Institutional Real Estate, Multi-Manager
What a year for commercial real estate. At the end of the Q309, the trailing four quarter return for the National Council of Real Estate Investment Fiduciaries (NCREIF) property index was -22.1%, the lowest one year return in its 31-year history. NCREIF was not alone – the MIT Transaction-based index was down 36.5% and Moodys/REAL CPPI was down 40.6%, both from their peaks.
However, we are starting to see signs of (at least) a recovery of confidence. In the first half of the year, as the real estate risk premium required by both investors and lenders soared, global transaction volumes dried up, down 57% from the first half of 2008. However, global transaction volumes increased 40% in Q309 versus Q209. Equity capital is returning to London to buy yielding assets at supposedly deep discounts, and China is on fire; with 17 markets having seen more than $1 billion in new acquisitions and more than 100 Chinese companies having done $100 million+ deals. Even the struggling U.S. posted its first transaction volume increase in two years (albeit total U.S. volume represents only 11% of global transactions). Additionally, after two straight years of rising, global cap rates actually fell 15 basis points in Q309.
Although the market is showing some early signs of improvement from a transaction standpoint, we still see weak fundamentals. Demand is still soft and rents will continue to fall and vacancies continue to rise in 2010. While global central banks have injected the financial system with massive quantitative easing, this will not heal sick real estate deals. The only remedy is rapid recovery or restructuring and default. We expect to see more of the latter before we see the former.
In the U.S., we have over $1 trillion in commercial real estate debt coming due in the next three years. The European NPL market is estimated to exceed $750 billion. These are awe-inspiring figures and with values in decline and lenders continually tightening criteria, there is more pain to be felt before we can have a sustained recovery in pricing. To date the "extend and pretend" attitudes of lending institutions has been mostly accepted by regulators, but, we believe that the banks are hoarding capital in preparation to take their write downs and shed assets in 2010 and 2011. Expect to see continually more volume in the first half of 2010.
There is also a silver lining. When markets are falling, our instincts tell us that risk is rising, and when markets rise, we feel risk is waning – this is a fallacy for long-term investors. As the asset class has been deleveraged, it also has been de-risked. Today, we are buying real estate at a cheaper price per foot (well below replacement cost), with lower rental assumptions, higher current yields and less leverage. With inflation at bay (for at least the intermediate term) the real cash-on-cash return for acquiring real estate today (which can be double-digits) presents an attractive opportunity to earn current income while waiting for future growth.
