How About Real Estate?
The following analysis of realty investment opportunities circa May 2001 is excerpted from Morgan Stanley Dean Witter’s report entitled "US Investment Perspectives" dated May 2, 2001. It is reproduced here with the consent of its author, Mr. Barton Biggs.
The Case for Real Estate circa May 2001
Decisions about asset class allocation are crucial, particularly for institutional portfolios. In the long run, say 20 to 30 years, we all recognize that equities are the place to be, but the long run is made up of a series of short runs. My guess, for all the familiar reasons, is that over the next five years even low double-digit returns are going to be hard to come by in stocks, venture capital, and private equity. I’m bullish on bonds for now and maybe even for a couple of years, but with the entry yield less than 6%, it’s hard to make the case that fixed income, even aggressive fixed income, will compound over five years at a double digit rate.However, there is one big asset class that could deliver 10-14% per annum, and that is global real estate. The caveat is that the investment program has to be properly structured. "Just showing up is not enough!" The benchmark weight we use for real estate for global multi-asset portfolios is 10%, because it seems like a nice, round, sensible number, and that’s what Garry Brinson and some major institutions use. The case can be made, however, that the benchmark should be higher. The total world institutional property market in which money can actually be invested is roughly $4.2 trillion, and the world equity market according to MSCI is about $2.7 trillion, of which publicly traded equity real estate securities are less than 2%. Traded real estate securities should definitely be part of a real estate investment program, but they simply do not have sufficient market cap to accommodate 10% or more of the assets of a large institution. A major real estate program has to be mostly private.
Over the long run, commercial real estate has provided returns that are competitive with stocks’ and superior to bonds’. The NCREIF Property Index goes back to 1977 and has produced an annual total return of 9.55%. Real estate has a very low correlation with financial asset returns (0.39 with stocks and 0.29 with bonds), so it is an excellent diversifier, has a high current income component, and has relatively low volatility (3.7% versus 14.2% for equities and 5.4% for bonds). It is probably the most effective inflation hedge. Its drawbacks are property-specific risks, its lack of liquidity, and high management and information costs. Real estate returns are inherently cyclical, and this characteristic when combined with leverage and illiquidity can be hazardous, as a number of institutions learned to their sorrow at the end of the last great commercial real estate boom in the late 1980s.
Our real estate investment professionals believe the fundamentals for real estate in many parts of the world remain strong. New construction is moderate, vacancy rates (while bottoming in some markets) remain very low, and rental growth looks positive in all but a few of the most overheated markets. US sectors are later in the real estate cycle but, we argue, are far better positioned to weather an economic downturn than in the past. Apartments, central business offices, industrial property, malls, and anchored strips are markets that are still expanding but look vulnerable, while suburban office, hotels, and other retail sectors have peaked and are already into the correction phase.
With the US economy weak and weakening, we expect landlords may lose pricing power and that there will be a pause in real estate. However, it should be far milder than the one in the early 1990s, principally because vacancy rates are half of what they were then, new supply is minimal, and declining interest rates are raising capital values. Another big difference is that owners of real estate are not "distressed" this time as they definitely were then. We think portfolios should have a defensive tilt, with emphasis on markets with high barriers to entry, apartments, industrial property, and CBD offices. Out-of-favor sectors such as hotels and suburban office buildings may also become interesting, and the dot-com collapse is creating new values by the day. In short, the US is a huge, diverse market with numerous subsectors. The agile professional can always find opportunities for above-average returns somewhere.
In Europe, both public and private markets are generally several years behind the US in the real estate cycle and are in the mid- to late expansion phase. Most seem well positioned for future growth. Germany, Italy, and France are furthest behind, Spain has some big discounts to NAV, and LBO takeover opportunities exist in Sweden and the UK. Although the so-called "Golden Triangle" in Paris is very expensive, the Paris commercial market looks particularly attractive. However we think the best values are in Milan, Frankfurt, and Berlin, where rental rates have turned up. The various structural changes transforming Europe are motivating companies to sell properties, which is creating opportunities for institutional investors. For example, the funding problems of the giant incumbent telephone companies are resulting in real estate liquidations at attractive prices.
In developing countries around the world, opportunities abound for the venturesome who know what they are doing. Commercial real estate prices in Thailand, Malaysia, and certainly Indonesia are still falling, but office markets in such diverse places as Seoul, Singapore, Beijing, Pudong, and São Paulo appear to have bottomed, which is the time of maximum potential. Nonperforming loan opportunities exist across Asia. Office, hotel, and resort properties have much richer yields in emerging markets, and prime locations have high and growing earning power. Brand new, state-of-the-art luxury hotels can be purchased to yield 20% in cities like Bangkok, Manila, and Kuala Lumpur. The foreign exchange risk can be managed.
Of course, the biggest opportunity is Japan, where a huge amount of property is for sale from the banks, or will be. Tokyo is the largest office market in the world, with 840 million square feet in 23 wards. Rents have dropped everywhere despite falling vacancy rates. Because of the bank crisis, buildings can be purchased at 10% of the face value of the mortgages and far below replacement cost. Money can be borrowed by foreign entities at 1.5% on a non-recourse basis. I hear of transactions where the yield on leased properties is 8% and the loans can be paid back in four years from free cash flow. Japanese real estate is far more distressed than US real estate was during the S&L crisis, when loans were being purchased at 20-25% of the face value. The financial buyers made huge gains on those transactions. The potential is at least as big in Japan, assuming as we do that eventually the economy will recover and the deflation will end.
In my view, major institutions should be moving toward having perhaps 15% of their portfolios in a global real estate program. "Pensions and Investments" says US pension funds have over $200 billion invested in real estate, compared with $110 billion in 1990. However, the allocation has drifted down to about 3.8% of total assets (back in the mid-1980s it was 6.5%) because they have been unable or unwilling to keep pace with the increase in total assets driven by the stock market. Real estate total returns are income-dominated, which may seem sweet in volatile, low-return times. For example, last year the NCREIF Property Index had a total return of 12.03%, consisting of appreciation of 3.41% and income of 8.62%.
If we have a slower-growth, low-inflation world, the total return from commercial real estate prices is going to be closer to 8-10% than the 12.75% the NCREIF Index has returned over the last five years. However, leverage and professional management can make a big difference in an asset class that is inherently inefficient. Most real estate firms are either local or specialized by category, so managers with a true global focus are relatively rare. However, to get returns in the mid-teens, a global manager is mandatory, in my view.
In thinking about a global real estate program, a fiduciary should design a mix of return expectations versus risk, as outlined in the diagram below. There is no precision in these projections. There are clearly big market inefficiencies in the less traditional strategies. Returns can be enhanced by co-investment, and I certainly recommend the use of opportunity funds to supplement the core positions.
A meaningful stake in real estate could be a distinguishing winner in dull return times for institutions willing to be a little unconventional.
