or whole loan senior finance, however
the capital raised to date is nowhere near the amount
that is needed to create a sustainable liquidity
provision for many holders of property. This
continued lack of liquidity, with sources of debt
focused on select core assets will in our opinion
continue to increase the spread between core asset
yields (those assets for which senior and alternative
debt is readily available) vs. secondary assets (where
in many cases, the real estate is not financeable at all).
Bank Deleveraging: Loan Sales
European banks are primarily de-levering
through loan sales or enforcement-driven asset sales.
Many funds and debt buyers that expected European
packaged debt sales following 2008 to be equal or
greater to those witnessed in the U.S. the last two
cyclical downturns (FDIC auctions in 2009-today
and RTC auctions of the 1980s) have been
disappointed to date. Loan sales have been slowly
unfolding in various markets, with the vast majority
of sale volume coming from U.K. and Irish banks.
The numbers are increasing as more portfolio sales
are announced. Although many loan sales are
completed off-market and not widely reported, we
note five large U.K. loan portfolios have been sold in
2011 and 2012 (Bank of Ireland’s £1.7bn U.K. loan
portfolio last year, RBS’s sale of a stake in a £1.4bn
loan portfolio in 2011, two Lloyds loan portfolios
totalling £1.6bn over the past 12 months, and
Bundesbank’s £1.1bn CMBS sale) and more are
announced in the coming year. However many note
that the pace of sales has been underwhelming
especially with respect to the size of the overall
Real Estate Investing – 2012
deleveraging that must take place within the
European banking sector.
So one must ask the question, if Europe is in
desperate need to reduce its debt exposure, why
hasn’t the market seen a wave of loan sales to-date?
We offer a few possible explanations below:
1. Unintended Consequences of ECB Support:
One possible explanation could be the €1
trillion of long-term refinancing operations
(LTROs) the European Central Bank (ECB)
has pumped into the banking system. In a
move of unprecedented scale, the ECB
injected €489 billion of relatively inexpensive funding on 21 December 2011 and a further €530 billion on 29 February 2012. This long-term refinancing contained a maturity of three years (double the maturity profile of previous issues). This was a welcome funding supply for Europe’s banks – priced at 50 basis points for three years – and initially deposited the funds with the ECB. Some banks have also used parts of their LTRO allocation to acquire sovereign debt thus creating a positive carry trade against lower sovereign yields. Most
view LTROs (initially designed to stimulate
bank lending to SMEs) to have reduced
urgency amongst the banks to sell assets in the short term.
2. Bid-Ask Pricing Spread: Buyers and sellers
bid-ask spreads have in many cases been wide
and banks with insufficient provisions against
problematic assets are unwilling, or unable, to
sell at market price. This is particularly true of
Spain, with banks’ provisions being deemed so
insufficient that very few loans or loan
portfolios have traded. Compounding this, the
legal jurisdiction in many Mediterranean
countries is by all accounts debtor-friendly and
largely untested for large-scale enforcements.
3. Mark to Market: A third explanation is that
many banks would not be able to take the
requisite hit on the remainder of the books if a
loan portfolio is sold at a discount. The “mark”
against other loans within their portfolio in
many estimates could take down a number of
smaller, less capitalized banks. Regulations on
provisions and write-downs will help alleviate
the log-jam of loans not being properly
provisioned.
4. No One Clear Market: In Europe, unlike the
U.S. which has one general set of laws, one
language, and transparency in the market, large
cross border loan sales are almost impossible
to achieve. Enforcement procedure and law is
specific to each country and in many cases is
significantly different in terms of resolution
timing, ability to enforce, and treatment of third
party unsecured creditor claims. Many countries
are still implementing new insolvency
regulations that are largely untested unlike the U.S. where there are clear precedents to follow. All of this has an impact on liquidity and cost effectiveness of banks to systematically sell down non-core holdings.
5. Interest Rate Swaps: Interest rate hedging
(typically through interest rate linked swaps)
was common in real estate lending (De
Montfort estimates that just under 60% of the
outstanding property debt in the U.K. had interest rate hedging in place). In certain
cases, banks sold long-dated swaps to real
estate owners with the justification that the
real estate owner should hedge out interest
rate risk against its underlying lease-term, in
many cases much longer than the duration of
the loan. These swaps were typically written when interest rates were high and now with interest rates forecast to remain at or near 1.0%, this represents significant losses if these hedging instruments are broken. Anecdotally, we know one situation where a 30-year swap was written in 2007 against a portfolio of high quality properties. With the debt due to mature in 2013, the remaining duration of the swap is still 25 years and the loss if crystallized today against that swap would total 15% of the current open market value of the properties. Situations like this, unless a resolution is forced, usually result in a stalemate between borrower and lender unless the bank is willing to take a haircut. As shorter duration swaps Stalemate or Crisis? Examining the European Real Estate Deleveraging Debate
naturally mature (those in line with debt maturity profiles), this should clear a roadblock that has stalled many sales processes to date.
All of the above leads us to believe that the
deleveraging within the European banking
industry will be a long and protracted one. Banks
are unwilling to create pockets of pricing
dislocation by unloading large amounts of stock to
a market unable to source new financing. This is
supported by policy intervention but in our view
will only slow the process rather than solve it.
Future Outlook
While the pace of deleveraging throughout
Europe remains to be seen, there are opportunities
unfolding for a variety of market participants.
Whether it is alternative lenders filling the debt
funding gap, opportunistic funds providing rescue
finance to recapitalize or restructure problematic
legacy assets, or distressed loan buyers picking up
loan portfolios at premium yields, the scale and
severity of the European debt issue should offer a
large and diverse set of opportunities. Our view for
Europe is a steady deleveraging process over the
next 5 – 7 years as banks continue to sell assets.
This will be accompanied by a structural shift in the
lending markets toward a U.S.-style CRE finance
model, with insurance companies, pension funds,
and specialised debt funds/REITs continuing to pick
up sizeable market share left behind by a severely
contracted commercial banking market.
Michael has his BBA in Finance and Accounting from Texas Christian University where he received the
Neeley School of Business Professors’ Award for Outstanding Finance Major.
