Bob Bach, national director of market analysis for Grubb & Ellis, sums up 2005 as the year of Goldilocks in commercial real estate. It’s neither too hot, nor too cold. While leasing activity is on the rise and vacancy rates are dropping, particularly in the office market, a projected rise in interest rates isn’t causing a pullback among yield-hungry investors.
What is the near-term outlook for capital flows into real estate exactly, and what are the challenges for acquirers and sellers of commercial real estate in this supercharged investment climate? To get the answers those questions and much more, NREI Editor Matt Valley journeyed to Miami earlier this year to moderate a roundtable panel at a key investment client conference hosted by Grubb & Ellis at the Mandarin Oriental Hotel.
The six-member roundtable panel included:
Nick Buss, senior vice president and group manager for real estate market research and valuations with PNC Real Estate Finance
Paul Michaels, director of portfolio management with Invesco Realty Advisors
Parker Hudson, senior managing director and vice president of portfolio dispositions at Wells Real Estate Funds
John Guinee, executive vice president and chief investment officer for Duke Realty Corp
Kevin Shannon, senior vice president of the institutional investor group for Grubb & Ellis based in Southern California
Eric Berkman, senior vice president with Grubb & Ellis, specializing in the acquisition and disposition of office investment properties in the greater Washington, D.C. area.
What follows is an edited transcript:
NREI: Nick, in a recent estate market outlook report, you write the following: “The strength of the capital flows will remain the critical driver of real estate markets in 2005 and will overshadow any improvements in space market fundamentals, good or bad.” Can you expound on that point?
Nick Buss: The capital flows issue is certainly, as I see it, the overriding factor again this year. It has been as we’ve come through the recession and the last three years where the strength of the capital flows has continued to overwhelm the weak fundamentals that we’ve had in the market on the good side.
Obviously, if you’d have asked anybody in this room five years ago, given where we saw vacancy rates go across all markets, if we would have had this inflow of capital that we have seen and have seen cap rates come down as slow as we have seen them, I’m not sure anybody would have been brave enough to predict that.
And the volume is off the walls. On the sales side, if you look at the numbers coming out of Real Capital Analytics, I think they’re going to show at the end of the year well over $150 billion worth of institutional transactions last year. That’s up 40% to 50% over 2003 levels.
The debt market grew by more than $200 billion in 2004. In the last seven years, we have doubled the size of the commercial real estate debt market from $1.1 trillion to $2.2 trillion. Capacity continues to grow.
To the question at hand: Are the flows going to continue over the next year? As you look ahead, it’s tough to see why they won’t. As Bob Bach, [Grubb & Ellis researcher] said, we’ve got the economy turning in our favor. We’re seeing decent growth, unspectacular, albeit. It’s decent growth. It’s going to put some wind in the sails of the leasing market this year, at least.
In terms of interest rate movement, our economist is looking for a 10-year Treasury at the end of the year to be a touch under 5%. We’re expecting on the short-term side to see the fed funds rate go up four or five times next year, again at a quarter percent a shot.
Having said that, we’ve really got to look at what the alternatives are. Over the last three years, we’ve seen the money come into real estate It’s really the best alternative out there. The best of the worst, as it’s often said. But the returns continue to be pretty good, even though cap rates are down. Again, if you look at Real Capital Analytics numbers, I think it’s showing an average cap rate of about 7.5% now. It’s down 200 basis points over the last two to three years, but having said that we’re still 350 basis points, plus or minus, above the 10-year Treasury, which is a pretty decent gap if we look historically. Typically, real estate has been trading at somewhere between that 300- and 400- basis point range.
And then you look at the alternatives for the year, and it looks like the equities market is not going to do anything off the charts. It’s tough to see where that money is going to flow to. If it continues to look to yield, real estate still looks like a decent place. So, I am holding my breath in terms of where the prices are. We are somewhat in uncharted waters. But I don’t see the capital flows slowing down significantly this year.
NREI: Paul, CalPERS, the largest U.S. pension fund, announced in December that it was decreasing its real estate allocation from 9% to 8%. That amounted to about a $1.7 billion shift. CalPERS still has $12 billion invested in real estate. The pension fund giant says it sees an opportunity to sell. What is happening with allocations of institutional investors over time? Is the CalPERS example, an isolated one, or are allocation ranges in general widening?
Paul Michaels: Sure. Luckily I happened to recently be with Mike McCook, who runs the real estate program for CALPers. And he was asked a similar question. Basically, the fund has grown by such a level over the last couple of years that it was really an adjustment for them to stay with the existing allocations that they had. So, while they’re decreasing the percentage, they actually have still more money to invest this year than they’ve had in the past.
I think that everyone is aware that the flow of money into real estate continues at the institutional level for all the obvious reasons. Alternative investments, as well as just the growth in all the other asset classes, just help the tide rise in terms of money available for real estate.
