By HENRY H. MCVEY Sep 19, 2012

In general, we are attracted to many parts of the real estate market because we view the asset class as a compelling play on our macro view that growth, yield, and inflation hedging powers are prerequisites for success in a Phase III environment. We also like that real estate is global in nature. Given these views, we think now is an appropriate time for investors to reconsider the role of real estate in their overall asset allocations.

Over the past few months we have used our monthly Global Insights pieces to delve deeper into both real assets and the U.S. housing market. Not surprisingly, quite a few clients have come back and asked whether traditional real estate fits into our overall constructive view of real assets. The short answer is yes—we do favor real estate as an asset class for two simple reasons. First, we view real estate as an elegant way to own an income producing inflation hedge. We do not see inflation as a threat today, but as we describe below, the current policy of artificially holding nominal rates below nominal GDP is almost always inflationary over time. Second, we think that real estate is a pure-play on financial disintermediation. Specifically, as Wall Street shrinks its balance sheet commitments to the real estate industry, there is a significant opportunity for new entrants, particularly those with patient capital, to fill this void and earn attractive rates of return.

Given these favorable macro tailwinds, we are increasing our target allocation to real estate to 5% from 3%. To “pay” for this additional exposure, we are reducing to zero our 2% allocation to gold, corn and other commodities—particularly in the wake of corn’s valuation increase of 50% over the last seven weeks.1 Overall, though, our 10% overweight allocation to real assets remains unchanged. Our key conclusions and investment allocations are detailed in Exhibit 2.

So, what are our key conclusions and investment themes that we think investors should consider when allocating to the real estate sector? We would note the following:

1. In our view, real estate is most effective as an inflation hedge in an extremely low-interest-rate environment, which is generally what we expect for the next few years. Our research shows that if we are wrong and rates do rise more than our current expectations in the near term, cap rates might be less vulnerable to this sort of “shock” than some investors currently believe .2 Key to our thinking is that there is now a substantial “buffer” between cap rates and the yield on the 10-year Treasury. All told, as we detail in Exhibit 11, the spread currently stands at 332 basis points, or one full standard deviation above its historical average since 1978.
2. Although real-estate investments provide yield, growth, and inflation hedging (all key underpinnings to our long-term macro view), we do think selectivity is warranted at this stage in the cycle. Specifically, today we feel that a decent chunk of the prime, or core, global real estate asset class is fairly valued and, in some cases, outright expensive. By comparison, we believe there are compelling investments in the non-core and opportunistic segments of the real estate market that can provide investors with a more attractive risk-adjusted return profile. The key, we believe, is to understand which locations will benefit from secular growth drivers in employment, including manufacturing re-shoring, oil and gas exploration, education, and technological/healthcare advances.
3. Given the magnitude and severity of the financial and government deleveraging that still needs to occur, we think there is a large and growing opportunity in providing solutions to the real estate sector, since traditional lenders are being forced to shrink their books and contract—rather than expand—their businesses. All told, the refinancing needs by the U.S. commercial real estate industry are estimated to total $1.7 trillion over the next five years3. Further enhancing this opportunity for new entrants, in our view, is the disappearance of the shadow banking system, as well as tighter standards administered by the credit-rating agencies.
4. On the international front, we also see a significant opportunity in Europe to generate compelling returns through real estate investments, particularly in distress-related situations. So far, Europe has deleveraged less than the United States, but we believe that tougher oversight, including the introduction of a new cohesive bank regulator, will now force it to deleverage more. That said, our “on the ground” visits to the Continent in recent months lead us to believe that real estate opportunities are more idiosyncratic than broad-based, and as a result, require both discipline and patience.
5. Investors may use REITs4 to gain exposure to real estate, but we believe they should heed their many shortcomings, such as high correlation to other financial stocks, which in 2011 stood at a sizeable 86%.5 In addition, publicly traded REITs constitute a relatively small part of the real estate investment universe,6 so institutional investors face a significant hurdle when trying to deploy large sums of capital through this segment of the real estate market.
6. Similar to investments like venture capital, manager selection in the real estate market can make all the difference. Moreover, as we show below, the disparity of returns tends to widen in a low rate environment. In addition to disparities in property types and locations, we also link at least some of the differential to the different degrees of leverage employed7. Our advice for the future: Given the diversity of opportunity sets we see ahead, we think having as much flexibility as possible to deploy capital, including the ability to provide equity, mezzanine, or even traditional loans, across a variety of industries and locations is likely to be a critical input to driving strong returns in the asset class.

