As the fourth largest institutional real estate manager in the United States, Des Moines-based Principal Real Estate Investors manages more than $40 billion in commercial real estate assets.
President and chief investment officer Randy Mundt joined Principal in 1983, and is responsible for the development and execution of client investment strategies across all Principal’s real estate quadrants, including investment pricing, performance and policy. He also chairs the firm’s real estate investment committee and client strategy committee. NREI recently spoke with Mundt about the state of the credit markets to get his take on what the future might hold for investors.
NREI: How has your real estate strategy changed in the past year? How have your underwriting standards changed?
Mundt: The primary change in strategy we have observed this year is a directional shift in client investment focus toward high-yield real estate debt strategies, given the sudden and major price corrections and subsequent relative value in that sector. This includes client interest in higher quality CMBS, given record wide spreads, as well as origination and secondary market purchases of private market subordinated debt. Our underwriting assumptions have been adjusted to reflect the increased uncertainties associated with both the ongoing credit crisis and economic outlook, including a likely reduction in rent growth and net absorption through the remainder of 2008 and 2009.
NREI: How have your return expectations changed in the past year or two?
Mundt: Commercial real estate values are likely to continue to come under downward pressure over the next several quarters, transitioning from what was a priced-for-perfection environment to now increasingly priced-for-correction. The forces of correction include a moderate weakening in space market fundamentals, especially on the demand side given that supply remains reasonably well controlled, and an uptick in cap rates and discount rates as required risk premiums increase. Using NCREIF (National Council of Real Estate Investment Fiduciaries) as a benchmark, it is conceivable that total returns for 2009 and early 2010 will be negative as value writedowns exceed current income. However, over the longer term, a return expectation of 8% to 9% for NCREIF seems reasonable.
NREI: What is the No. 1 challenge facing commercial real estate investors?
Mundt: The most important issue is the risk that the disruption in the credit markets, which is now over a year in duration, could become so prolonged and severe that it tips the economy into an extended recession that results in even larger job losses and a sharp deterioration in space market fundamentals. We don’t believe that such a scenario is the most likely outcome, but it does represent a risk that needs to be considered.
Since the U.S. commercial real estate markets have largely managed to avoid oversupply, the greatest risk is a sustained decline in demand. Thus far the U.S. economy has proven to be quite resilient, and even the job loss numbers to date have been less severe than previous downturns. If the commercial real estate markets can manage to navigate the credit crisis and economic downturn with vacancy rates staying below levels reached during the downturns of the early 1990’s and 2001, the adverse economic impact on commercial real estate should be manageable.
NREI: What role does international/emerging market investing play in Principal’s future strategy?
Mundt: At this stage, non-U.S. markets have played a limited role in our business plan, as we are predominantly U.S. centric in terms of our current investment strategies. However, this is beginning to change, as we do have a global property securities capability and in addition we have plans to expand our global capabilities in the other commercial real estate quadrants over the next three to five years, given the attractiveness of these markets to our institutional clients.
NREI: What role do investments in the debt markets play in your strategy?
Mundt: Debt investments represent a very key element of our overall commercial real estate strategy. In fact, approximately half of Principal Real Estate Investors $45 billion in assets under management are real estate debt oriented. Client demand for commercial real estate debt investments is on an upward trajectory, given that debt markets have already undergone a very significant pricing correction, and in some cases an overcorrection, that we believe represents excellent relative value.
NREI: Which property types do you favor and why?
Mundt: Warehouse, renter-by-necessity apartments, student housing, and grocery-anchored retail centers are all property types that have strong appeal due to their defensive nature in the current environment of economic uncertainty.
NREI: What markets do you favor and why?
Mundt: Principal generally favors markets with geographic or regulatory supply constraints, strong long-term demographic drivers, and a dominant presence of industry sectors or companies with strong global pricing power and sustainable competitive advantages. Given that the era of cap rate compression is over, we believe the key to future performance is maximizing occupancy levels through both strong leasing activity and minimization of tenant credit defaults, as well as growing rents by focusing on markets that provide the opportunity for sustained landlord pricing power.
NREI: How wide is today’s bid/ask spread, and when will it narrow enough to foster more deal flow?
Mundt: The bid-ask spread remains quite wide, and it is not uncommon to see a gap of 15% or more between seller expectations and buyer bid levels. One reason it has not narrowed materially is that only a few sellers are under distress currently, given low interest rates and still reasonably strong space markets, resulting in very low mortgage delinquency rates to date. Most current distressed situations are tied to the borrower’s inability to refinance highly leveraged maturing debt, as opposed to term defaults, and as such are still fairly isolated and not causing widespread concessions on the part of the majority of sellers.
At the same time, buyers are patient partially because there are other sectors such as CMBS and mezzanine debt where they can get equity-like returns. We expect the narrowing of bid-ask spreads to be a very gradual process, linked to the timing of ultimate restoration of stability in the credit markets, including greater availability of commercial real estate debt capital.
NREI: Is the credit crunch deeper than you expected, and are its effects more onerous than anticipated?
Mundt: Yes, the duration and severity of the credit crisis has exceeded the expectations of many investors, including ourselves. Despite repeated government policy initiatives which have gone well beyond traditional monetary response, market volatility and ongoing credit losses have become the norm in 2008. A key underlying theme is a loss of confidence in both the balance sheets of financial intermediaries and in securitized investment products, which has pushed spreads to record wide levels. However, despite all of the credit market turmoil, the U.S. economy continues to demonstrate its resiliency in the face of major housing and consumer headwinds.
NREI: As a long-term investor, what do you make of sagging property valuations and their impact on your portfolio?
Mundt: While price corrections clearly will have an unfavorable impact on total returns over the near to intermediate term, increased risk awareness and risk re-pricing is a healthy development for the real estate markets long term. Years of upside-only variances had led to risk complacency in many sectors of commercial real estate and contributed to the asset class becoming priced for perfection.
Also, while reduced availability of debt capital is certainly not favorable from a transaction volume and liquidity perspective, it will help further control new supply, in turn supporting space market fundamentals. Price corrections will also create buying opportunities for institutional clients that have additional capital to get invested.
NREI: Are you doing more joint ventures?
Mundt: Principal has traditionally engaged joint venture partners on its value-add and opportunistic projects, given these partners’ strong local knowledge and capabilities, which allow for more effective risk management, and we plan to continue to do so. It is also worth noting that green or sustainable properties are increasingly part of our investment strategies, and as a result, joint venture partners with green capabilities will be an important element of our success.
NREI: Can you give us an example of one particularly successful investment?
Mundt: Sure. We are in the process of developing a two-phase, LEED-certified office project in the energy corridor of Houston. The first phase was started on a speculative basis, but became 100% leased to a single tenant before shell completion, providing excellent returns for our investors. We have started construction of the second phase, and the leasing pipeline looks quite robust, with a good likelihood that it also will be substantially leased before shell completion.