❖ Real Estate Financing –
The New Debt Landscape
The European real estate debt market has undergone an unprecedented and
permanent shift in the past five years, driven primarily by regulatory change
and the performance of the real estate market since the banking crisis. As
banks have been forced to substantially deleverage and reduce their
exposure to real estate, they have become increasingly unwilling or unable
to continue to provide their previous level of financing, causing challenges
for investors and developers with funding acquisitions or refinancing
maturing loans. However, this has also created opportunities for alternative
providers of capital to enter the market and reshape the real estate debt
landscape going forward.
Much has been written about the ‘funding gap’ that now exists as banks
have, to a greater or lesser extent, reduced their new lending and refinancing
or extension of existing loans. Bank debt remains by far the largest component
of the European finance market; latest estimates indicate that commercial real
estate debt in Europe stands at €2.4 trillion (Morgan Stanley: Banks
Deleveraging and Real Estate, March 15, 2012) and 93% of that is held or
managed by banks. Estimates are that a large portion of that, between €300
billion and €600 billion, needs to reduce off the banks’ balance sheets in the
next three to five years, and the question is how that will happen and what are
the long term consequences.
The most fundamental driver behind this shift in the debt market is the
regulatory change brought in under Basel II in January 2008, which revised
the way in which banks apply capital to their lending books. Given the
European banks’ exposure to commercial real estate, Basel II would ultimately
fundamentally change the real estate finance market. This is because the
regulatory change moved us from a situation where banks applied similar
amounts of capital, regardless of the risk of its lending, to one where higher
risk deals required exponentially more capital. The result of this is that
lending beyond traditional ‘investment grade’ level senior debt, of about
60-65% gearing, has become commercially unviable, as the scale of capital
now required, combined with the cost of such capital has made such lending
prohibitively expensive. Basel III has further exacerbated this situation, by
requiring banks to hold more absolute capital on their balance sheets, in order
to protect against future market volatility. However, the real catalyst that has
led to a significant increase in the amount of deals coming to market has been
the European sovereign debt crisis. Banks’ balance sheets have been hit across
Europe by write-downs against Greek, Italian and Spanish government bonds,
and they have been forced to look at other areas of their businesses to
Andrew Radkiewicz
Managing Director
Pramerica Real Estate
Investors
Real Estate Investing – 2012
and the insurance sector was rarely active. However,
there is now a definite opportunity for insurers to
take a larger role and it is something that we are
already seeing. The risk adjusted returns available in
That is the bigger picture, but within that we have
Europe for good quality real estate senior lending has
seen three distinct ‘funding gaps’ developing in the
European commercial real estate debt market. Firstly, attracted the interest of a number of active U.S.
insurance companies. European insurers are also
there is the senior debt gap caused by the overall
impact of banks reducing their aggregate exposure to allocating resources to expand their activity, as they
have an additional regulatory incentive through
commercial real estate debt, which is limiting the
Solvency 2, which potentially makes investing in the
supply of new senior financing. Secondly, there is
real estate debt space market more attractive from a
the junior funding gap between traditional levels of
senior debt and equity, which has grown increasingly capital allocation perspective, than holding direct
assets. The senior lending gap has also given rise to a
wide as what senior lending is available is focused
growth in senior debt funds coming to market
on lower risk opportunities with historically low
seeking investor capital. This is a new phenomenon
levels of leverage – in many cases below 50%.
in Europe, and it remains to be seen whether capital
Finally, there is the gap around more distressed
can be raised and deployed on a scale that is
situations, which cannot secure new debt.
sufficient to support such platforms.
Although it suffers from a substantial debt funding
The junior funding gap, defines the shortage of
gap, the distressed sector is likely to require equity
capital between equity and current levels of senior
solutions, either in the form of recapitalization, or
debt. Following the implementation of Basel II, a
through a growth in non-performing loan
clear gap developed as banks retrenched from all but
acquisitions by opportunistic investors. To date,
evidence of this activity in the European markets has ‘investment grade’ style of senior lending, with
been scarce, and we do not see wide-scale bank sales average levels of gearing cut-off at 65% loan to
of discounted commercial real estate loan portfolios. value. However, further regulatory change, combined
It is more likely that equity opportunities in this area with wider European market factors, has pushed
will be more targeted, with closer collaboration with down senior lending risk appetite to historically low
levels – 50% loan to value is now considered
lenders and respective borrowers.
‘normal’, even for high quality core assets. From a
However, the first two funding gaps offer
banking market five years ago that regularly
significant opportunities for new debt providers to
provided senior debt finance in excess of 90% loan to
enter the European market and create a new real
value, the comparison is stark and the challenge
estate debt market, with a broader range of more
considerable to the European real estate sector.
diversified funding sources.
Within the challenges of the junior funding gap lie
The first of those, the senior lending gap has
attractive opportunities for alternative providers of
materially reduced the capacity of the banking
capital, and it is this area of the European real estate
market to fund real estate. Due the pressure on banks debt market that has seen the most activity to date in
to reduce their overall lending exposure, both the
terms of being identified and targeted by existing and
number of active banks and the smaller scale of their planned funds. This is also the segment that we have
appetite have created a dearth of liquidity in the
been investing in actively through its real estate
European market. In contrast to the U.S. market, the
capital platform based out of London, for which
dominance of the banking sector did not allow for
around $800 million was raised in May last year,
the development of alternative providers: the CMBS making it the largest dedicated operator in this space
market, although active for a few years, is currently
in Europe. In our dealings with the market we have
more the source of problems, rather than a solution;
become aware of a definite shift in institutional
European REIT’s cannot invest in mortgage assets;
investor interest, together with a broadening of the
recapitalize balance sheets, including real estate
debt.
Real Estate Financing – The New Debt Landscape
types of deal where junior capital is being used.
The only way for junior debt funds to raise
sufficient capital to become a material part of the real
estate debt market is for global institutional
investors, such as major pension funds and sovereign
wealth funds, to commit parts of their real estate
allocations to the market. We believe that, following
a period of education and in the wake of an
increasing number of deals being successfully closed
in the past couple of years, there is a growing
appetite for junior debt among this type of investor,
with new investors entering the market and existing
ones increasing their exposure. Investment platforms
are attracting significant interest from European,
U.S., Canadian, Asian and Middle Eastern investors.