From an asset allocation perspective, we feel confident realizing our gains on corn and other commodities and increasing our exposure to the non-core and opportunistic segments of the real estate market. This move is consistent with our desire to own — in size — real assets that can provide yield, growth, and inflation hedges in today’s low, government-induced rate environment. Besides this shift, there is no change to our asset allocation framework as our preference for ‘spicy’ credit and other alternatives at the expense of government bonds, cash, and European equities remains unchanged (Exhibit 2).

Real Estate as an Inflation Hedge

If an investor is worried about inflation today, we think his or her angst is probably misguided. As one can see in Exhibit 4 deleveraging is usually disinflationary as it almost always pressures the money multiplier. Importantly, though, we are investing today for tomorrow, and as we peer around the corner and look ahead, we do not see how massive debt loads around the world contract without some form of inflation over time. All told, the U.S. government has increased its massive debt overhang by $6.6 trillion to $15.5 trillion in 2011 from $8.9 trillion in 2006.8

History suggests that governments have several options for attacking excessive debt loads. One option is to significantly raise government revenues through higher taxes; the other is to cut social benefits. However, neither seems particularly popular in a slow-growing economy and a demographic environment in which a new baby-boomer turns 65 every 8 seconds.9

A third alternative, which the government is currently pursuing and is almost always inflationary in nature, is to hold interest rates down and do whatever it can to get nominal GDP growth above nominal interest rates in order to reduce the debt burden over time. As Exhibit 7 shows, after about a three-year period of this strategy, inflation typically starts to increase — and typically at a pretty good clip.

As we show in Exhibit 9, real estate actually performs best as an inflation hedge in a low rate environment, particularly if economic growth is moderate to solid. So, it appears that real estate should do well as an asset class in today’s low rate, muddle through environment. We also think real estate looks quite compelling relative to the alternatives. In particular, given that Treasury Inflation Protected Securities (TIPS) have a negative yield (Exhibit 10), anything with a positive carry and some growth and inflation protection seems like a compelling arbitrage these days.

However, if we are wrong and interest rates climb into the 4–8% range, real estate may prove less effective as a hedge, as history shows (Exhibit 9). This is a risk, albeit one that we don’t believe will materialize. Key to our thinking is that from almost any vantage point, we believe the U.S. government’s debt load is just too big for the Federal Reserve to allow rates to increase that much before employment levels regain their footing and progress is made toward fiscal rebalancing. Indeed, if the cost of the government’s debt had risen to 6% unchecked, the 2011 fiscal budget deficit would have inflated by 300 basis points to a sizeable 11.3% of annual GDP11. Separately, we would also just highlight that any material increase in interest rates would be wholly inconsistent with current quantitative easing initiatives and the Fed’s intention of holding nominal interest rates below nominal GDP for an extended period of time.

Probably more important, though, is that we believe if rates nonetheless begin to climb in the near term, the current spread between cap rates and the risk free rate should act as an initial cushion. All told, the current spread between cap rates and the 10-year U.S. Treasury yield stands at 332 basis points, or one standard deviation above its average since 1978 (Exhibit 11). At today’s 10-year Treasury yield, this excess spread equates to 315 basis points of “buffer” that the cap rate has in excess of the risk free rate. So, similar to the previous argument we made about corporate bond yields relative to Treasuries a few months back, our belief is that any initial back-up in the interest rate is likely to be muted, for the most part, by the spread of the cap rate over the risk-free rate “normalizing” before heading higher in tandem12.

So what’s our bottom line? As we think about real estate’s role in asset allocation on a short- to medium-term basis, we are quite optimistic about real estate’s attractive performance in a low rate environment because cap rates are likely to remain low in the near-term as Europe deleverages and the United States attempts to address its fiscal woes. Moreover, as inflationary pressures begin to gain momentum as a result of the current policy of holding nominal interest rates below nominal GDP for an extended time, our research leads us to expect that any increase in nominal rates to account for higher inflation should be offset initially by a normalization of the spread between cap rates and the risk-free rate for at least the next 4–6 years.

Core is Expensive, and We See Better Value in Non-Traditional Areas

Core properties are typically high-quality assets in prime locations—with high occupancy rates by high quality tenants—and their ownership stakes are characterized by relatively low leverage. Think Midtown Manhattan or London West End.

