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Commercial Real Estate: The Long Grind Up

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The commercial real estate sector is underappreciated and may offer good value going forward.

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Long time Minyans know that even though I spend 99% of my time trading the markets, 95% of my company's operations are in commercial real estate, specifically the office market.

That's where we have our best ear on the ground, and that's why for months I have been suggesting that at least some areas of commercial real estate (CRE) appear on the verge of a prolonged grind up in valuations.

Mind you, I was not always as sanguine as I am now. During 2010 and a good part of 2011, I was convinced that CRE would follow in the steps of the housing debacle in a "second shoe to drop" scenario. It was not to be. A boatload of forbearances and friendly restructurings, combined with leverage that never reached the levels seen in housing, proved enough for most projects to pull through until cash flows returned.

Fast forward a couple of years, and during 2012 and 2013, allocations of new money by large investors looking for outsized yields began focusing more and more on CRE. 

As an asset class CRE offers:
  • Cash flows;
  • Potential capital appreciation from valuations that have been depressed by the crisis;
  • A sector that can absorb the large amounts of capital looking to be invested;
  • And, for the more conservative players, a place to invest in the debt layer of the capital structure, creating CRE's own credit echo-system (aside from financing from traditional lenders, in 2013 and 2014 investors poured $36 billion in real estate debt financing funds (Preqin data).
Beginning in early 2013, those allocations started hitting the market, and they are now in full swing. This dynamic would usually be enough for a healthy up period, but, as it is often the case in the boom-and-bust nature of CRE, when the going is good it tends to swing to excesses. 

There are multiple catalysts likely to underpin a long and strong cycle:
  • According to research firm Preqin, funds targeting North American commercial real estate are expected to raise about $51 billion in new equity commitments in 2015 after raising $45 billion in 2014 and $53 billion in 2013. And as of June of last year, funds had an aggregate of $94 billion in uninvested equity due to a lack of supply;
  • There is vast amounts of foreign money fleeing a Eurozone that can't get out of its own way;
  • Foreign funds are seeking out more and more the economic and political stability of the US;
  • And foreign speculators are looking at US CRE as a proxy for investing in an ever strengthening dollar;
A mere 340 words into this article, I suspect that "bubble-worshipers" already have their boiler-plate arguments ready to explain how this is "obviously" another sign that the financial apocalypse really-really-really is upon us. 

They will be right -- eventually -- but starting to play the unwind of CRE right now will be as pleasant as shorting the Treasury market has been for the last several years.

If there is one truism in CRE, it is that it is viciously pro-cyclical. Buying an asset, putting in place higher rents to increase its value, repositioning core-plus, value-ad and speculative properties, and finally selling the investment to lock in the targeted Internal Rate of Returns, all require an inherently long time, generally measured in years. 

During such time, as the early investments prove successful, they tend to attract even more money, creating and extending the virtuous cycle. The party usually comes to a close when assumptions of future rents no longer pass the "laugh test", new equity money starts to dry-up, the cost of debt rises, spreads on CMBS widen (reflecting the worsening debt-to-value ratios), and finally, properties turn over faster and faster as the Johnny-come-latelies realize that the exit door is closing fast. 

In my humble opinion, based on the amount of equity capital sloshing around and the tone of the market as I see it first-hand, the office subset of CRE is very very far away from the day of reckoning:
  • The rental market is anything but frothy in its assumptions in part because of a cyclical period of higher than normal vacancies;
  • CMBS spreads in all credit tranches remain steady at historically tight levels;
  • The amount of equity on the sidelines equates to approximately $10 of demand for each $1 of product on the market;
  • And, partly because more and more buyers are using CRE as a long-dated bond substitute, and partly because those who own don't want to sell, the turnover of properties is decent and growing, but hardly frantic. (For more color I strongly urge you to read this article)
Is it all roses? Of course not.
  • Malls are not doing great as retailers struggle with tough sales and a secular shift away from brick-and-mortar;
  • In the core areas of the super-premium office markets (New York, San Francisco, and Washington DC for example), some transactions have been underwritten at frothy cap rates, values have returned to pre-crisis levels;
  • The valuation of the recent Paramount Group (PGRE) IPO was a bit of a head scratcher;
  • The institutional size multi-family market is probably overbuilt at this point, but it is still attracting more money even as rental rates are seeing a competitive environment;
  • And lastly, there is a significant wall of CMBS maturities coming up in the next 3 years, which is likely to compete with new-deal financing.
One noteworthy point concerning the frothiest of recent deals: the most extravagant buyers tend to be foreigners and sovereign wealth funds looking to "export" large chunks of money away from unstable environments, and not fundamental investors mispricing potential returns.  

However, perversely enough, in my opinion these headwinds are a "good" thing, as rolling worries across different areas of CRE are keeping broader expectations grounded.  

So, since I know most Buzz readers tend to trade stocks and not real estate, here are some ways to play this CRE cycle:
  • The passive way is to look at ETF's like the liquid iShares U.S. Real Estate Fund (IYR) or the not-so-liquid iShares North America Real Estate Fund (INFA). Both have been impervious to the recent sharp up-and-downs of the broader market, so they have reached DeMark buy exhaustion levels. Waiting for some weakness may not be a bad idea.
  • There are also the two "deans" of real estate -- Colony Capital's Tom Barrack, and Sam Zell -- who chair publicly traded REITs, Colony Financial (CLNY) and Equity Commonwealth (EQC). The latter is particularly interesting: it was taken away from derelict management and handed off to Zell to be turned around; it also trades a convertible preferred that yields about 7%.
  • And those who really want to get fancy might want to consider pairs trades of REITs in different sectors of CRE.
In summary, pension funds and other large institutions looking for extra yield are increasingly looking toward CRE as an alternative to corporate bonds, and this money flow seems to be still in the earlier to mid stages of growth.

Twitter: @FZucchi
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No positions in stocks mentioned.
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