Archive for July 2012
Real estate and the “long game”
The two big economic stories right now — and probably for the rest of the year — will be the impact of the Euro problems and the impact of the impending “fiscal cliff” in the U.S. We don’t want to minimize the significance of either of these impending problems on the financial world in general and real estate in specific. Indeed, either of these problems has the potential to bring down the global house of cards.
Nonetheless, it’s important to keep our eyes on the longer trends within which these crises exist. The exit strategy for either of these crises depends heavily — maybe even totally — on the trajectory of these longer-term trends.
A very brief article in the current issue of The Economist caught our eye this week. The article was about the disparity between the median population age of various countries and the average age of that country’s cabinet ministers. The goal was to show that in the “rich” world (e.g. — Germany), the cabinets more closely resembled the general population, while in the “emerging” world (e.g. — India, China) there was a large disparity, with attendant potential instability. In that context, however, the article wasn’t very compelling — the U.S. has a huge disparity, while Russia has a high degree of alignment. Go figure. What caught our eye, though, was the variation in population age among various countries, and the implications for long-term growth. Quite a few years ago, I was at an academic conference which discussed the increasing age of the population in Europe, and in that context how Europe had the potential to be the next Japan. An aging population has very significant implications for real estate — particularly in the commercial sector. As a decreasing portion of the population is working to support a larger and larger retired segment, there is both a generic malaise inherent in the economy (unless high increases in productivity are induced) and a decreasing need for commercial real estate space (particularly in offices, warehouses, and manufacturing).
In that context, the emerging nations of the world have an edge — note the low median ages in India, China, Brazil, and Canada. Ironically, the U.S. is also in that mix, and to a lesser extent Australia and Russia. At the other end of the spectrum, Japan and Germany have nearly the same median age problems. The latter is most problematic, since the German economy has been entrusted with bringing the Euro zone out of its doldrums. Clearly, a rapidly aging German population has less need for commercial real estate, but also less ability to drag the ox cart of Europe along the road to recovery. Britain, solidly part of Europe but outside the Euro, has a somewhat younger population — indeed slightly closer to the U.S. than Germany and about equal to economically stalwart Canada. The short-term horizon will continue to fuel real estate challenges and opportunities, but the “long game” context needs to be taken into account as opportunity-seekers consider down-the-road exit strategies for today’s purchases.
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REIS reports on the office market
Got an early peek this morning at the forthcoming office market report from ReisReports. Like everything else in the economy today (except apartments), the operative word is “sluggish”. Indeed, even in the bullish apartment market, the core driver is the sluggish economy turning “owners” into “renters”.
On the surface, the facts aren’t all that bad. Office vacancy rates topped out above 17.5% in mid-2010, and have been on a slow trend downward. However, for the last two quarters, the rate has stalled at 17.2%. Quarterly absorptions have been in positive territory since early 2011, totalling about 4 millions square feet nationally in the 2nd quarter 2012, even in the face of the lowest office completions level since REIS began tracking data in 1999. Rents remain at 2007 levels, with 0.3% gains in both asking and effective averages.
The reasons are obvious — continued fears from Europe (which may be abating, given very recent pronouncements from European central bankers), the close presidential election, and the very real fear of of the “fiscal cliff” in early 2013 contribute to an anemic jobs recovery. Without new jobs, there is no demand for office space. You do the math.
In most American cities, the stark reality on the skyline is the absence of high-rise cranes. Given the very long pipeline for office construction, coupled with the difficulty financing in this sector, and it may be many years before we see this market turn fully around.
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Apartments, economic uncertainty, and demographic shifts
The latest issue of Marcus & Millichap’s apartment research just hit my desk, and while they may some important observations, I think they may miss the bigger picture about why the apartment market is so hot today.
First, the good news — apartments are the brightest star in a recovering commercial real estate market. As M&M note, leading economic indicators are trending up — not nearly as high as the pre-crash peak, but higher than we saw at any time between 1990 and 2005 or so. Job growth is rugged, but at least it’s in positive territory, albeit not at levels we need to get America’s fiscal house in order. Apartment absorption is in strong, positive territory, with some of the best, sustained numbers we’ve seen in over a decade. These are all positive trends for the apartment investment market.
