Throughout 2003 and 2004, private buyers held the upper hand, winning many trophy properties with record bids. But now institutions are pulling ahead. According to Real Capital Analytics, institutions emerged as the top buyers in 2005 and will likely remain active players in 2006.
Pension funds plan to invest $59 billion in real estate in 2006, up from $51 billion in 2005, according to a survey of the largest plans conducted by Institutional Real Estate Inc. and Kingsley Associates. “The pensions and institutions have plenty of cash now, and they should remain dominant buyers throughout 2006,” predicts Josh Scoville, research strategist for Property & Portfolio Research, a Boston-based research consultant.
In recent years, many institutions have been frustrated, losing bidding contests because prices were simply too high for portfolios with a conservative strategy. Aggressive private buyers often emerged as winners.
But shifts in interest rates have changed the picture. After hitting a low of 3.89% in June 2005, yields on 10-year Treasuries rose to 4.66% in November. Since then the yields have drifted down to around 4.4%. This modest rise in rates has eroded the profit margins of leveraged private buyers and strengthened the hand of institutions that pay mostly with cash.
Rising cost of leverage
A year ago, mortgage rates on trophy office properties stood as low as 4.5%, while cap rates on prime properties hovered around 6%. Under those favorable conditions, aggressive private buyers could borrow 80% of the cost of buying a building and still obtain double-digit cash flow returns.
With such rich payoffs, private entrepreneurs could afford to leverage 95% or more of the purchase cost and pay high prices. In one of the splashiest deals of recent years, the Chetrit Group and other private investors paid $840 million for Chicago's Sears Tower in 2004. Bank of America reportedly loaned 98% of the purchase price. “If you can put down a few million dollars and control a big building, that's a pretty incredible deal,” says Robert White, president of Real Capital Analytics, a consultant in New York.
Conservative pension funds, which usually won't leverage more than 50%, could not keep up in the bidding wars. But in recent months, mortgage rates on prime offices have risen 100 basis points to 5.5%, and cap rates on prime office buildings have dropped about 50 basis points to around 5.5%.
In that environment, many highly leveraged deals no longer make sense. “Leveraged deals like the Sears Tower purchase are very hard to do in today's environment,” says Timothy Welch, executive managing director of brokerage Cushman & Wakefield based in New York.
With private buyers less active, the way has been cleared for institutions. Last July, Metropolitan Life bought 575 Fifth Avenue in Manhattan for $376 million, or a cap rate of 5.2%. The seller was Sterling Equities, a private firm. In another deal last year, Teacher's Insurance & Annuity (TIAA), the pension giant, bought 99 High Street, a Boston office building, for $272 million at a cap rate of less than 6%.
The seller was Walton Street Capital, a private group. Of the nine losing competitors that bid on the Boston property, most were private groups. “Pensions are winning more properties because the private buyers are holding back,” says Doug Poutasse, chief investment strategist of Boston-based AEW Capital Management, which oversees investments for pensions and institutions.
Weighting the portfolio
Whether or not private buyers provide formidable competition, institutions are likely to remain aggressive participants. For starters, many institutions are holding lots of cash.
In the late 1990s, many invested in real estate funds with time frames of five or seven years. At the end of the defined period, the funds must liquidate their assets and return cash to investors. That trend has been growing in the past year. “The pensions have been very happy with their returns, but now they must put the cash back to work,” says Scoville of Property & Portfolio Research.
Besides reinvesting cash, many funds hope to increase the size of their allocation to real estate. With bond yields still skimpy, real estate looks like an appealing alternative. And compared to the erratic moves of stock markets, real estate has appeared rock solid. Many properties look especially attractive now because their operating profits are improving. Occupancy rates are climbing in many markets for apartments and offices.
Pension funds hope to have 7.9% of their assets in real estate in 2006, according to a recent survey conducted by Institutional Real Estate Inc. But many plans are far from their goals. According to a separate survey compiled by the Pension Real Estate Association (PREA) of its members, 77% of plans own less real estate than they would like.
Part of the shortfall can be traced to aggressive bidding by private investors. In addition, pension funds suffer from what is known in the industry as the “denominator effect.” Total assets in pension funds have risen so dramatically that the percentage invested in real estate has stagnated.