This greater appetite stems from the fact that
junior debt ticks a lot of boxes for what these
institutions are looking for in an investment:
• It provides income from day one, with no J-curve in terms of taxes or fees that you would have with direct property investment
• The majority of returns are predictable, being
contracted, priority and fixed when the deal is
signed
• It offers an attractive risk profile, since equity
will, to an extent, soak up downward
movements in property values
• Investor capital can be deployed even in a tight
real estate market with low transaction
volumes, as debt investments can access deal flow through refinancings, which allow
exposure to properties that are not on the market.
As the volume of capital invested in the junior debt
sector and the number of deals has increased in the
European market, we have also seen a broadening of
the types of deals that are being financed. The junior
debt market today is more nuanced and much more
flexible than the common perception of mezzanine
debt priced at 15%. How a deal is now structured and
priced will depend on where you sit in the capital
stack combined with the characteristics and risk of
the underlying real estate, and the breadth of returns
from junior debt can now range between 8% and
15%+, dependent on these factors.
At one end of the spectrum, low risk ‘senior
subordinated’ deals are picking up the shortfall in senior
lending against high quality assets – an example would
be a deal that we financed through our European
platform for a well known real estate investor
refinancing a prime, fully leased London office asset,
that had senior lending in place up to 55% loan to value,
but needed additional debt up to 75%. We financed that
at a rate of around 9%. At the other end of the scale are
deals with good quality real estate, but more underlying
asset management risk (for example: asset repositioning,
development, leasing), such as a financing that we did at
60-85% of the capital stack for a major German
shopping centre with significant asset management
required, but in an excellent location, with strong tenant
repositioning prospects. We structured that more like a
hybrid equity deal with a priority income return and
profit share on capital upside, targeting a 15% plus
return. However, the ability to successfully execute,
particularly in cases such as this, is not only dependent
upon debt structuring capability, but also on an in-depth
understanding of the underlying real estate.
These examples illustrate the flexibility of junior
debt as an alternative form of capital. The range and
volume of deals that we have successfully completed
this year has led us to the next stage of developing the
European real estate capital platform, where we expect
to raise additional commitments of around £1.5 billion,
which will target opportunities within the junior debt
gap, ranging from senior subordinated through to
mezzanine and preferred equity style loans.
The European real estate debt sector has
undoubtedly undergone a seismic shift in recent years,
and continues to evolve all the time. There is an
overall shortfall of debt availability, which is forecast
to last for at least three to five years. However, this
creates an unprecedented opportunity for alternative
providers of capital to build new and sustainable
platforms, which bridge the gap between institutional
investor demand and the opportunity to invest in high
quality transactions, with historically attractive risk
adjusted returns.
Andrew is an Economics graduate of Warwick University.
Real Estate Investing – 2012
DISCLAIMER
These materials represent the views, opinions and recommendations of the author(s) regarding the economic
conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information
to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized,
and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without
prior consent of Pramerica Real Estate Investors (‘Pramerica’) is prohibited. Certain information contained herein has
been obtained from sources that Pramerica believes to be reliable as of the date presented; however, Pramerica cannot
guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed.
The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is
subject to change without notice. Pramerica has no obligation to update any or all of such information; nor do we make
any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for
errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security
or other financial instrument or any investment management services and should not be used as the basis for any
investment decision. Past performance is no guarantee or reliable indicator of future results. No liability whatsoever
is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information
contained in or derived from this report. Pramerica and its affiliates may make investment decisions that are
inconsistent with the recommendations or views expressed herein, including for proprietary accounts of Pramerica or
its affiliates.
The opinions and recommendations herein do not take into account individual client circumstances, objectives, or
needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular
clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments
or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the
recipient(s) of this report must make its own independent decisions.
In the United Kingdom and various other jurisdictions in Europe, all investment activities are carried out by
representatives of Pramerica Investment Management Limited (‘PIML’), which is authorised and regulated by the
Financial Services Authority of the United Kingdom (registration number 193418). Pramerica Real Estate Investors,
which is affiliated to PIML, is the real estate investment management business of Pramerica Investment Management.
Both Pramerica Real Estate Investors and Pramerica Investment Management are trading names of Prudential
Investment Management, Inc., the principal asset management business of Prudential Financial, Inc. (“Pramerica
Financial”). Pramerica Financial is not affiliated in any manner with Prudential plc, a company incorporated in the
United Kingdom. PIML is registered in England No. 3809476 VAT no. 447 1835 36, Registered Office, Grand
Buildings, 1-3 Strand, Trafalgar Square, London WC2N 5HR. Pramerica, the Pramerica logo, and the Rock symbol are
service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.
❖ Capturing Growth
Investing in Asia Pacific Real Estate
❖
Glyn Nelson
Executive Summary
• We believe Asia Pacific is arguably the most dynamic real estate
investment region in the world and is becoming increasingly difficult for
real estate investors to ignore.
Head of Property
Research, Asia Pacific
• Surging economic growth is fuelling the rapid expansion of the invested
universe. We expect this growth is set to result in Asia Pacific becoming the
largest invested region in the world by 2025.
• Within the region, the change to the investment landscape could prove to
be even more dramatic. We expect the rise of the developing markets to be
strong; on this basis, by 2025 China is set to double as a proportion of the
invested Asia Pacific market whilst the largest current market in the region,
Japan, is set to broadly halve. 1
• Asia Pacific markets are being impacted by key megatrends, notably
rapid population growth and urbanization at an unprecedented scale. The
rise in wealth of the population is likely to lead to surging demand for
appropriate residential property. This is expected to have an enormous
impact upon mass consumption and the consequent growth for industry and
commerce. The potential for investors to capture such growth should be
enticing as new and exciting investment opportunities are created. A key
risk for investors is whether the supply response from developers is
sufficiently constrained given such demand side growth – we believe that
local knowledge is imperative in assessing such issues. Professionalism and
transparency are improving across the region; global industry trade groups
are well established, performance measurement services are growing fast
and advisory service groups familiar to investors from outside the region are
well represented.
