The Great Recession shattered a host of illusions — and a few pocketbooks as well.
Many homeowners were shocked that the value of their properties could decline by double-digit amounts. Such downside volatility was supposed to be confined to riskier assets like equities, pork bellies, and high yield bonds. Yet from peak-to-trough, the average house price nationwide tumbled about 33%.1
Commercial real estate fared marginally better, falling by roughly 20% between the third quarter of 2008 and the fourth quarter of 2009.2
Kelly Finegan, a Northern Trust investment analyst for the firm’s multi-manager investments group, was not caught unaware.
"Real estate is a cyclical asset and it is not immune to market forces," she said. "But that dynamic took a lot of people by surprise, especially since it was exacerbated by the credit crisis."
Though credit quality in the commercial space — an expansive group that includes apartments, hotels, resorts, shops, malls, offices, warehouses, factories and hospitals — was never a major issue, the sector nonetheless felt the impact of withering demand. Office properties in suburban areas were particularly hard hit.
But price cycles go both directions, and real estate has staged a robust recovery.
While homeowners are understandably focused on the rebound in residential property values, investors in real estate securities have pocketed significant income and capital gains from an even stronger revival in the commercial sector.
Thanks to a combination of favorable demographics, low interest rates, minimal supply and yields that soundly trump those on safe-haven debt, commercial global property prices are back in record territory.3
According to Al Otero, managing director and portfolio manager at EII Realty Securities, a sub-advisor to the Northern Multi-Manager Global Real Estate Fund, the commercial sector in the United States appears to have plenty of upside remaining.
"We think the real estate cycle is still in the early innings," he says. "There is lots of capital looking to get invested in commercial properties."
He also believes the subdued pace of U.S. economic growth is actually good for commercial real estate, since it provides enough juice to keep the economy expanding but not enough to stimulate too much new building, or supply.
While banks are willing to make loans for high-quality projects, "they are not looking for speculative development," Otero says. "That could change later in the cycle but, for now, less supply is a major positive."
Otero notes that with a few exceptions — mostly shopping centers and suburban office facilities — U.S. commercial real estate did not experience the overbuilding and over-lending that defined the country’s residential housing boom.
That leaves plenty of reason to do deals, assuming the economy cooperates. Importantly, residential real estate functions as a catalyst for big-ticket industries like appliances, furniture and electronics. Eventually, gains in those key sectors often benefit commercial property values as well.
"We call it derived demand," says Otero. "Improvement in single-family housing generally helps commercial real estate."
Fortunately, there’s been improvement in the residential market. The median U.S. house price in February was up 11.6% from a year earlier.4 After years of glut, some areas of the country are actually experiencing a shortage of homes for sale.5 As Americans feel wealthier — if only tenuously — any increased spending could continue to push commercial real estate prices up as well.
Just as elevated unemployment caused consumers to adjust their spending patterns, businesses have adapted as well. To contain costs, companies have gone to an "office lite" approach.
"The rule of thumb used to be that businesses allotted 250 square feet of space per employee," Otero says. "Now that number is down to about 150 square feet. So there certainly is less need for office space."
But while office property is struggling, other sectors have been prospering.
Apartments have been particularly strong, as tightened lending standards force more people to rent rather than own. The nation’s wobbly job market also has injected a high dose of caution into the home-ownership decision.
"Demographic trends are very favorable for multi-family properties," says Finegan. "Rents have been increasing at double- digit rates for several years."
Though Finegan expects the pace of rent hikes to moderate, she notes that income growth in the sector remains strong.
"Apartments should continue to do well as the economy recovers and household formations accelerate," Finegan says. "People are much more circumspect about sinking their life savings into a 20% down payment on a house. Plus, many don’t have the ability to put down that amount."
Otero is bullish on hotels, which he says trade at a sharp discount to replacement cost. Like the industrial property sector — an area that also has experienced significant price appreciation — hotels are closely tied to an economic revival.
Of course, cyclicality is a double-edged sword. But given the recent improvement in the labor market, residential property values and the stock prices, Otero thinks the odds favor an acceleration of U.S. economic growth later this year.
"In that environment, hotels would be a primary beneficiary," he says. "And the price is still right."
West End story
Otero and Finegan each recommend a global approach to investing in commercial real estate because of the added diversification it provides.
Just as commercial real estate is comprised of multiple sectors with their own supply-demand dynamics, the property market also differs by country and region.
London’s famed West End, for instance, is home to some of the world’s most coveted properties.
"London is a global city, the ultimate safe haven for capital worldwide," Otero says. "It has gotten more expensive, but the fundamentals are still strong and vacancy rates have been declining."
The situation in continental Europe is more complicated. European banks have been slower to off-load non-performing real estate loans than their American counterparts, thus restricting the availability of credit in the region.
Aside from the eurozone periphery, though, property values have held steady.
"Vacancy rates are relatively low in most of the prime markets," says Finegan, "and there hasn’t been much new development." Though European property companies generally are trading below their net asset values, Finegan thinks the discount is appropriate given the region’s lackluster growth rate and the possibility that the banking crisis will have yet another unpleasant chapter.
Still, private equity and hedge funds are combing the more economically distressed regions of the eurozone for distressed properties. Insurers and sovereign wealth funds desperate for yield are on the prowl as well.
So far, Otero has kept a safe distance, but acknowledges that "a wall of speculative capital" is looking to snap up secondary and tertiary real estate on the cheap.
That hasn’t happened yet, despite a growing price gap between prime real estate and everything else. Over the last three months of 2012, Germany, France and the United Kingdom attracted almost three-quarters of the money invested in European properties, with Italy and Spain getting only 3%.6
The emphasis on quality echoes Warren Buffett’s iconic line that he’d rather own a great company at a fair price than a good company at a great price.