In 2003, real estate accounted for 5.5% of the assets in the average pension fund, according to PREA, while stocks made up 57.4% of the investment portfolio. In 2004, pensions bought more real estate, but the sector still accounted for only 5.5% of assets.
Meanwhile, stocks as a percentage of total assets had climbed to 60.2% because of a steep climb in the S&P 500. “Four years ago, many institutions were at their target levels for real estate,” explains Russell Appel, president of Praedium Group, a real estate private equity investor. “Now many people are below their targets, so you will see more capital moving into real estate this year.”
Brokers say that private buyers began facing obstacles in 2004 and 2005. At the time, cap rates were dropping sharply for nearly all property types. Cap rates on garden apartments fell from above 7% in the summer of 2004 to around 6% by late 2005, according to Real Capital Analytics. During the same period, cap rates dropped on offices from 7.5% to 6.3%. Retail cap rates also fell from 8.5% to 7.2%.
Lower cap rates along with rising interest rates have helped institutional cash buyers compete against leveraged private buyers. Conditions could continue favoring institutions for some time. Many economists forecast that rates on 10-year Treasuries will stay flat or rise a percentage point to 5.5% in the next year. That trend would continue to squeeze leveraged buyers.
Eventually rising rates could cause lower property prices and an increase in cap rates. But not many observers expect real estate prices to fall sharply. Demand for most property types remains strong. “The fundamentals are getting better for offices and apartments,” says Poutasse of AEW. “If long-term rates don't rise much, the current cap rates can remain at these levels.”
Monitoring The Fed
The impact of rising rates is already being felt. With rates climbing, cap rates have stopped falling in recent months, according to Real Capital Analytics. Among some property types — such as strip centers and high-rise apartments — cap rates have actually risen a bit.
For institutions, the stagnant cap rates and slightly rising interest rates are welcome. Yields on new purchases are rising, and leveraged competitors are being prevented from bidding quite so aggressively.
What would happen if rates dropped sharply? Then leveraged players might be back on top. But it is hard to see how rates can drop much unless the economy slows dramatically, a scenario that few economists predict. “The Fed is not going to lower rates unless there is significant weakness in the economy,” predicts Poutasse.
Rising rates could have a particularly big impact on the apartment market. Last year, the biggest buyers in the sector were condominium converters, which accounted for 35% of all multifamily purchases in the first 10 months of 2005, according to Real Capital Analytics.
The converters typically aim to buy leveraged properties, then convert and sell the units within a year or so. That kind of high-stakes action holds little appeal for cautious pension funds.
Rising rates could dampen condo purchases in Florida and other hot Sunbelt markets, leaving more opportunities for slow-moving institutions to buy apartments and keep them as rental units. “Condo converters are incredibly leveraged buyers,” says White of Real Capital Analytics. “They are very sensitive to changes in interest rates.”
Despite the strong appetite of condo converters, institutions have managed to buy apartments. ING Clarion spent almost $3 billion on acquisitions in 2005. Other big buyers included TIAA and RREEF. At least 10 institutions each acquired $500 million or more worth of apartments in 2005, according to Real Capital Analytics. The number of big institutional buyers could increase in 2006, if the condo activity cools.
Don't write off private buyers yet
While private buyers will slow down, they will not disappear altogether, says Welch of Cushman & Wakefield. Some private buyers will accept deals with negative leverage, where cap rates are lower than the interest rate on mortgages. Cash flows on such deals would be skimpy, but buyers will hope that rising rents and appreciation will make the properties profitable. More commonly, private buyers will simply use less leverage. Lenders will encourage these efforts.
Faced with competitors that are eager to finance deals, lenders will continue courting private investors. Many lenders are offering interest-only loans, which don't require borrowers to pay back any principal for five or 10 years. That will help borrowers hold down monthly payments at a time of rising rates. In addition, lenders are eager to offer mezzanine debt. After private buyers secure mortgages that cover 70% of the purchase price, they should be able to cover another 10% or so of the cost with more expensive mezzanine financing.
Besides pressuring lenders for more favorable terms, private buyers may become more competitive by pulling back from markets with low cap rates, such as Southern California and Washington, D.C. “Instead of bidding on offices and retail properties in Los Angeles, the leveraged buyers will consider Phoenix or Dallas, where the cap rates are higher,” says White of Real Capital Analytics.