• In considering what investment strategies investors might seek to adopt
we set out some broad comments as a ‘one size fits all’ approach is unlikely
to be appropriate always.
• We believe the diversification benefits of investing in the Asia Pacific
region for ‘core’ investors are greatest for those from smaller domestic
markets. Investors with a large and diverse domestic market may find
1
Aberdeen Asset Management, September 2012
Andrew Allen
Director of Global
Property Research
Aberdeen
Asset Management
Real Estate Investing – 2012
relatively limited benefits from a ‘Core’ Asia
Pacific exposure.
development of the Asia Pacific markets in three
sections:
• We believe the greatest opportunity is for
those investors seeking ‘value add’ and
‘opportunistic’ strategies; those seeking enhanced
returns from this region can expect numerous
prospective opportunities. The opportunity set is
broad and deep.
• Megatrends set to drive future growth
•
• In considering the entry point to choose, we
question how meaningful a direct real estate strategy
can be for all but the largest investors. We believe
investors seek indirect exposure either through
listed securities (REITs and publicly traded real
estate development and service companies) or
unlisted funds (including joint ventures, club deals,
multi-manager accounts etc.). The balance of
investment across the two approaches can be driven
by multiple considerations that include scale of
opportunity sets, tolerance of volatility, investment
horizons, liquidity and so on.
• The improving professionalism and transparency that are expected to shape investor strategies
The Asia Pacific region is expected to become the largest share of the global property market with huge internal structural shifts
Part B focuses on the appropriateness of
investment strategies for the region and entry
points, direct or indirect, listed or unlisted.
In this paper we do not reflect on the current
market conditions of individual markets, nor do we
seek to comment on the current pricing of specific
markets against our assessment of ‘fundamental
value.’ Such work is covered in the global and
regional (Asia Pacific, Americas, UK, Continental
Europe and Nordics) quarterly market outlooks
that set out our current projections of pricing and
approach to risk.
• In conclusion, we are confident that global
investors are set to remain attracted by the strong
growth of this region. We believe that the scope
for return-enhancing strategies is arguably greater
than diversification-related strategies and we
The quarterly market outlooks are supplemented
believe the best access point is through indirect
by a series of one-off papers that in 2012 include:
vehicles. The proximity to the local markets of
• ‘Real estate strategies for US based experienced and trusted managers of indirect
investors’ (September 2012)
vehicles should, we believe, be of paramount
importance in shaping the prospects and risks of
• ‘Property and inflation - not an easy prospective returns.
relationship. Can Asia Pacific property offer an inflation hedge to investors?’ (2012)
Introduction
We estimate the Asia Pacific region already
accounts for around a third of the invested global
real estate investment universe; it is set for strong
growth through a combination of economic
expansion and the rapid modernization of the real
estate investment market.
This paper is set out in two parts.
Part A addresses the long-term drivers and
• ‘Dawn of recovery in the land of the Rising Sun? The macro-economic window of opportunity‘ (October 2012)
• ‘Dawn of recovery in the land of the Rising Sun? Opportunities in the Japanese office market’ (September 2012)
• ‘Targeting the jewels amongst the GEMS (Global Emerging Markets)’ (August 2012)
• ‘Investment routes into commercial property’ (June 2012)
Capturing Growth
Part A. Asia Pacific: In Our Opinion, The Scale of The Opportunity
Set is Unrivalled
growth, along with more people living in cities, is expected to increase dramatically the demand for modern, quality residential • Asia Pacific is experiencing unprecedented units. This is contributing to a sustained demand for all types of residential economic demand-side expansion. We focus on two megatrends: surging demographic accommodation, from low-cost, affordable housing through to luxury villas.
changes and the explosion of mass consumption in the region. We believe that The rise of mass consumption
this region offers a scale of new and potentially rewarding opportunities that is
• The rise of the middle class and the unrivalled within other regions.
emergence of the aspiring consumer are changing the shape of industry and • As these trends evolve we expect the Asia commerce.
Urbanization
creates
wealth
at
a
Pacific region to become the largest share of the global property market by 2025; within greater density and dramatically increases discretionary spending, leading to an the region the prospective changes in the explosive demand for global brands and an investment landscape are very marked.
evolution of consumer trends. Global • We expect economic growth to drive a rapid retailers are expected to continue to improvement in the accessibility of the increase their exposure in these markets, markets to investors; professionalism and creating demand for modern-quality, transparency improvements are already organized retail space.
marked. The supply side response is both an opportunity and a risk
Megatrends Set To Drive Future Growth
New development can be expected on a
We see two overriding trends in the region: a
tremendous scale, transforming skylines and creating
surge in demand for residential accommodation
what we believe is a huge variety of investment
and the rise of mass consumption.
opportunities. A key risk for investors is the too rapid
expansion of supply as developers rush to meet
Surging demand for residential development demand. We observe that whilst indiscriminate
• Pent up demand. Future demand for modern development has caused considerable oversupply in
quality residential space is multifaceted and some markets, this is by no means a universal risk
across the major cities of the region. We strongly
interlinked. Perhaps more important than strong population growth is the implication advocate that local knowledge is critical to
successful investing and believe that investors with
of dramatic urbanization; the Asia Pacific city-resident population is expected to grow the highest research-based conviction are better set to
by over one billion in the 14 years from 2011 outperform the market.
to 2025, which is more than four times the Asia Pacific to Become Largest Share of Global Property
2011 U.S. urban population. 2
•
• The combination of income and wealth 2
3
Household sizes are shrinking. We note that the average Chinese urban household in 1998 comprised 3.1 people; by 2011 it had fallen to 2.8. 3 We expect this trend to continue.