Despite the well-wishing about owner occupied housing, that market continues to be sour — home sales are moribund, with a report out today that new home sales have trended back down to 350,000/year. While some statistics show prices beginning to stabilize or rise, others continue to show cycling around 2003 levels. Our own models here at Greenfield suggest that home prices and new home sales volumes will not return to healthy levels until the home ownership rates stabilize. In addition, a recent report out of the homebuilding community points to lack of buildable lots as a very real impediment to growth in this area. We would add that structural issues in the lending arena will keep lot development at all-time lows for several years to come.
In short, many investment funds have viewed apartments as the next instant money machine, and indeed occupancy rates are frequently well above optimum levels. There is plenty of research to suggest that a “healthy”, profit-maximizing apartment market has an occupancy rate around 93%. A 100% occupancy rate suggests that rents are too low, and indeed this has happened in many markets as developers have chased occupancy rather than profitability. As stabilized apartments raise rents, NOI increases, and with them cap rates. As a result, cap rates are actually on the rise again, up from 2006 levels, and with the decline in 10-year Treasury rates, the cap-to-T spread has expanded to the widest level we’ve seen (490 basis points).
One would think that investment funds would chase this NOI, forcing cap rates down. Indeed, just the opposite is true. Funds are looking for income, not future growth, and unlike the private equity and hedge funds of the past, aren’t trying to buy low and sell high. They’re perfectly contented to buy a cash flow and hold forever, thus allowing cap rates to float upward.
Add to this the demographic part of the equation — America forms about a million new households per year, but we’re only building owner-occupied homes for about a third of them. M&M notes that we’re currently only building about half of the units needed to meet demand. They project occupancy rates by year end at about 95.6%, far above optimum levels. As such, they expect rent growth of about 5% by year end. This will flow straight to the bottom line, pushing up both transaction prices AND cap rates simultaneously.
Apartments were grossly underbuilt during the last decade, so what we have is a pure supply-and-demand play. With constrained supply, and demand pushed both by population growth (particularly in the key 20-t0-34 age bracket) and shortage of new owner-occupied housing, this trend appears to have legs.
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Real Estate Portfolio Choices
Thanks to my friends at PERENEWS.com for bringing this to my attention. It’s a fascinating story about how two funds can make subtly different choices about real estate investments and end up in two different places.
The two funds are CalPERS and CalSTRS, two of the largest pension funds in America. For those of you not familiar with them, CalPERS is the California Public Employees Retirement System, and CalSTRS is the separate California teachers system. As of March 31, 2012, CalPERS had $237.6 Billion under management, with $21.8 Billion (9.2%) of that in real estate. As of May 31, 2012, (they have slightly different reporting dates) CalSTRS had $146.8 Billion under management, with $21.2 Billion (14.5%) in real estate.
Ironically, both pension funds underperformed their own targets for the year ending June 30, and yet for both of them, real estate was their best performing asset class. Both funds have put emphasis on core, income-producing properties. CalSTRS, however, despite having a fairly good real estate year (9.2% overall return), underperformed their real estate benchmark (the NCREIF Property Index) by a full 4.2 percentage points. Notably, CalSTRS had a much higher return in the 2010-2011 period, enjoying a 17.5% overall real estate return.
CalPERS, on the other hand, enjoyed a 15.9% return, outperforming their goals by 3 percentage points. This represents a much higher return than 2010-2011, when they marked a 10.2% gain, and very much a rebound from their disasterous 37.1% loss in 2009-2010.
Notably, neither fund did poorly this year — there is nothing about CalSTRS 9.2% overall return to scoff at. But, why does CalPERS continue to trend upward while CalSTRS is underperforming? Is there something key to this difference that we should be noting and learning?
Intriguingly, CalPERS devotes more of its attention to core properties — currently at 70% with a goal of 75%. CalSTRS, on the other hand, is evenly split between core and opportunistic. Also, CalPERS is underallocated to real estate and is in a position to make significant core investments, while CalSTRS is overallocated, and is trying to get from 14.5% down to 12% by selling existing opportunistic holdings, likely at a loss. Additionally, CalPERS was aggressive in taking write-downs during the painful 2009-2010 season, but CalSTRS was not, and is thus still feeling the pain.
Finally, CalPERS was quick to move into core assets after the global financial crisis, allowing it to buy quality assets at bargain-basement prices. CalSTRS was not so quick to move, and thus waited until cap rates compressed.