Foreign buyers should also remain a strong force. Foreigners emerged as one of the largest buyers of retail strip centers last year, and that interest should continue because so many overseas buyers remain flush with cash.
Australian pensions should continue to lead the invasion. With a limited amount of real estate available in their home markets, they have been looking abroad, particularly to the U.S. Middle East investors are also busy, employing the petrodollars that have been flooding into their region. Such overseas investors will be bidding against U.S. institutional investors that are hungry to win more properties.
Stan Luxenberg is based in New York.
STRATEGIC DISTRIBUTION OF PRIVATE REAL ESTATE INVESTMENTS
The Pension Real Estate Association asked its reporting members to allocate their investments into three categories. Core properties, which are well-stabilized assets, remain by far the most popular.
| $Billions | % of Private Real Estate Equity | |
|---|---|---|
| Core | $73.4 | 70.4% |
| Value-Added | $18.13 | 17.4% |
| Opportunistic | $12.68 | 12.2% |
| Total | $104.21 | 100% |
| Sources: Pension Real Estate Association, 2005 Plan Sponsor Research Report | ||
GEOGRAPHIC DISTRIBUTION OF REAL ESTATE ALLOCATION* (COMPARISON 2002-2004)
Changes in geographic distribution among plan sponsors tend to move at an extremely slow pace, but the South and the West regions are showing a slight investment gain over time.
| U.S. Holdings | 2002 | 2003 | 2004 | Change in Allocation 2004 vs. 2002 |
|---|---|---|---|---|
| East | 27.6% | 28.3% | 27.3% | -0.3% |
| Midwest | 14.7% | 13.2% | 13.8% | -0.9% |
| South | 23.3% | 23.4% | 23.6% | +0.3% |
| West | 32.9% | 33.6% | 33.7% | +0.8% |
| *Limited to plan sponsors reporting in 2002, 2003 and 2004. U.S. plan sponsors only | ||||
| Source: Pension Real Estate Association | ||||
Emerging strategies headline PREA show
At a time when conventional U.S. real estate markets are flooded with investors, pension funds may need to consider alternative approaches as well as new property types. That is the central theme of the Pension Real Estate Association's spring conference slated for March 8-9 at the Palace Hotel in San Francisco.
“There is a lot of capital in the markets, and some pensions are thinking about looking for more returns by taking extra risks,” explains Gail Haynes, president of PREA, who anticipates 400 attendees at this year's conference.
One session that is likely to generate a lot of interest among attendees is titled “Opportunity and Risk in the World of Emerging Markets.” In the past, few pensions considered real estate in countries such as Brazil and China. But now more institutions are closely examining emerging markets. The chief draw is the chance to earn higher returns. Capitalization rates range from 9% or 10% for prime office buildings in the emerging markets compared with 6% or less in the U.S.
“The potential returns are significantly greater in the emerging markets because not much capital is available in these countries,” says Komal Sri Kumar, chief global strategist of Trust Company of the West, who will moderate the conference panel on emerging markets.
Kumar says that sale prices in emerging markets have already started rising, and more gains are likely in the next few years. Cap rates in Poland, for example, have dropped from about 13% to 9% in the last seven years, amid improving business conditions and the country's inclusion in the European Union.
Still, the cap rates are much higher in Poland than they are in neighboring Germany. But that gap won't last. “Cap rates around the world are going to reach similar levels as a result of the free flow of capital and goods,” Kumar says.
Institutions are investing in funds specializing in single countries, such as China or South Africa. There are also funds focusing on regions, such as Latin America. Some pensions are trying limited partnerships or separate accounts.
In addition to focusing on emerging economies, institutional investors also are considering emerging managers — new managers who have not yet established long track records.
New managers may have advantages over their more established competitors. While well-known firms oversee huge portfolios, new companies may be more nimble because they have fewer assets to watch.
“The idea is to search for managers who can deliver exceptional returns,” says Bret Wilkerson, chief executive of Property & Portfolio Research, who will moderate a session on “Emerging Managers: Who Are They and Why Invest With Them?”
— Stan Luxenberg