United Nations, September 2012
Thompson Reuters Datastream, September 2012
Market
Asia Pacific is already a third of the invested
global market and is growing fast. With a
combination of economic expansion and rapidly
improving market maturity we forecast that the
region will comprise 37% of the global universe by
Real Estate Investing – 2012
Exhibit 1
USD (bn) Asia Pacific Americas Europe Forecasts of The Changing Global Real Estate Universe
2011 2015 2020 size % size % size % 1,844 33 2,369 34 3,177 35 2,126 38 2,568 37 3,401 37 1,669 30 2,001 29 2,614 28 2025
size %
4,639 37
4,564 36
3,464 27
Source: IPD, DTZ, EPRA, Aberdeen Asset Management, September 2012A
For Illustrative Purposes
2025 and is set to become the largest global
destination for real estate capital. 4 A Exhibit 1,
shows the speed at which we expect the Asia
Pacific property market to grow; it is increasingly
difficult for global investors not to be well versed
on the opportunities and risks of the region.
Significant change within the region: Perhaps
more important than the growth within the region
is the changing dynamic across the region. We
anticipate a significant change in the composition
of the stock of assets in the Asia Pacific market.
At the end of 2011 we estimated that most of the
stock (72%) lay within the mature markets and, of
this, Japan dominated accounting for half of the
regional universe. As can be seen in Exhibit 2, by
2025 what we now call developing markets could
represent the majority of the regional opportunity
set (56%). Leading this is the volume of growth in
the Chinese invested property market, expected
to be around USD 1.3 trillion (2011 to 2025). This
increase in value is approximately the same as
adding the combined 2011 value of both the
Japanese and UK markets.
Exhibit 2
The Rise of Emerging Markets in the Asia Pacific Region
Source: IPD, DTZ, EPRA, Aberdeen Asset Management, September 2012
For Illustrative Purposes
4
A
Investors can refer to our future paper ‘Sizing-up the global property market: Positioning for growth’ November 2012
Forecasts are offered as opinion and are not reflective of potential performance, are not guaranteed and actual events or results may differ materially.
Forecasts are based on a number of assumptions including capital and rental growth assumptions.
Capturing Growth
Improving Professionalism and Transparency
Investors can expect transparency to be
materially improved. In the eight years to 2012,
India, China, Philippines, Thailand and Indonesia 5
have all markedly improved their transparency
score. According to Jones Lang LaSalle, the Asia
Pacific region has four transparent or highly
transparent markets (Australia, Singapore, Hong
Kong and New Zealand, Exhibit 3, for
transparency as at 2012) as well as having five of
the top 15 markets with the best improvement
from 2010 to 2012 (Indonesia, Philippines,
Vietnam, South Korea and Thailand).
In addition to more transparent property markets, we note:
•
Asset and fund performance services are advancing. IPD 6 have recently published their 2nd annual Pan Asia Return Research (PARR) service. This now extends to nine countries 7 (Australia and New Zealand are not included in this report but are covered Exhibit 3
Asia Pacific Transparency 2012
by IPD), some US$244 billion of assets and has a five-year history.
•
Globally recognized industry trade bodies are prominent. ANREV 8 is the industry body for unlisted real estate vehicles, with over 150 members. APREA 9 is the industry body for ‘suppliers and users of capital in the real estate sector’, and has over 170 members.
•
Market transaction data are readily available from real estate brokers and specialist monitoring companies such as RCA, 10 and further insight can be gained from multiple industry specific publications that provide much improved news flow.
Notwithstanding this additional insight available in the market, at Aberdeen we believe in undertaking our own bottom-up research.
However, there remain risks that may be less
familiar to investors from established, mature
markets; these include an uncertain regulatory
climate, unfamiliar political processes, a lack of
freehold tenure which is common in some markets
(China and Singapore), and so on.
Consequently, how the Asia Pacific property
markets function can be very different from an
investor’s domestic market. In our opinion, onthe-ground investing can be challenging and we
believe it is difficult for global investors to invest
from their home markets successfully without
specialist local help.
Source: Jones Lang LaSalle, 2012
For Illustrative Purposes Only
Categorizing The Markets For Investor Allocation
Recognizing the enormous breadth and diversity
of the Asia Pacific region, we find that classifying
the markets into three broad categories helps as
countries within these categories tend to share many
features. This can assist in setting allocations in light
of common market norms and risks.
Jones Lang LaSalle Transparency Index
Investment Property Databank
7
China, Hong Kong, Indonesia, Japan, Korea, Malaysia, Singapore, Taiwan, Thailand.
8
Asian Association for Investors in Non-listed Real Estate Vehicles
9
Asia Pacific Real Estate Association
10
Real Capital Analytics
5
6
Real Estate Investing – 2012
•
Mature markets - Australia, Japan, Singapore,
Hong Kong, New Zealand. These represent large, accessible, lower-risk markets which are well developed with regard to market professionalism and the range of investment opportunities open to investors.
•
Semi-mature - Korea, Taiwan, Malaysia. Korea dominates these markets which have grown out of their development stage but have yet to mature fully with a full range of investment opportunities.
no one allocation strategy just like there is no one
investor. Allocation strategy is contingent on
many factors such as the domestic market, risk
tolerance (including the use of leverage) and
target returns.
Broadly, we believe investors can be grouped
into two kinds, those seeking diversification 11 and
those seeking higher returns.
Investors looking for diversification 11 are
likely to be ‘core’ investors targeting the highest
risk-adjusted returns. These investors may not
• Developing - China, India, Thailand, have the same intensity or drive to invest in the
Indonesia, Philippines. These are typified by Asia Pacific region as return seeking investors
surging economic expansion and burgeoning because of the region’s volatility. Investors with
property investment markets, but such large domestic markets, such as those from the
growth leads to additional risk. We feel the U.S., tend to have a compelling domestic risks/
region’s developing markets represent the return trade off, especially when the reality of
most interesting opportunity set but are the non-domestic core investment is taken into
hardest to access.
account, i.e. leverage, fees, tax. However, in our
opinion investors with smaller domestic markets
Typically the use of such classifications is just
can be expected to benefit from a much more
the starting point for our investment strategies
outward looking investment approach as their
and, whilst we would like to share a ‘typical’
domestic risk/return trade-offs are typically
allocation approach, there is no ‘one size fits all’
relatively poor.
as investors are heterogeneous.