Lessons to be learned? Obviously, in hindsight, cleaning up the messy books and moving forward was a smart thing for CalPERS to do. It gave them the freedom to move forward and take advantage of opportunities. Looking forward, there is clearly a sense that allocation is key.
However, the bigger picture is that two of the nation’s largest investment funds have a major committment to real estate, aiming for 10% and 12% allocations respectively. The fund that is in the accumulation side (growing from 9% up to 10%) is the one making the most money, because it can take advantage of buying opportunities in core assets. The fund that is selling is the underperformer, albeit probably for reasons other than just capital losses on sales.
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Real Estate Securities and Stock Markets
Is securitized real estate a stock, or is it real estate? It’s a bit of both, but the degree of correlation between securitized real estate (most often “REITs” in the U.S., other forms elsewhere) and the stock market in general has long been a matter of some debate. In my own work I’ve cited studies that show a high correlation between REIT returns and the S&P 500, but I’ve always been a bit uncomfortable with such gross generalizations.
In the current issue of the Journal of Real Estate Research, Prof. Nafessa Yunis of U. Baltimore does an excellent job exploring this topic, not only in the U.S. market but also nine other countries that have both mature stock exchanges as well as mature securitized real estate markets. She not only looks at inter-market correlation, but also controls for other macro-variables, including GDP changes and interest rates.
She finds that real estate securities returns are “cointegrated” with both the respective stock market returns as well as key macroeconomic factors, but that the degree of linkage varies among countries. The greater the degree of market maturity, the greater the cointegration. In general, shocks to the stock market or to macro-variables impacts the real estate market, but not necessarily the other way around. Intriguingly, shocks in stock returns, M1, GDP, and CPI have positive impacts on real estate returns, but shocks to long-term interest rates induce negative but temporary responses in real estate returns.
In a way, these findings are both useful and disturbing to portfolio managers. On one hand, Dr. Yunis’ findings help allay fears that real estate securities are “something else” and difficult to understand. However, she also notes that there are no diversification gains (she doesn’t use “arbitrage”, but I believe that’s what she means) from holding both real estate and non-real estate securities.
Full disclosure — I’m a reviewer for this journal, although I did not review her paper. The Journal of Real Estate Research is widely regarded as one of the two top real estate academic journals in the world. Inclusion in this journal is a mark of distinction for any young author, and it gives significant credence to Dr. Yunis’ findings.
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REIT Development Pipeline
On June 28, Fitch Rating Services issued a report on the REIT development pipeline that has generated a bit of discussion in the real estate community. Fitch’s emphasis was on the lack of development — with some noteworthy exceptions — and how this has “not a meaningful” implication for REIT credit risk. However, the topic is important from a fundamental perspective, and deserves a bit more discussion.
Historically, REITs weren’t in the development business. REITs are a tax vehicle, and to maintain that status, they’re supposed to collect rents and pay 95% of those rents out to shareholders (well, that’s a gross oversimplification, but let’s go with it). As such, REITs enjoy preferential tax status, and have usually enjoyed excellent leverage. REITs have some significant limitations on the proportion of profits which are supposed to come from business enterprises, capital gains, and such, and can lose their preferential tax status if these other items exceed a certain threshold.
During hot and heavy times (let’s say, pre-2007), REITs are hit with a triple-whammy. First, they depreciate existing properties, and need that depreciation to shelter income (and thus exceed the 95% threshold, which they usually do and which investors expect). Second, they were loathe to sell fully depreciated properties in order to buy new ones, because the huge capital gains from sales would impact the preferential tax status. Finally, developers were demanding large premiums — income producing buildings were selling for amazing multiples which barely made sense (that’s called a “bubble”, folks).
The good news for a REIT was that if they developed their own properties, the development profits could be kept in-house, and there would be no fatal tax recognitions. Depreciation expenses stayed high, and they could thus pay-out higher and higher funds from operations to shareholders. It was a win-win. The only downside, of course, was that development activities were considered risky, and so the credit rating agencies kept a close eye on these practices. However, REITs were typically less leveraged than other ownership vehicles, to the riskiness was usually minimal.