Within core, there are broadly four categories of assets: office, retail, industrial, and multifamily. Theoretically, core real estate, which tends to reward investors in the form of basic cash-flowing assets, should be a strong play on our demographic thesis that favors yield and growth.13

However, despite Andrew Carnegie’s famous decree that “90% of all millionaires become so through owning real estate14,” we are somewhat leery of the core market these days. Many investors, scathed by opportunistic real-estate investments that turned sour following the 2008–2009 financial crisis, have flooded the core market with capital. And as financial crises batter the likes of Spain, Greece, and other peripheral countries, we believe foreigners are redirecting large sums of personal net worth toward high-end real estate in prime locations in such cities as London.

Our research shows that, in aggregate, much of the core market has become expensive, with cap rates falling in some instances more than 200 basis points from their 2009 peak (Exhibit 13). In highly coveted areas like Manhattan, cap rates have fallen even lower, towards an average of just 4.6%, while Hong Kong and Singapore have cap rates of just 2.9% and 4.2%, respectively (Exhibit 14). That level of yield may appeal to some, particularly against treasury yields of just 1.4%.15 But we think that for investments that tie up capital for several years (such as real estate), the “net” return to investors should embody an illiquidity premium that would bring the yield into the mid-to-high single-digit range, or even higher. We believe this premium, in many instances, is not reflected in investors’ total-return analysis.

On the other hand, we believe there are a lot of interesting investment opportunities in non-core properties, despite their typically less desirable locations, lower occupancy rates, and/or greater need of renovation relative to core assets.16 In particular, we see several non-core locations outside major metropolitan areas that are now experiencing equal or stronger growth rates than core locations in New York and London—and that are more attractively valued (Exhibit 15). While non-core properties do carry their share of risks, we believe their current valuations and potential returns can more than compensate investors—especially compared to many prime properties on offer.

Opportunistic Part of the Market Is a Direct Play on our Macro Worldview

We also find the opportunistic segment of the private real-estate market compelling as a play on our Phase III thesis of heightened volatility and deleveraging (Exhibit 17). We believe as economic cycles become shorter and more volatile, financing needs tend to rise—and with them, opportunity. After all, traditional financial intermediaries are less levered and have a smaller appetite for illiquid investments in today’s environment. In our view, this backdrop opens the door for private, non-traditional lenders with flexible financing capabilities to step in and provide the necessary capital to complete transactions—whether in bridge equity, restructuring, reorganization or spin-offs—especially with predictions calling for refinancing needs of $1.7 trillion by the U.S. commercial real estate industry over the next five years (Exhibit 18).

Besides Wall Street’s downsizing, the shadow banking system has contracted, too. Nowhere is this truer than in the mortgage market: Issuance of non-agency residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) has shrunk 95% to $37 billion in 2011, down from $766 billion in 2007 (Exhibit 19). As a result, the cost of capital for financing the shadow banking system has skyrocketed; mortgage REIT yields, which are a good proxy for cost of equity, are now at 11.9%, up from 4.3% in January 2007 (Exhibit 20).

But it’s not just mortgages. As the shadow banking system has contracted, we believe real-estate investors have a compelling opportunity in such areas as mezzanine to earn similar returns with more rewarding risk/return profiles in today’s market. This opportunity is apparent not only in valuations but also in the levels of seniority and leverage in the capital structure (Exhibit 22), particularly after the 34–39% correction in commercial real estate prices.17

International Opportunities

These days it takes a touch of genius—and a lot of courage—to move in the opposite direction of convention, which is precisely why Europe’s predicament requires both genius and courage to solve. Our base case is that, as European banks slowly deleverage over the next few years, history will probably repeat itself, and lending will remain muted for some time (Exhibit 23). There are also likely to be a lot of adjustments in the European corporate sector as companies are forced to deal with the fallout from the efforts of member states to reduce their fiscal deficits to 3% in coming years (Exhibit 24).

