New York-based TIAA-CREF is considered one of the largest institutional real estate investors in the world. The self-described financial services organization has more than $435 billion in total assets under management and about $25 billion in real estate assets.
That size alone makes TIAA-CREF’s perspective important in today’s uncertain economic environment. We caught up with Philip McAndrews, the company’s managing director and head of real estate portfolio management, to pick his brain about the state of the markets and how the company is sourcing and building its investment portfolio.
NREI: What is your investment allocation for commercial real estate in 2008 and how does that differ from recent years?
McAndrews: Our allocation is between $5.5 and $6 billion for 2008, which is an increase over our 2007 program. That is higher because in addition to servicing our individual participants into our real estate investment program we also have an existing open end core fund with third-party institutional investors and continue to raise capital for that. And we are launching several new strategies, including one in the value-add space.
NREI: What commercial property sectors are most attractive and why?
McAndrews: Real estate is a very local business. With $25 billion in the U.S. and Europe where we have over $3 billion invested, we see different dynamics driving the four primary sectors [public equity and debt, private equity and debt] depending on the local issues as well as macroeconomic forces.
I feel that there are opportunities in all sectors, depending on your risk tolerance and your return expectation. We wouldn’t wholesale carve out any particular sector. At the present time we think retail investments and the apartment sector need to be evaluated with particular scrutiny due to the effect the current economic climate has had on each of these sectors.
The grocery-anchored sector within retail is certainly driven by the local economy and is less recession sensitive than power centers or regional malls. So we would not have as much of a level of concern on a grocery-anchored center as we would analyzing a power center or a regional mall.
Operating across the risk spectrum – core, value and opportunistic – at the economic inflexion point that we’re in right now, there are opportunities to take advantage of all four sectors depending on your risk tolerance. If we have a particular asset and it’s in a location that we’re interested in, we’ll just make sure we are paid appropriately for the risk relative to the transaction. Relative pricing is the most important consideration we have.
NREI: How do you source deals?
McAndrews: We have over 80 people in the equity area of real estate that are involved in acquisitions, asset management, sales, and portfolio management, all with years of real estate experience and a lot of relationships. From those relationships we’re able to derive a fair amount of off-market transactions, which is a portion of our pipeline.
In addition, the acquisition team works very closely with the commercial real estate brokerage community sourcing transactions. We see over 3,000 deals a year flowing into the house and we know from back testing and surveying that we are seeing the whole marketplace very clearly.
NREI: What percentage do you pursue and close?
As a typical real estate investor, when we’re evaluating 3,000 deals the amount you actually underwrite and bid on is probably 20% or so.
NREI: You have a lot of money to put in the ground. Will you be able to find suitable investments in the present market environment?
McAndrews: We feel confident that when we’re in inflexion points like we’re in right now that there is sufficient deal flow to satisfy investors’ needs while being able to navigate through some challenges in the economy.
We had the Russian ruble devaluation, we had 9/11, we had the dot-com bust, and real estate operators and managers managed through that. We’re faced with a capital markets issue now. Fundamentally, when you look at the subprime issue and how it has migrated into the CMBS marketplace, what’s going on is a repricing of risk. From our vantage point, though, commercial real estate fundamentals are very strong.
Our view is that the capital markets will probably take the better part of this year to clear the current backlog of securitized debt and once it recovers, there will be more stringent lending standards. Long term, we think that liquidity will come back to the marketplace.
NREI: So it’s a matter of finding the right properties at the right price?
McAndrews: While deal flow for the first quarter is a little slower than in years past, there are opportunities to invest and buy. We can buy all cash and then leverage when the markets clear. That puts us in a very strong position and as an all-cash buyer you certainly have more purchasing power and ability to source transactions.
NREI: What role, if any, do joint ventures and other investment vehicles play in your strategy?
McAndrews: We employ joint ventures on a tactical perspective and we will employ them in the future. We’re very active in the development phase, with about $1 billion in development now. We’ll use joint ventures to do development transactions and bring in local market expertise as well as construction management skills.
We also use joint ventures on very large transactions to serve as a risk mitigator. We also use them for managing third-party money. On certain separate accounts we have co-investments and we use the joint venture format for that.
NREI: How has the recent credit crunch and subprime residential situation changed your long-term investment perspective?
McAndrews: It really hasn’t changed our long-term perspective. In the short term, it could affect valuations, but we have always had a long-term investment perspective, not necessarily be a market timer but be able to navigate in a marketplace.
For example, right now we can have certain transactions that have stress and we can take advantage of that from our value-add or opportunistic perspective to recapitalize a transaction that may be under stress.
When we model real estate, like most traditional investors do, we create a 10-year model and run scenarios based on different hold periods and analyze the optimization of the transaction’s return profile. It’s the profile of the deal we’re faced with which would affect the underwriting and the perspective would also be driven by the particular investment strategy of the fund that we’re operating for.
The local perspective is so important. As much as we try to genericize sectors and the marketplace, we always have to remind ourselves that the real estate marketplace continues to have a lot of local dynamism to it. For example, there are markets that are more liquid than others. We’re seeing very strong buying power in Los Angeles and San Francisco.
While one might think that the marketplace has slowed down, the reality is that it is still localized and there is still strong demand for certain markets and people are pricing through uncertainties even now because they feel that the long-term prospects for these markets remain very strong.
NREI: Is commercial real estate more or less highly regarded today as an investment class?
McAndrews: We still see strong support for the asset class from our third-party clients. They recognize the long-term diversifying effects it has on portfolios and lower volatility relative to the other asset classes. It has matured in terms of its perspective in the investment universe.
We’re a cycle-tested team. All of the senior managers have over 25 years of experience here. We’ve seen a lot and we’re here to educate and remind people that while it’s right to be aware and concerned about the economic stresses round you, we still have to manage through those. As professional investors, we look to see if there is erosion in the underlying fundamentals and we don’t see that now. Even if they do move, we have a long way between the 12.5% vacancy rate we have right now and the 19% vacancy rate that existed in 1990 when we had that recession.
NREI: Do you use a benchmark to measure your performance, like NCREIF?
McAndrews: Like any other investor we use the NCREIF index, and it is not a perfect index, but we all recognize it is the current index. We try to understand it and all of its nuances, and we use it particularly in the core space where it has application.
We are also evaluating the use of the NCREIF Odyssey, which is an index for open-end funds.
When it comes down to the rubber hitting the road on each individual deal, we’re always deep into cap rates and IRRs. That’s where real estate people live and evaluate deals.
NREI: In your 2008 planning, how much have you already discounted the possibility of an economic recession?
McAndrews: I’m not an economist, but I can tell you we work very closely with our research team, which is headed by a PhD economist. Our real estate products are driven by both a top down and bottom up approach. We did consider the possibility of a recession this year, and it’s just a function of our culture. We have a focus on risk and we integrate research into the business planning process.
We have to design our strategies and our tactics around potential downturns. Our portfolios are constructed with sensitivity to many of the dynamic forces which are associated with recessions, such as rollover risk, tenant quality, geographical diversity, and the physical integrity of the buildings. All of these things are features we focus on in order to mitigate risk.
If you construct a portfolio like that and move into a recessionary climate, and you’ve considered all of those factors, then you’ve built a highly defensible fortress around a myriad of pressures.