A tthe peak, in 2007, the REIT universe had an aggregate investment of 7.6% of undepreciated assets in the development pipeline, or a total of $34 Billion. By March 31, 2012 (the cut-off for data in the Fitch report) that had collapsed to 2.7%., and indeed over a third of that is in the fundamentally sound apartment market.
Fitch summarizes the market as “fairly muted”, and says that “By and large, companies have not ramped up development pipelines,” according to Steven Marks, managing director at Fitch in a follow-up interview to Globe Street. “It is really growth via acquisitions and organic cash flows from existing portfolios.”
The report also noted that over the past 10 years, REIT development activities have had a high correlation with U.S. GDP changes. Thus, improvements in U.S. GDP would signal development opportunities for REITs, but continued stagnation in the U.S. GDP suggests that REITs will continue to remain quiet on the development front.
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International Financial Reporting Standards
I know I’m sounding like an overly technical geek on these subjects, but as we know from the recent (current?) economic malaise, seemingly back-page issues can have major impacts on large segments of the economy.
Buried deep inside Friday’s issue of the Wall Street Journal (OK, page C1, but that’s pretty deep) was news that the SEC will once again delay implementation of the International Financial Reporting Standards (“IFRS”) for U.S. regulated businesses (from a practical standpoint, essentially all of them). For those who aren’t up on their accounting theory, U.S. accounting standards — generally referred to as “Generally Accepted Accounting Practices” or “GAAP” for short — have been developed over time from essentially three sources: “best practices” which have evolved literally over the centuries, pronouncements of the Financial Accounting Standards Board, or “FASB”, and its predecessors, and adaptations to conform with U.S. tax practice. IFSR is more of a top-down approach, and governs accounting practices pretty much anywhere in the developed world EXCEPT for the U.S. (One might argue, and with some validity, that recent accounting problems among Chinese businesses reveal real problem with IFRS compliance, and one wouldn’t be altogether wrong. That’s a topic for a different day, though.)
American businesses dealing in global commerce (as nearly all big ones do, now-a-days) have been anxious for a unifying accounting paradigm for many years. Indeed, the differences between IFRS and GAAP are significant, and in fact adoption of IFRS in the U.S. may cost many businesses quite a bit in tax penalties, since IFRS doesn’t recognize certain tax avoidance strategies (e.g. — last-in-first-out inventory accounting) that are common in the U.S. Nonetheless, American businesses are willing to suffer the tax pain in order to get a common accounting language globally.
From an accounting perspective, this delay by the SEC is a royal pain in the neck, but that too is a topic for another day. The reason I bring it up today is the implicit impact on real estate appraisal standards. I’ve noted, with some interest, that appraisal standards are increasingly derivative of accounting practices. Back when America’s Uniform Standards of Professional Appraisal Practice (“USPAP”) was developed, accountants could barely care about appraisal standards. Today, a close examination of the International Valuation Standards Council (IVS) reveals a substantial degree of input from the accounting and banking fields, much more than we saw 25-ish years ago when USPAP was first codified.
In my own observation, this SEC delay gives the appraisal profession another year or so to decide if they want a top-down or bottoms-up approach to appraisal standards in the U.S. Do appraisers want to be driving the truck or riding in the back? I’ve observed that the three constituent “regulatory” bodies (the professional organizations, such as the Appraisal Institute and RICS, the Appraisal Foundation, and the state and federal regulators) seem to be of three different minds on the subject. The constituent bodies seem to be more proactive and ready to move forward with IVS adoption. The Foundation seems to have been constantly playing damage control in the past couple of years over the mortgage market meltdown and the resultant sturm-and-drang from the Federal regulatory bodies. None of those regulatory bodies seemed to have a dog in this hunt, so haven’t appeared to care. I will say, however, that proposed changes to USPAP 2014, which are currently being circulated in draft form, are very forward-looking, albeit with baby steps.
Finally, state regulators are almost 100% reactive. Some are very good at reacting, and some are very bad. Currently, they are all overwhelmed with the double-whammy of very real budget cuts and very real appraisal standards violations problems emanating from the mortgage market meltdown. As such, a major paradigm shift in appraisal standards will be difficult for them to swallow.
This all seems to be back-page stuff, but in fact these issues have very real implications for the way “business does business”, particularly in the real estate valuation world. We’ll keep you posted.
From a small northwestern observatory... 