The dominant factor impacting property values in Asia is the relentless relocation of Chinese workers to the cities from the countryside. It’s a human dynamic that has vexed monetary policymakers caught between an irresistible historical force and the equally strong need to avert a property bubble.
Though Otero remains "constructive" on China — particularly its retail sector — he prefers to use Hong Kong property companies to gain exposure to the mainland. He believes that the problem for real estate investors in China is not excess credit, but rather the unrelenting demand for housing that is a corollary to the country’s transition from an agrarian economy.
Chinese migrants now number about 160 million people, and another 100 million rural residents are expected to move to urban areas by 2020.7
Surprisingly, some of the best opportunities in Asian commercial real estate might be in Japan, which has fought a mostly losing battle with deflation for two decades.
"We are seeing some positive trends in Tokyo office property," says Finegan. "Vacancies are down over the last two quarters,8 and there is reason to believe this positive trend will continue for the remainder of 2013."
The "REIT" stuff
Companies that invest in income-producing properties — a group known as real estate investment trusts, or REITs — provide individual investors with a means of both liquidity and broad-based participation in the commercial market worldwide.
"If you want to achieve global exposure to real estate with income producing potential, there is no better way to do it," says Otero, "You cannot go out and replicate the types of portfolios that investment managers can buy every day on the New York Stock Exchange."
Finegan believes that while many U.S. REITs are trading at a premium to net asset value, demand is being sustained by investors attracted to their clear yield advantage compared to Treasury bonds.
"Valuations can be viewed in a number of ways, and relative to the underlying real estate, they do look a little pricey," she says. "But what’s driving the bull market in REIT prices is the unprecedented low-interest rate environment."
As of March 31, the average domestic REIT, as measured by the MSCI U.S. REIT Index, posted a 3.54% yield,9 which compares favorably to the 2.05% yield on the S&P 50010 and 1.87% yield on 10-year Treasuries.11
Otero and Finegan each believe that most investors should have some exposure to commercial real estate and, preferably, on a global scale.
Besides increased diversification, Finegan sees other potential benefits as well.
"Commercial real estate securities can provide investors with the possibility of an attractive income stream and a potential hedge against inflation," she says. REITs are required to pass along at least 90% of taxable income to shareholders each year.12
Will Rogers famously quipped that owning land made sense because they weren’t making it any more. For investors seeking income and growth in a low-yielding, slow-growing world, his advice seems well worth considering.
Accessing the Real World of Bricks and Mortar
Northern Trust offers investors two strategies for adding global real estate to their portfolios. As its name implies, the Northern Multi-Manager Global Real Estate Fund uses carefully vetted active managers (sub-advisers) whose complimentary styles are designed to potentially mitigate volatility, but without sacrificing upside potential. As of March, about half of the Fund’s assets were invested in North America. See the Fund fact sheet for more details. Investors preferring a passive management style might choose the Northern Global Real Estate Index Fund, which seeks to replicate the total return of the FTSE EPRA/NAREIT Global Index, a popular world benchmark of publically traded real estate securities. See the Fund fact sheet for more details. "Both funds offer broad exposure to the global real estate market," says Northern Trust’s Kelly Finegan, an analyst for the firm’s multi-manager investments group. Talk to your Northern Trust relationship manager for help in deciding whether the active or passive approach is best for your situation.
Past performance is no guarantee of future results.
Equity Risk: Equity securities (stocks) are more volatile and carry more risk than other forms of investments, including investments in high-grade fixed income securities. The net asset value per share of this Fund will fluctuate as the value of the securities in the portfolio changes.
Index Fund Risk: The performance of the Fund is expected to be lower than that of the Index because of Fund fees and expenses. It is important to remember that there are risks associated with index investing, including the potential risk of market decline, as well as the risks associated with investing in specific companies.
International Risk: International investing involves increased risk and volatility.
REIT/Real Estate Risk: Investments in the Fund are subject to the risks related to direct investment in real estate, such as real estate risk, regulatory risks, concentration risk, and diversification risk. Investments in REITs involve certain additional unique risks. By itself the Fund does not constitute a complete investment plan and should be considered a long-term investment for investors who can afford to weather changes in the value of their investments.
The FTSE® EPRA® /NAREIT® Global Index is a free float, market capitalization-weighted real estate index designed to represent publicly traded equity REITs and listed property companies globally. Expanded in December 2008, the FTSE EPRA/NAREIT Global Index covers both developed and emerging markets, and represents 38 countries worldwide. It is not possible to invest directly in an index.
The MSCI U.S. REIT Index broadly and fairly represents the equity REIT opportunity set with proper investability screens to ensure that the index is investable and replicable. The index represents approximately 85% of the U.S. REIT universe. It is not possible to invest directly in an index.
1 "Home prices may not return to peak until 2023." Les Christie. CNNMoney. September 26, 2012
2 NCREIF, PREI Research
3 NCREIF, PREI Research
4 "Existing home sales touch three-year high." Lucia Mutikani. Reuters. March 21, 2013
5 "Sudden Rise in Home Demand Takes Builders by Surprise." Catherine Rampell. The New York Times. March 20, 2013
6 "Secondary meltdown: Prime assets stay central to demand." Ed Hammond. Financial Times. March 11, 2013
7 "The Impact of Chinese Migration: We Like to Move It Move It." The Economist. February 25, 2012
8 "Tokyo office market fights back after 20-year slump." South China Morning Post. March 13, 2013.
11 Federal Reserve
12 Securities and Exchange Commission