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US Commercial Real Estate: Will the Good Times Last?


The CRE market has experienced a gradual recovery in asset pricing since the 2008 financial crisis, but it is uncertain whether this will continue.

Q: Do you expect a pullback in values, given the potential for interest rates to rise further over the next several years?

Chen: PIMCO remains constructive on many areas of the US CRE market. However, picking the right assets, the right part of the capital structure and the right local operators to invest with is more important today than three years ago. In PIMCO's view, the Fed is likely to remain accommodative for several years and keep yields from rising significantly. So while there was a sharp increase in interest rates early this summer, reducing the spread between cap rates and borrowing costs, we don't expect a severe uptick in cap rates unless fundamentals begin to deteriorate.

Furthermore, trends in capital flows and demand for space are the key drivers of CRE performance, not just interest rates. If rates were to rise amid an improving economy, as is typically the case, demand for real estate should have a positive effect on property performance, particularly in an environment of limited new supply that is making rents and occupancy levels less dependent on increased demand. In terms of capital flows, there are two important tailwinds: Investors currently have a risk-on attitude regarding the underwriting and pricing of CRE assets, and large institutional investors such as pension funds and sovereign wealth funds are increasing their allocation to CRE to diversify their portfolios, both as a source of income and as an inflation hedge.

Q: Can the volatility in bond yields we've witnessed create relative-value opportunities in the CRE market?

Chen: Volatility such as the sharp rate increase in June can create dislocations in the CRE market and present buying opportunities, especially if you have flexibility in how you deploy capital. For instance, public equity REITs fell 15%–20% over the summer months (as represented by the MSCI US REIT Index (INDEXNYSEGIS:RMZ)), primarily due to interest rate movements. Certain companies suddenly trade at a compelling discount to net asset value (NAV).

At PIMCO, we cast a wide net to search for undervalued CRE assets – across geographies, up and down the capital structure, and in both private and public markets. We work closely with our analytics team to determine investment outcomes across various economic conditions. This allows us to identify the most undervalued assets, since the optimal asset isn't simply one that has the most absolute return potential in a strong growth environment. That may mean, for instance, that at times of sudden deleveraging, buying CMBS is the better relative-value alternative than acquiring whole loans, or that mezzanine loans offer better risk-adjusted return profiles than equity. We're able to be flexible with our investment approach because of our broad network of contacts across the financial and real estate sectors. If you have the expertise and depth of resources to analyze a broad opportunity set, along with a longer investment horizon, there is an abundance of attractive relative-value opportunities in CRE.

Q: Where are you finding the most attractive opportunities today?

Chen: We believe certain properties in non-major markets look attractive for acquisition. We are seeing opportunities to acquire high-quality assets for attractive initial cap rates in markets with improving fundamentals, at a price point that is well below peak pricing and replacement cost, and with financing that is still cheap by historical standards. These assets offer relatively limited downside risk and the potential for rent growth and capital migration into their markets. We have also been acquiring residential land on an opportunistic basis. When PIMCO analysts predicted a bottom to the US housing market, we began to focus on residential land opportunities because of land's inherent correlation to home prices. We also observed that there were many motivated sellers. Macro views certainly don't replace robust bottom-up analysis, but in this case they helped us focus on a compelling area of dislocation.

We think this is a good time to be in the loan origination business, particularly on assets that are not stabilized. Transaction activity in the CRE capital markets is expanding the demand for floating-rate mortgages and bridge financing for so-called transitional assets. Over $1.7 trillion of CRE loans mature over the next five years and property sales are rising. Yet many banks' capacity is still handicapped by deleveraging and regulatory forces. Dodd-Frank-mandated risk-retention rules could, if adopted, make CMBS lending less profitable for conduit programs and more expensive for borrowers. Similarly, Basel III standards increase Tier 1 capital requirements and the risk weighting of certain CRE loans for banks. Both sets of regulations could decrease credit availability and increase the cost of that credit to CRE borrowers, creating a funding gap for non-bank lenders to step in and provide liquidity at attractive terms (see Figure 2). This is especially true in Europe, where tougher and cohesive regulatory oversight has begun to speed up deleveraging in the form of bulk CRE asset sales by banks. PIMCO has increased its CRE presence in Europe in anticipation of this opportunity.

This article originally appeared on PIMCO.
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