Ten percent has kind of been your historic expected allocation for the real estate asset class. For many, many years the challenge was that the investor just couldn’t achieve that level. Then, of course, you had the 2000 crash and what became known as the denominator effect: All of a sudden someone’s 6% allocation to real estate became 10%, or even over their allocation.
So, there was a little bit of slowdown of capital. But now that both the growth of inflows into the funds, as well as appreciation in the equities and international, is once more freeing up a lot of money available for real estate.
Real estate continues to be a desirable asset class, a hard asset class that people like. Obviously, we’ve all heard about the attraction of the income component for pension funds. So, I think the wave continues. The allocations of most institutional investors are increasing – perhaps going from a range of 7% to 8% to a range of 8% to 10%.
One area that’s having a larger impact, but maybe not quite as known, is the number of investors coming into the asset class that previously didn’t have real estate in their portfolios at all. That may be a signal for all of us. But the truth is the money is continuing to flow. And we don’t see that slowing down, like Nick says, any time soon.
NREI: Have institutional investors lost their competitive advantage in the marketplace because of this flood of capital. How are they adjusting to this situation?
Paul Michaels: That’s the million-dollar question: What should they be doing? Obviously, institutional money is typically known as being a little more patient. So they’re more apt to sit and watch, and then maybe on the negative side react late, or at the wrong time, or for some of the wrong reasons.
But, again, I think we all know about the private buyer, the TIC (tenant-in-common) buyers, the highly leveraged buyers. Historically, that’s not the area most institutions played in. I think most have been patient. The challenges that we all experience in terms of deal flow and accessing deals due to pricing is just the nature of the business.
Hopefully with this small uptick in interest rates (during the first quarter of 2005), I think that’s helped level the playing field a little. I think that institutions are becoming more accepting of leverage and leveraged returns. Lowering yield expectations, frankly, is probably the single issue that may be a little slow to get to the party. But today it’s not uncommon for institutional investors to talk about 8% total returns. That took a while to swallow.
NREI: In terms of product types, what are the real opportunities at this point for institutional investors? For example, I know that CalPERS is getting back into seniors housing.
Paul Michaels: Other than the basic four food groups, the most interesting one that I’ve heard of recently — and some of you all may have even more experience with it than me — is the condo conversion craze on the residential side. We’re here in the heart of it in Miami. Just look out your window — both condos and condo conversions.
But I would point to “for-sale” housing in general, including condos and for-sale land development. I believe CalPERS has had a program for many years. Historically, that’s not an arena that institutions and pension funds in particular have played in. There are certain tax reasons and other specific reasons why that’s not the case. I definitely see that as an oncoming wave, and clearly international. We all see that whole globalization of real estate. I think that will continue as well as all the other peripheral areas that you mentioned.
NREI: Let’s turn to Parker Hudson. At the start of 2005, Wells Real Estate Funds’ sponsored programs own more than $6 billion in real estate assets with some 30 million sq. ft. of space. Early this year, Wells disclosed to shareholders that it’s considering selling roughly 20% of its real estate portfolio, something like 32 office and industrial properties in the Sun Belt for close to $1 billion. Are dispositions something new for Wells? Or have they always been a part of the strategy and we just haven’t noticed it?
Parker Hudson: Being the head of dispositions at Wells is a fun thing right now. We did a multi-regression analysis over the course of about three months. We had a lot of advisors, and determined that we could sell some of this real estate for more than we paid for it. So, we’re going to sell it. (Laughter)
Wells hasn’t sold much over the 20-year run. From the company’s beginnings in the mid-1980s until 2003, we had sold a total of $40 million worth of real estate. Last year we ramped up and sold about $100 million, of which probably 60% was from some of our older limited partnerships that are still out there because Leo Wells never used debt. So, when the RTC (Resolution Trust Corp.) came through and wiped out everybody else’s limited partnerships because they had overleveraged for tax purposes, we didn’t ever have any debt. And so we own small office buildings in the suburbs of Atlanta, and it’s a good thing.
Part of what we’re selling includes those properties simply because of the lifetime of limited partnerships. The real estate may be great, and you may want to keep it, but people have been in our program for 15 years and it’s just time, for their sake, to sell. That’s a lot of what we’re doing.
But then moving to the REIT, we’re basically doing portfolio balancing like everybody does. And maybe some of the properties that we bought when the REIT first began in 1998 and 1999 are in markets that subsequently to that we haven’t gained a critical mass. And so it just makes sense if we have one building in one place, why not sell that and invest somewhere where we have a critical mass.
And so we didn’t start out to say, “Let’s go sell $1 billion of real estate.” We started out looking at each of the 114 or so properties in the portfolio, and we did an analysis on each one of them, and decided that this group for various reasons needed to be sold. It’s as much an art as a science. So, we are net buyers of real estate. We hope to acquire close to $2 billion worth this year. But we will sell about $1 billion worth as well.