No doubt, we believe the potential deleveraging of Europe’s financial-services industry appears to qualify as a large and compelling opportunity for anyone with capital and involved in real estate. One can see this in Exhibits 23 and 25. According to the investment bank Morgan Stanley, European commercial real estate faces a €400–700 billion financing gap, mainly from bank deleveraging.18 In all, banks are set to reduce their exposure by €300–600 billion, or 12–25% of the total. Further, run-offs on CMBS and open-ended fund liquidations could generate an additional outflow of €100 billion. This potentially opens a total financing gap of €400 –700 billion for non-bank lenders to plug. Such alternative lenders will most probably be “niche players” and thus cherry-pick their opportunities, offsetting this gap by perhaps only €100–200 billion, according to our estimate. This then could leave a €300–600 billion gap in need of funding.

Importantly, though, we expect the process of asset-shedding by European banks to be more evolutionary than revolutionary. Why? Because we think the banks will face challenges in jettisoning those assets off their balance sheets without significantly impacting their equity. So, our research shows that while we clearly expect asset sales to accelerate, our base case is that European deleveraging could be more incremental than many anticipate as many banks will be forced to ‘extend and pretend.’ Thus, we expect the banks to abstain from renewing lines of credit or terminate non-core lending relationships—rather than engage in massive loan sales across the board in a hurried fashion. Meanwhile, we believe there should be compelling demand for refinancing in the market (Exhibit 25).

So, our bottom line is that opportunity to invest in European real estate is still appealing from a return perspective, but we think it will require patient, flexible capital, and the ability to operate in multiple countries across the region.

Separately, having traveled extensively to the emerging markets, we believe that rising consumption and urbanization trends are creating attractive investment opportunities. As GDP per capita improves, we expect the usage of office, hotels, and apartments to increase—but as with any investment in emerging markets, finding the right local partner, understanding the pricing model, and assembling the appropriate transaction is more art than science. We’ve witnessed multiple instances in which input costs, project delays, and cost overruns have all diminished opportunities that were theoretically attractive—and even resulted in losses.

REITs: A Tough Way for Institutional Investors to Play Real Estate

In recent years, we have seen an increasing number of individuals and institutions seeking exposure to real estate via REITs. While we favor the liquidity of REITs, investors—particularly the sophisticated individual and institutional variety—should be aware of their shortcomings too. These include their high correlation to financial-services equities, which reduces their diversification benefit (Exhibit 29). For one, consider the 86% correlation between REITs and the S&P 500 Financials index over the past year compared to the -7.5% correlation between the NCREIF Transaction Based Return index and the S&P 500 Financials over the last 20 quarters ended 1Q2012.19

The sector’s relatively small size is also a factor institutional investors should consider: REITs make up just 2.7% of the S&P 1500 Super Composite index20. That’s a quite small representation in a diversified portfolio. In absolute dollars, the total public equity REIT market capitalization is a mere $0.4 trillion, according to National Association of Real Estate Investment Trusts, compared to the $7.5 trillion U.S. Commercial Real Estate market (and that excludes U.S. household real estate, worth an additional $18.1 trillion21). So we believe the REIT market really isn’t a viable mainstream option for large institutions looking to invest sizeable sums of money to work on behalf of their pensioners or retirees (Exhibit 30).

The bottom line is that although we perceive public REITs as potential destinations for tactical investments at the margins of a core allocation to real estate, we do not think that they are well-positioned to serve as a core allocation per se. This could change over time if the public REIT universe market capitalization increases substantially and its correlation to equities decreases significantly, but we do not see this happening in the near term.

Summary

In our view, today’s environment presents attractive investment opportunities in certain parts of the real estate market that can provide yield, growth and an inflation hedge. We favor opportunistic investments that capitalize on Wall Street’s need to shrink its exposure to real estate financing, and also view compelling opportunities in non-prime (or non-core) properties with defensible business models and moderate-to-solid growth potential. The key, though, we believe, is to find cap rates that allow room for growth and that properly compensate investors for illiquidity and leverage.

Yet manager selection is paramount, as in any global investment entailing leverage that is affected by multiple economic factors. In the words of English poet Herbert Read, “Progress is measured by the degree of differentiation within a society.”22 He might as well have referred to real-estate returns. In 2008, for example, the median return of real-estate funds was 3.3%, with a high of 44.6% and a low of -96.2%—a spread of 140 percentage points, no less (Exhibit 31). Return dispersion is often higher when cap rates are low, like they are today (Exhibit 32). Therefore, as we look ahead, our view is to favor managers with flexible capital that can step in and provide the necessary financing to earn sound risk-adjusted returns in today’s unstable macro environment.