Return seeking investors can find many
Part B. Investing in Asia Pacific
opportunities in the region’s property markets.
The
growth in the Asia Pacific economies and their
• We believe that return-seeking investors industries implies significant and steady demand
should find significant opportunity in the for
property. Investors can target ‘opportunistic’
region while ‘core’ investors, particularly strategies or lower risk or high conviction ‘value
those from large domestic markets, may 11
add’ strategies, such as manufacturing ‘core’ assets
find limited diversification benefits.
to sell (we only believe in holding ‘core’ assets
• We believe the material opportunity is for over the long term in relatively few markets).
those investors seeking ‘value add’ and We believe to get appropriate market access
‘opportunistic’ strategies.
and coverage, investors should focus on indirect
• We believe investors should seek indirect investment funds. Due to the size, scale and
exposure either through listed securities or diversity of the local markets, direct investing
unlisted funds; we believe accessing direct (owning and operating property assets) is only
assets is a high risk approach for most investors. feasibly available for the largest global investors
which might be able to build a large enough
How should investors allocate to Asia Pacific?
portfolio to reduce risk to tolerable levels. These
will have a sophisticated property platform,
How should investor’s allocate to the region?
typically with local market representation as well
The answer, regrettably, is ‘it depends.’ There is
as the full suite of back office functions (from
11
Diversification does necessarily not guarantee a profit or protect against a loss.
Capturing Growth
accounting and legal to operations and treasury) to
support the investment team.
We feel that for most investors access the
region’s property markets is best accomplished
indirectly, using either the listed or unlisted
markets as entry points. Listed markets provide
investors with more liquidity but at the cost of
short-term volatility. Real Estate Investment Trusts’
(REIT) availability is limited and accessing
opportunities beyond this requires trade-offs such
as investing in developers (typically not a cash
flow vehicle like REITs) or property proxies such
as upstream industries (for example concrete and
steel production). Also, REIT regulations can differ
widely between markets, adding another layer of
complexity.
diversification(by style, country, sector and manager)
as well as expert due diligence processes, local market
experience and off-market investment opportunities,
such as joint venture and club deals through the
manager’s relationship network.
The balance of investment across the two
approaches can be driven by multiple considerations;
the most prominent being scale of opportunity sets
which we believe favours an unlisted approach. We are
mindful of multiple other issues such as tolerance of
volatility, liquidity, investment horizons, how active or
passive an investor wants to be, and so on.
Non-Core Investing In our opinion, emerging markets represent both
the greatest absolute return opportunity as well as the
riskier markets with higher volatility. We believe a
The unlisted fund universe is growing and
maturing, expanding an investor’s opportunity set. strong investment strategy for long-term investors in
the region is not to time market entry/exit but rather to
They can offer access to a wider array of
investment strategies and target returns; from ‘core’ “drip feed” investment over time, an approach favoured
by private equity investors to avoid vintage risk;
in mature markets to ‘opportunistic’ in developing
history tells us that the precise volatility of some
markets. Investors unfamiliar with a market or
markets
is very hard to predict.
without the internal platform to underwrite direct
fund investments can consider multi-manager
We also feel that accessing developing market
investing. We feel that this investment type can
growth through proxy markets is also worth
provide investors with multi-faceted
consideration. For example, our research has shown
Exhibit 4
Source: Hong Kong and Valuation Department, Jones Lang La LaSalle and Aberdeen Asset Management, August 2012
For Illustrative purposes only
Real Estate Investing – 2012
investors could improve the risk-adjusted returns of
investing in the emerging markets of Thailand,
Philippines and Indonesia by investing via Hong
Kong or Singapore as a proxy. Property returns from
these developed markets are closely correlated with
the higher growth emerging markets, Exhibit 4,
previous page, while having the added benefit of
being highly transparent, mature markets with lower
risk characteristics. We believe that the drivers of
this concept include the ‘hub’ function of the major
commercial markets (rather than the more ‘satellite’
economic function of the emerging markets)
together with its greater supply constraints.
Conclusion
• We believe Asia Pacific is arguably the most dynamic real estate investment region in the world and is increasingly difficult for institutional real estate investors to ignore; we expect growth is set to result in Asia Pacific becoming the largest invested region in the world by 2025.
be relatively limited for those with large and diverse domestic markets but that investors from smaller domestic markets could, potentially, achieve far greater benefit.
• The material opportunity is for those investors seeking ‘value add’ and ‘opportunistic’
strategies, the region has substantial appeal on this basis as investor funds are used in the development of this region.
• In considering the entry point, we feel there is limited justification for global investors to seek direct real estate exposure; investors can seek indirect exposure either through listed securities or unlisted funds.
• Such is the breadth of characteristics of the markets that we strongly advocate the use of local practitioners and local analysis to fully understand the tensions and issues.
• The key megatrends of rapid population growth, urbanization at an unprecedented scale, the rise of mass consumption and consequent growth for industry, commerce and the real estate markets should be tantalizing for global investors. The expansion of the region brings improved professionalism and transparency for investors and the number and quality of access points for investors are markedly improved and improving as a result. In considering investment styles, we believe that the diversification benefits of investing in Asia Pacific for ‘core’ investors may • Finally, we expect global investors to continue to be attracted by the opportunities arising from the high growth of this region. We believe that the scope for return enhancing strategies is arguably greater than diversification related strategies and the best access points are through indirect vehicles. Because this strategy is not risk free and is subject to considerable information disadvantages, the proximity to the local markets of experienced and trusted managers of
indirect vehicles can be of paramount importance in shaping the prospects and risks of prospective returns.
Andrew has an MSc Degree in Property Investment, Cass Business School and BSc in Economics and
Business Finance from Brunel University.
Capturing Growth
Disclaimer
Important Information
FOR PROFESSIONAL INVESTORS ONLY - NOT FOR USE BY RETAIL INVESTORS
PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.
Issued in Europe by Aberdeen Asset Managers Limited which is authorised and regulated in the United Kingdom by the
Financial Services Authority. Issued in Singapore by Aberdeen Asset Management Asia Limited, Registration Number
199105448E. Issued in the United States by Aberdeen Asset Management Inc., a registered investment adviser with the
Securities and Exchange Commission. Issued in Canada by Aberdeen Asset Management Inc., registered as a Portfolio
Manager in the Canadian provinces of Ontario, Nova Scotia and New Brunswick.
