Archive for the ‘Economy’ Category
REIT Fundraising on the Rise
According to SNL Financial, U.S. Equity REITs have raised $35.27 Billion through August 10th, over 10% more than was raised during the similar period last year. Continuing with the debt/equity theme we noted in a recent post, senior debt only constituted about 38% of this total ($13.53 B) with the remainder coming from common equity ($14.72 B) and preferred equity ($7.02 B).
Interestingly enough, Health Care REIT had the largest stock offering at $810.8 million, followed by Kilroy at $230.5 million and Taubman Centers at $281.5. All three of these are notable, as none of them are in the “hot” apartment sector. Indeed, of all of the sectors, health care raised the most at $7.7 Billion, followed by retail at $7.61 B.
The bigger question, of course, is what does this say about the real estate market? REITs buy cash flow, not capital growth, and respond to investor demand for something to take the place of flat-lined bonds. Given the risk of holding long-term bonds in an up-ticking interest rate market, compared to the yield margin and inflation hedge of REITs, this may be less a commentary on the quality of the property market and more a comment on the demand for REIT shares.
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REIT Valuations — Looking Forward
We’re still picking thru the immense amount of information that came out of REIT week back in June. Paul Whyte, a managing director at Credit Suisse in charge of their investment banking sector, is looking for “continued growth in valuations and operating income in the commercial real estate industry during the second half of 2012,: according to an article posted by REIT.com writer Matt Bechard last week.
Whyte says investors will continue the “flight to quality” in terms targeting trophy assets, noting that “In uncertain times, capital tends to go where they see long-term opportunity.” Whyte singled out two sectors, retail and data centers, for particular attention. In the retail arena, investors appear to be looking for higher-quality class-A mall properties rather than suburban investments. He suggested that data centers are “intriguing,” and that with continued movement to cloud computing and social media, “there’s just enormous demand there.”
Reflecting our own sentiments here at Greenfield, Whyte has deep concerns about property investments in the Eurozone. “I think that what Europe lacks is a comprehensive, long-range plan for fiscal unity,” Whyte said. “Without it, we’re just really putting Band-Aids on the patient.” He also noted, “From a headline perspective, Europe is influencing the markets more so than I think anybody had ever imagined,” he said.
As for the U.S., he concurs that we are in a recovery mode, and projects investment interest in energy, health care and technology sectors.
REITWeek was held June 12 – 14 at the New York Hilton. It is the annual investor forum sponsored by the National Association of Real Estate Investment Trusts.
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Louisiana, oil spills, and the Atchafalaya
I spent most of last week based out of New Orleans, with trips north (into St. Tammany Parish) and southwestward into the Atchafalaya Basin. It’s this latter foray that I wanted to discuss today — probably one of the most significant and rich ecosystems in the U.S., and yet one that hardly anyone knows about. From a real estate perspective, it’s both beautiful and critically important.
Courtesy USGS
The Atchafalaya is the largest swamp in the United States, located basically where the Atchafalaya River pours into the Gulf. It spans all or part of 15 parishes (Louisiana has “parishes” rather than “counties”). The Atchafalaya has a growing delta system and fairly stable wetlands, which is significant for several reasons. Louisiana, believe it or not, has 25 percent of the forested wetlands and 40 percent of the coastal wetlands in the 48 contiguous States but accounts for 80 percent of wetlands losses according to the USGS. The State’s coastal area (wetlands, estuaries, and barrier islands) is under stressed conditions resulting from a complex array of adverse natural environmental processes and human-related activities. Every year, the Louisiana coastal area, one of the world’s most productive ecosystems, loses as much as 20 to 25 square miles of land. Thus, about 1,000 to 1,500 square miles of Louisiana’s coastal wetlands have been converted to open water during the past half century. The processes and activities that have contributed to this conversion include long-term erosion and land subsidence (sinking of the land) caused, in part, by compaction of Mississippi River Delta sediments and by large storms that strike the area about every 5 years, rising sea levels, changes in human population, energy development, flood control, and maintenance of navigation channels. As wetlands, estuaries, and barrier islands vanish, the State loses important natural buffers protecting New Orleans and other populated coastal areas from storms and flooding.
As you might guess, what with Hurricane Katrina, various oil field contamination disputes, and the BP Oil Spill, I’ve spent a fair amount of time in and around the Atchafalaya. If you ever get the chance to go, don’t miss it! Nonetheless, we’re still assessing the damages resulting from the oil spill and resultant economic effects. Stay tuned — this research continues!
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Appraisal Institute meeting in San Diego
I had the pleasure of being invited to speak at the Appraisal Institute’s annual meeting in San Diego last week, which brought together many of the top minds in the valuation field for three days of seminars and business meetings. While AI is fairly small (only about 23,000 members globally), its influence in the real estate field cannot be understated. In the U.S., appraisal license law and standards (the Uniform Standards of Professional Appraisal Practice, commonly known as USPAP) owe their genesis to work done by AI back in the 1980’s during the Savings and Loan Crisis, and possession of an AI designation (either MAI or SRA) is frequently cited in real estate contracts as required for establishing lease renewal rates or other contractual matters. Courts throughout the land routinely accept testimony from AI members without question. Real estate regulatory bodies throughout the U.S. are populated by AI members, and rare is the state legislature that will make changes to real estate law without the consultation of AI members. The AI’s government affairs team in D.C. has influence throughout the real estate arena, which of course today transcends traditional boundaries and includes regulatory efforts of the GAO and SEC, among others.