NREI: And who’s buying?
Parker Hudson: I was a real estate broker for 30 years, and I found that since being the managing director of dispositions at Wells that a lot more people return my phone calls. (Laughter.) Everybody is buying. I really mean that seriously. We have Canadian REITs. We have foreigners. We have other public entities and individuals.
In really thinking back on the sales that we’ve done in the past two years, it seems like in every case there’s somebody who sort of steps forward, whether it’s an institution or an individual, and just sort of from the beginning basically announces, “I want to buy this asset.” Not quite in those words, but just sort of let’s you know by their activity, by what they do.
In the cases of these $10 to $15 million assets that we have in limited partnerships, in most cases the buyer is an individual who is coming out of a 1031 Exchange. He or she has owned an apartment building, for example. We’ve got an asset that has a single tenant, and that investor just makes a real great effort in terms of price and commitment to doing the deal.
NREI: Is price most important to you as the seller or is it one of many factors?
Parker Hudson: We consider ourselves stewards of these 150,000 investors that we have at Wells Real Estate Funds. As you probably know, we don’t raise any of our money from Wall Street. It all comes through financial planners and through individual mom-and-pop investors like your parents and you. We have a real commitment to stewardship for those people. So, we don’t sell something because someone calls and says, “I’ve got $100 million and what do you have to sell?” We go through very serious analysis of each asset.
And the good news for those of you who are real estate brokers from Grubb & Ellis is that we list every property with somebody. We want the full marketing. We want to expose it to the broadest possible market. We don’t do direct deals. And the point of that whole process is to get the best price. And that is what we’re focused on, because at the end of the day I need to be able to sit down across from any of your moms or dads and tell them that we got the very best price for them.
NREI: Let’s turn to the brokers for a moment. Eric, you’ve stated that Washington, D.C. has evolved from a sticks-and-bricks type market to one that’s much more sophisticated. Tell me a little bit more about what you mean by that exactly.
Eric Berkman: Every major player in real estate is coming into Washington, D.C. right now. Washington, in a lot of ways, has kind of led the transformation in real estate from a sticks-and-bricks old school type of transaction where the guy at the country club went to his buddy down the street that was the banker and they did a deal on the back of a napkin. Everything in the old days was secretive and there was no transparency in the transaction. Today, however, it’s an incredibly efficient, transparent market where almost every single aspect of a transaction is known.
Probably every single one of you in this room has probably scratched your head at how efficient the Washington market is. As soon as you’re poking around at a property, everybody knows about it. Everybody knows the purchase price. Everybody knows the rent roll. The analysis that you do on the property is now standard and uniform. You have these incredibly efficient tools like Argus, CoStar and broker information.
In some ways, the information that we provide on a property is much more accurate and detailed than what you’d see a Wall Street analyst preparing on a stock. It’s an incredibly efficient system out there valuing real estate.
Real estate has moved from a sticks-and-bricks type of analysis to really now a pure stock type of an asset-class analysis. And we’ve really seen that in the last couple of years.
A lot of people ask me where the opportunities are. The next wave that that you’re going to see is the continued push into the core markets like Washington, D.C. But now you’re going to see some of that pulling up the second-tier and third-tier markets where there’s more opportunity, and I think that’s the place to be looking in the next year or so.
NREI: Let’s follow up on Eric’s point regarding secondary markets. Parker, Wells bought One West Fourth Street in Winston, N.C., a 431,000 sq. ft. office building in Winston-Salem, N.C. Do you expect to do more of that type of deal going forward, or was that the rare exception?
Parker Hudson: We’re focused on the core markets like everybody is, but we’re income-driven. So, we will take a small part of the overall $5 billion REIT and do different things with it. In that case in Winston-Salem, we had probably one of the top buildings in the city that included a long-term lease with Wachovia and with one of the Southeast’s largest law firms. So, we wouldn’t have invested the entire portfolio in that type of property. But it was a good return. If those types of opportunities come along, we certainly will look at them?
Audience question: What kind of pricing premium do you get in a tertiary market like that vs. a well-known secondary market like the suburbs of Virginia, or a core market?
Tom Hallowell (former senior vice president of acquisitions at Wells and audience member): It was about 12 months ago for that particular transaction. That was easily a 150-basis-point differential. What made that opportunity unique was that we were able to assume some life company debt at a very low interest rate that had a very aggressive amortization schedule. And it matched up very well with some aggressive steps in the lease.
So, at the end of a 10-year hold period our basis on that asset was considerably lower than what we paid for it. As Parker alluded to, it was one of the two best buildings in Winston-Salem, with two very strong credit tenants leased long-term. But I would say at the time it was probably 150-basis-point differential. I suspect that gap has shrunk considerably since then.