This document is strictly for information purposes and should not be considered as an offer or solicitation to deal in any
of the investments mentioned herein. The market or investment views expressed in this document do not constitute the
provision of a personal recommendation nor are they intended to be read as research or other information recommending
or suggesting an investment strategy, explicitly or implicitly, concerning financial instruments or the issuers of financial
instruments or should they be read as an opinion as to the present or future value or price of any such instruments. This
document does not constitute investment research, as defined under EU directive 2003/125/EC. Consequently, this
document has not been prepared in line with the requirements of any jurisdiction in relation to the independence of
investment research or any prohibition on dealing ahead of the dissemination of investment research.
Any research or analysis used in the preparation of this document has been procured by Aberdeen for its own use and
may have been acted on for its own purpose. The results thus obtained are made available only coincidentally and the
information is not guaranteed as to its accuracy. Some of the information in this document may contain projections
or other forward looking statements regarding future events or future financial performance of countries, markets or
companies. These statements are only predictions and actual events or results may differ materially. Readers must make
their own assessment of the relevance, accuracy and adequacy of the information contained in this document and such
independent investigations as they consider necessary or appropriate for the purpose of such assessment. Any opinion
or estimate contained in this document is made on a general basis and is not to be relied on by the reader as advice. The
information herein shall not be disclosed, used or disseminated, in whole or in part and shall not be reproduced, copied or
made available to others.
Neither Aberdeen nor any of its employees, associated group companies or agents have given any consideration
to, or made any investigation of, the investment objectives, financial situation or particular need of the reader,
any specific person or group of persons. Accordingly, no warranty is given and no liability is accepted for any
loss arising, whether directly or indirectly, as a result of the reader or any person or group of persons acting on
any information, opinion or estimate contained in this document. Aberdeen reserves the right to make changes
and corrections to any information in this document at any time, without notice.
Investments in property may carry additional risk of loss due to the nature and volatility of the underlying
investments. Real estate investments are relatively illiquid and the ability to vary investments in response to
changes in economic and other conditions is limited. Property values can be affected by a number of factors
including, inter alia, economic climate, property market conditions, interest rates, and regulation.
❖ Global Core Investing – What Strategies
and How to Implement
❖
Core investing has always been part of a global strategy. In this financial and
eurozone debt crisis core investing has proven itself as a shelter, protecting
income and portfolio performance. Price adjustments have provided an adequate
defence over the cycle. Liquidity has, of course, been affected by the crisis, but it
has not dried out. At the same time, fresh capital sought core exposure. The
core’s qualities are well appreciated, and, thus, this strategy will remain prevalent
among investors. That is hardly surprising. Strong national and international
covenants, liquidity, availability of data and price discovery, income return
making up a high proportion of total return, and safety make core investing
across continents compelling.
This paper highlights the fact that a core strategy should always advance to
better enhance portfolio performance and risk-adjusted returns. Even in core
investing there are risks that a passive, conservative strategy can lead to missed
opportunities and underperformance of a benchmark. It is argued that an
integrated approach should be employed utilizing a range of tools to assess core
strategies and allocations in core investing. An evolving strategy that is based on
extracting signals from more tools can prove advantageous for the portfolio The
presentation shows how signals are generated from such techniques that can help make the portfolio less vulnerable to risks and more able to take advantage of
forthcoming opportunities.
A core investor should bear in mind that in the global scene core markets
differ. The economic and real estate cycles are not synchronised. Core markets
are not homogenous, although the attributes common to all entice investors. Core
investors, however, can achieve greater diversification.
Descriptive key statistics capture the differences between them. The U.S.
and the U.K. show similar risk (measured by the standard deviation) — return
characteristics for office market returns (Exhibit 1 on the following page). France
gives lower returns with greater volatility. On the other hand, Germany’s low
average office returns are associated with lower volatility. When we consider
skewness, the U.S. clearly presents a situation in which there is a substantial
probability of a big negative return (larger than in European office markets). Also
the U.S. kurtosis is well over three, suggesting a higher probability for extreme
values than the European office markets.
The application of metrics such as the Sharpe and Sortino ratios picks global
markets that achieve superior performance. The Sharpe ratio is a commonly used
metric to rank the markets by the return per unit of risk. The Sortino ratio relates
Sotiris Tsolacos, Ph.D.
Director, European
Research
Property & Portfolio
Research Inc
Real Estate Investing – 2012
Exhibit 1
Main Statistics Illustrate Distinctive Core Markets
Source: PPR as of August 2012
to the volatility of returns when returns are below our
target rate. The higher the value of these metrics the
more attractive the market is. What the results show is
that these two metrics differentiate between markets
even within the same country and be used for filtering.
Using a group of four core countries we construct
an efficient frontier and calculated the resulting
allocations presented in Exhibit 2. This composition
Exhibit 2
France Has No Place in the Four – Country Office Portfolio?
Source: PPR as of August 2012
Global Core Investing – What Strategies and How to Implement
is obtained by assigning a targeted return and
calculates the weight of each market in the portfolio,
under the constraints that each adds up to one and that
the portfolio variance should be minimal. Lower-risk
portfolios are achieved with a higher proportion of
German assets, whereas a riskier portfolio is
predominantly composed of U.S. assets. U.K. assets
can be added to the portfolio for a higher return, but
the risk is proportionately higher. For example, a
portfolio with an expected return of 11% and a risk
level of 9.8% is composed 60% U.S., 32% U.K., and
8% Germany. France is not included in any frontier
portfolio because an efficient allocation cannot be
obtained with a portfolio that includes the French
national market. Of course this finding may not be
representative of individual French markets.
Several optimization tools are at the analyst’s
disposal. In addition to the mean-variance
application, we show the Black-Litterman (B-L)
allocations (Exhibit 3). This asset allocation
mechanism uses both statistical information and
investors views. Views are expressed in different
ways (absolute/relative) with historical information.