I was asked asked to deliver an address on advanced statistical methods. I’ll leave that discussion for another day, and focus on what I learned there — which was significant — rather than what I said. Other sessions dealt with meaty topics like the attorney/appraiser interface and the complexity of real estate valuation in the financial reporting arena. Not unexpectedly, there was a tremendous amount of attention paid to technology, which is really leading to an interface between “automated valuation model”-type tools and the individual appraiser. In short, we may be very close to a day, thanks to technology, when the individual home appraiser is tapping into a more robust set of analytical tools in order to produce collateral valuations with strong statistical support. Anyone who has been following the mortgage meltdown news for the past few years will understand the significance.
The keynote speaker was Dylan Taylor, CEO/USA of Colliers International. He riffed off of the title of the book “The Earth is Flat”, and talked about barriers to globalization in the real estate biz which he called “rounders”. The two principle ones for our field are regulatory barriers (licensure problems, even across 50 states, much less across countries) and capital needed to grow businesses (technology, etc.) He notes that in most professions, there is a tipping point to consolidation, and uses CPA firms as examples. The total billings of U.S. CPA firms last year was about $120 Billion, and the big 4 accounted for $80 Billion of that. The need for technology, increased specialization, etc., will probably stimulate that in appraisal firms (which currently have world-wide billings on the order of $3 Billion, but the top few only account for a small fraction of that). He says that in the future, there will be a handful of very large appraisal firms plus “boutiques”. In his view, the boutiques will do quite nicely, but the middle-market appraisal firms will die on the vine.
Taylor notes that USPAP will be generally moving toward International Valuation Standards (“IVS”) in the same way Generally Accepted Accounting Practice (“GAAP”) is moving toward International Financial Reporting Standards (“IFRS”). The latter sets of standards provide much more “client defined” reporting standards. He notes, for example, that several aspects of IFRS will cause “disruptive change” in American real estate, such as the way the two different paradigms treat carried interest.
As noted, a separate session dealt with the interface between appraisal and financial reporting. Earlier this year, the SEC “kicked the can” toward 2013 for U.S. adoption of IFRS. It was noted that while 90% of GAAP and IFRS are functionally identical, the changes needed to adopt the remaining standards could be so costly and disruptive as to dwarf the problems following adoption of Sarbanes-Oxley. Nonetheless, some movement in that direction is inevitable. From a real estate perspective, this may include the elimination of depreciation for financial reporting, substituting annual “mark-to-market” valuations instead. That is a very different paradigm for property valuation in the U.S.
Other sessions included a presentation from the FDIC’s General Counsel’s office, a presentation on standards and practices for Federal land acquisition, and a VERY informative presentation on “getting published”.
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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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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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S&P Case Shiller Report
I WISH I could be excited about the most recent home price index report. I really wish I could.
The news is mediocre, at best — home prices in April rose by 1.3% on average from their record lows in March, and are still down 2.2% (for the 10-city composite) from April, 2011. Not surprisingly (after March’s terrible news), no cities posted new lows in April. Of the 20 cities tracked, 18 showed increases (NYC and Detroit being the exceptions).
So, why? If you read my blog yesterday, you know we have a terrifically supply-constrained market. This morning’s Wall Street Journal had an article about Chinese investors who are providing about $1.8 Billion in kick-start capital to Lennar to get a big 12,000+ home community underway in San Francisco — a project Lennar has been working on for 9 years. While I congratulate the Chinese and Lennar for this partnership, it does not at all bode well for U.S. investment liquiity that off-shore capital is needed to get a new project off the ground in one of America’s most dynamic cities.
Recall from ECON 101 that “price” is what happens at equilibrium when supply intersects with demand. (OK, technically “price” can emerge in disequilibrium, as well.) Right now, supply is hugely constrained, with a lot of REO-overhang and little new construction. If demand was healthy and growing, prices should be soaring. Instead, prices remain flat-lined, suggesting that demand is also stagnant. However, population continues to grow and household formation should be positive.
What’s taking up the slack? The apartment market continues to explode, with huge demand for rental units. What’s the end game for all of this? I can only think of two results:
1. The home ownership rate in America continues to languish, finding some new post-WW II low; or
2. Eventually, home ownership will go on the rise, and we’ll have an overbuilt situation in apartments.
Where would I bet? Sadly, given the state of the world’s economy, #1 looks more tenable in the long-term. That doesn’t mean we’re moving from being a nation of home owners to a nation of renters, but it does mean that the tradition of home ownership which has prevailed in the U.S. for decades may be becoming passe. Either way, in the intermediate term (the next several years), we’re probably looking at the status quo.
From a small northwestern observatory... 