In an extract taken from the Pension Plan De-Risking, North America 2019 Report, David Grana, Head of Production at Clear Path Analysis, interviews David Amsterdam, President, Investments and Eastern Region at Colliers International on the subject 'Pension funds should stop overlooking commercial real estate as an asset class'. Click here to download the full Report.
David Grana: What are the main characteristics of commercial real estate that you feel would greatly benefit pension funds by having greater allocations of it in their investment portfolios?
David Amsterdam: A key characteristic of commercial real estate is historically strong capital value growth with exceptional residual value, something not typically seen from traditional investment products (i.e. stocks and bonds). Real estate also offers significantly better risk mitigants as compared to other investment products. For example, if you own a multi-tenant building, the decision to lease space, and at a particular rent, is the landlord’s decision. Owners and landlords are able to take all the outside factors into account (i.e. are we in a rising or compressing cap rate environment, how much tenant improvement should we contribute, will we get the cost of the work back next generation, etc.) before making an investment decision. With equities and fixed income, the investor has very little say in risk mitigants – those factors are dependent on the company or shareholder.
David G: What would you say to a pension manager who believes the term “real estate” carries some bad connotations with it, specifically along the lines of the Financial Crisis of 2008?
David A: Very few, if any, asset classes return yields as strong as real estate over a five- or 10-year hold. Any time an asset yields a premium there will be inherent risk and the 2008 crisis was borne from the risk profile afforded by real estate. However, the crisis was exacerbated by products tied to real estate – not the real estate itself. When looking at asset values and assets themselves today vs. 10 years ago, you’ll find that there has been very little diminution in value. Yes, many people lost their homes and buildings were foreclosed on, but the underlying factor was the financial products trading on secondary markets, such as credit default swaps, CMBS and RMBS. The lending community was motivated to source opportunities as traders capitalized on global wealth appreciation both domestic and international, institutional and entrepreneurial. The ratings agencies (S&P and Moody’s) loosened standards in a market that experienced a re-pricing of risk nearly overnight. More than 10 years later the market has seen continued discipline by the lending community, more bank regulation and oversight by the government, a renewed focus on risk pricing by ratings agencies and an overall discipline trained to keep lending standards in place. By 2019 standards the definition of “bad” has been adjusted to focus less on the financial crisis and more on repurposing obsolete assets.
David G: How is real estate - specifically commercial real estate - performing in today’s market relative to other asset classes, and what are some of the factors that are contributing to that performance?
David A: Performance is very asset and market specific. The one product that can be generalized is the weakened state of the retail market. Online sales have increased from 11.5% of the market in 2016 to 14.3% in 2018. In real numbers that means online sales accounted for $390 billion in 2016 increasing to $517 billion in 2018, a compounded average in excess of 10%, while in-store sales have seen growth of less than 3.5%. While in-store sales have decreased, resulting in less demand for shopping malls and street level retail, online’s increase has resulted in a marked uptick in demand for industrial space, storage and final-mile distribution facilities. Proximity to transport hubs has become a critical component of industrial decision making and, as a result, markets that may otherwise not have drawn investor attention are now attracting diverse interest.
As for office, job growth continues to be strong. March jobs numbers were positive, in excess of 196,000 and February was adjusted upwards to north of 30,000. Unemployment is at 3.8%, signifying a strong labor pool and commitment to job growth.
David G: What are the types of commercial real estate (e.g. retail, industrial, office, etc.) that should be on investors’ radars, and what’s driving their growth?
David A: Industrial will continue to be a point of strength for the reasons stated above (i.e. uptick in online retail and distribution facilities). Office continues to be a best bet for long-term capital appreciation. Values in key gateway cities such as New York, San Francisco, Los Angeles, Boston and Miami outperform most other asset classes in terms of yield stability over a long-term horizon. For near-term yield, multi-family product in secondary markets or markets with strong tech-based universities are an interesting thesis. Tech growth is atypical from financial services growth. Tech is driven by the talent pool instead of the talent pool being drawn to the industry as we see in financial services. As a result, tech and startup businesses have as much of a chance of success regardless of their location. Many investors are recognizing the desire of these tech companies to stay close to their roots, even if it means a secondary or tertiary market. Identifying markets that attract tech businesses or are incubating companies becomes a compelling investment market for both rental and for-sale housing. Healthcare continues to draw a lot of interest from today’s investor groups. Medical office, senior housing, assisted living and outpatient/urgent care centers are becoming higher value propositions. As the baby boomer generation ages, the need for senior/assisted living becomes more pronounced. Further, as the cost of insurance rises and individuals office visit copays or deductibles increase, more and more people are choosing to go to urgent care facilities in lieu of their primary care providers. Creative repurposing of functionally obsolete real estate will start to play a bigger role on investors radars. These assets will be acquired at well below replacement cost allowing investors to create and deliver flexible, attractive space at a discount to the overall market – if executed correctly.
David G: Which strategies (i.e. core, value-add or opportunistic) do investors tend to favor in today’s market?
David A: The strategy employed by an investment group comes down to their specific risk threshold. Core investments will always have appeal to long-term investors – generally more institutional, perhaps off-shore, looking for capital value appreciation over near-term yield. Opportunistic deals will consistently appeal to shorter-term investors. These are generally equity funds or those buyers seeking to arbitrage their low cost of capital, looking for immediate upside and illustrating a strong IRR.
Value-add will appeal to investors looking to get involved in a project in a very hands-on type of way. These investors tend to be more entrepreneurial and hyper-focused on the micro market. One important factor to note is that investors are acutely aware of information transparency in today’s market. This has blurred the lines of strategy, levelling the playing field in a way we have not seen historically.
David G: What role are secondary and tertiary markets playing, and which ones seem to be grabbing investors’ attention.
David A: Industrial and multi-family are both in the spotlight for many of the reasons previously discussed. The same holds true for medical space as it is less dependent on market factors. It is a need-based service, regardless of location.
David G: By going off the data that you have available to you, where do you see the best opportunities for long-term investors, such as pension funds?
David A: Best bets for long-term investments are office assets in key gateway markets, industrial and storage proximate to transit hubs, medical, assisted living and senior living facilities and multifamily in growth markets. If there is a creative opportunity, long-term repurposing of existing shopping malls and other retail space also provide a unique long-term opportunity at a lower cost basis than other cash flowing assets.
David G: Thank you for sharing your thoughts on this subject.