If investor views are correct, the new portfolio should
have lower variance and probably a higher return. We
apply B-L allocations based on the view (and high
probability) that the eurozone will break up (southern
countries will exit). The allocations in a threecountry portfolio (we exclude Germany since it
dominates the European side of the portfolio) change
with the U.S. gaining but both France and the U.K.
losing out. This is based on the assumption that
volatility will increase significantly in France and
less so in the U.K., whereas there will be no impact
on the U.S. office market.
Allocations based on these tools may not suffice
to achieve full diversification and reduce risks. For
example, allocations on unconditional volatility
(variance and standard deviations) will not capture
current volatility. Exhibit 4, on the next page,
presents estimates of time varying volatilities. This
plot shows that volatility does not rise simultaneously
Exhibit 3
Black – Litterman Allocations
Source: PPR as of August 2012
Real Estate Investing– 2012
in the office markets of the four selected countries. In
the past five years, volatility in France increased
earlier than in the U.S. and that was followed by
rising volatility in the U.K. Last year, U.S. officemarket volatility rose again; however, it was not
matched by rising volatility in the European office
market. Hence, global factors causing volatility will
not affect all markets similarly. Market assessments
and allocations should pay attention to the patterns of
time-varying volatility.
Spreads (defined here as the gap between real
estate yield and the 10-year government bond yield)
are a popular tool used by real estate investors to
assess future adjustments in real estate yields. For
example, in the U.S. the current spread is nearly 6%
and its average value has been about 4%. Two
adjustments are expected. Either bond yields will
rise, or cap rates will fall or both, so that the spread
returns to some kind of a long-term mean. Spreads
also stand high in the three European office markets.
However, what we should also consider is whether
these spreads are mean reverting. Appropriate
statistical tests confirm that the U.S. spread is mean
reverting. In Europe, the tests establish mean
reversion for the U.K. and French markets in the
period 1997 to 2012. Germany fails that test. Hence
the signal here is that we should expect mean
reversion in the U.S. and to a good extent in France
and in the U.K.. The fact that in Germany the spread
is the highest historically invites speculation of
similar adjustments as those expected in the U.S. But
it is difficult to gauge the size of this adjustment in
the absence of a mean value.
We complement the spread analysis with signals
from the long-run analysis between real estate yields
and bond yields. Finding a long-term relationship is
Exhibit 4
Volatilities are Not Synchronised in Core Geographies
Source: PPR as of August 2012
Global Core Investing – What Strategies and How to Implement
powerful. It means that in the long-run cap rates and
bond yields will move together as a group; however,
there will be deviations from the equilibrium path in
the short run. These deviations will be corrected after
a while. We find evidence of a long-run relationship
in all markets including Germany. In Exhibit 5 we
plot the deviations or disequilibrium paths. We can
see how the deviations swing around the zero line.
Currently the U.S. is most in disequilibrium with a
positive reading denoting that the gap between cap
rates and bond yields is too large and has moved the
relationship away from its equilibrium path. The
current position of the U.S. market in conjunction
with the signal from the yield spread analysis
presents an opportunity. Most likely U.S. cap rates
will adjust. A similar assessment is made for the U.K.
and France with the U.K. office market moving away
from equilibrium whereas French offices trend
towards equilibrium. Small adjustments in the spread
can be expected, but these might well come from
bond yield rises. The disequilibrium path in Germany
shows very little cyclicality, and the current reading
cannot really be assessed. What we can say with
confidence is that this analysis cannot be used for
signal extraction in Germany.
What investors find themselves in during periods
of global turmoil is the so-called ‘tail’ risk. This is
when correlations rise across all asset classes in the
portfolio. Correlation rises at a time when low
correlation is more desirable than ever. Such
situations cannot be overlooked. Consider the rising
five-year rolling correlations between U.S. and
eurozone GDP growth during the crisis. This can
translate into rising correlations in asset returns and
presents a source for ‘tail’ risk.
What can we do? How can we hedge? Such
increases in correlations are unavoidable. Our
strategy should contemplate reducing the impact of
such risks to the portfolio and securing income. We
Exhibit 5
U.S. Disequilibrium Presents An Opportunity
Source: PPR as of August 2012
Real Estate Investing – 2012
should identify and include markets where the
demand-supply balance can support future net
operating income. Again, there is divergence in the
degree to which fundamentals will strengthen or
weaken going forward. A rebalancing of a core
portfolio may be necessary to increase exposure to
locations where the fundamentals are forecast to
strengthen most.
peaks within eight quarters. The Chicago office
market remains indifferent for about four quarters to
any changes in national GDP and then begins to
reflect it. In a downswing this market could provide
diversification.
As global cap rate volatility is accompanied by
economic turbulence, exposure to markets where the
occupier market responds differently to economic
swings should be sought. In Exhibit 6 we plot the
responses of three markets to sudden GDP changes.
The London City office market responds quickly and
more severely to U.K. GDP swings. The impact
peaks after six to eight quarters, and the effect
dissipates. The Tokyo office market responds in the
same way, but the impact is milder. The impact also
The key message from this analysis is that a core
strategy should not be passive or conservative.
Opportunity to improve the risk-return profile of the
portfolio arises from the fact that global core markets are not homogeneous. They exhibit different
dynamics and responses to shocks. It is important to
‘now cast’ using a range of tools to extract signals and
execute decisions. Our criteria for core exposure and
achieving diversification should broaden.
Diversification in reserve currency areas (U.S. and
eurozone, if it survives) could be part of the strategy.
Let us also consider how the macroeconomic
environments are changing. An example is the
Exhibit 6
Office Rent Market Adjustments Vary Significantly
Source: PPR as of August 2012
Global Core Investing – What Strategies and How to Implement
eurozone environment after the Fiscal Stability Pact
is fully adopted by member states. Further, the use of
the traditional tools for optimization can be
augmented to incorporate views and sentiment as the
Black-Litterman technique.
Sortirs has his Ph.D. in Economics from Reading University, UK, M.A. in International Finance from Reading
University, UK, and B.A. in Economics and Econometrics. University of Athens, Greece