NREI: Paul, how do institutional investors view a secondary market vs. a primary market in terms of the risk-return profile?
Paul Michaels: It’s a tough question without an easy answer. Obviously, liquidity is a key area that we look to. But as the question alludes, if there’s enough of a premium is it worth the risk to go into those types of markets?
To us, the fundamental underlying real driver is just the projected growth and fundamentals. So a secondary market like Austin, [Texas,] or Raleigh, [N.C.], might have a stronger appeal to than maybe some of the Midwestern secondary markets that maybe have just a little growth. But like anything, you just have to look at the overall market and then the specific opportunity, the specific product type. But I do think it’s fair to say that most institutional investment has gravitated toward the primary markets.
NREI: Can you give us some insight into how the cap rates differ between primary and secondary markets? Tell us what’s going on out there.
Paul Michaels: I think cap rates are compressing. Clearly all things being equal, we will stick to the primary markets. But if there is the pricing differential, that might pull you to the secondary. And then you get into the question: Is 50 basis points or 100 basis points worth that differential or risk. I would say there is a premium, but it’s narrowing.
NREI: Kevin, with respect to the investment sales market, can you give us some insight into the trends you’re seeing on the West Coast?
Kevin Shannon: The West Coast is similar to Washington, D.C. Eric and I were talking last night about how fortunate we are to be in the markets that we’re in. In our market every buyer group is in play. The fundamentals are strong. I think Chicago, New York and then D.C. and Southern California/Los Angeles account for half the sales nationally. The deal flow is terrific.
The leasing fundamentals on the West Coast really improved in the fourth quarter of 2004. Cap rates are down to 5% for core office product in San Diego. If you have a listing in Southern California, you’re going to do very well. On the flip side, a lot of you are acquisition people, and it’s tough right now. But for the investment brokers and for the sellers, right now it’s a terrific time.
NREI: Let’s bring in John Guinee into the discussion to talk about the industrial market, in particular. Duke owns interest in more than 109 million sq. ft. of properties, both industrial and office. The company also runs or controls more than 4,000 cares of undeveloped land, so there’s a huge development potential there for something like 63 million sq. ft. John, would you describe the company today as a net buyer or seller?
John Guinee: We are primarily a development company. The last couple of years we acquired about $250 million worth of product, and we sold about $150 million worth of product each year. And we are always looking for development equivalent yields on the acquisition side, which pushes us out the risk curve.
We also are a little bit constrained because we know too much about what the leasing markets are really like and what tenants will pay for and why. And we are extraordinarily reluctant to acquire any industrial product unless it’s state-of-the-art. That pretty much puts us in the development game only on the industrial product. Over the past six years, we acquired six different industrial deals, but each one of them was a redevelopment or an expansion.
On the other hand, in the office market you can still acquire office product for less than replacement costs in a lot of markets, though it’s getting tougher to do. And the dated office product is not as functionally challenged as the dated industrial product. So, we continue to be fairly active on the office side (in terms of acquisitions).
What happened in 2004 the investor expectations in the secondary markets, which is where we operate, got a lot more aggressive, which sort of squeezed the margins for us. So 2005 will probably be a year where we dispose of more product than we acquire.
NREI: John, nationally there is a lot of speculative industrial building occurring. Does that concern you?
John Guinee: On the industrial side, we think that the crazy aunt that lives in the basement that no one talks about is the new development. Essentially when you’re in Dallas, Atlanta, Chicago, Columbus, Indianapolis, where you have some industrial absorption, everyone who can spell real estate is trying to develop in those markets. And we keep a very active inventory of who owns what land. And the amount of land that has sold to people who are about to break ground is pretty extraordinary. Some of the analysts on Wall Street have picked that up and others haven’t. But we really do see an incredible oversupply coming in, particularly in industrial and particularly in those markets where merchant builders can exit.
That’s another important point. For most of our competition on the development side, it’s a very simple equation: build it for $30 bucks per sq. ft, find someone who can fog the mirror for a few months and send in a couple of rent checks, and sell it to an institution for $35 or $40 per sq. ft.
NREI: Nick, are the lower cap rates cap rates a permanent shift, a new paradigm if you will, or is it simply a function of historically low interest rates?
Nick Buss: I think it’s a mixture of those two. Certainly you’re never going to take the cyclicality out of the business. Real estate is a cyclical business. That isn’t going away. But I think you have seen somewhat of a re-pricing of the asset classes. As Eric talked about, it’s the institutionalization, if you want to use that term, of real estate that we’ve really seen over the last decade. The emergence of REITs and the CMBS market over the past decade has led to greater transparency in terms of the timeliness of the information and the quality of the information. We’re basically all working with the same deck of cards. I think that has really removed some of that volatility and has removed the premium, for the lack of knowledge, that was there previously.