The outlook on the United States real estate market is not without risk and historically low level yields are making even the most experience real estate professional a little uncomfortable, even if they are reluctant to admit it, according to a leading report.
The following commentary updates our outlook for the U.S. real estate property and capital markets based on our observations through the first quarter.
Debt Market
Conditions in the real estate debt markets changed very little in the first quarter, despite rising short-term and long-term interest rates. Long-term interest rates began to climb in late January, just ahead of the first of the Fed’s two rate hikes. After starting the year below 4.4%, the yield on the 10-year Treasury bond spent much of the first quarter in the 4.5% to 4.6% range before climbing above 4.8% in late March as the Fed raised short-term rates for the second time and offered no indication that its work was done. After the quarter ended, the 10-year Treasury pushed above 5% for the first time in nearly three years, as the global economy appeared to be expanding more quickly than economists initially expected. Much as we anticipated at the start of the year, however, commercial mortgage originations and securitizations continued to surge as transaction and refinancing activity showed no signs of abating from last year’s torrid pace.
Nowhere is this more apparent than in the commercial mortgage-backed securities (CMBS) market. According to Commercial Mortgage Alert, global CMBS issuance soared to more than $57 billion in the first quarter, easily topping last year’s first-quarter volume of $41.3 billion.
Domestic issuance was particularly strong. The $45.5 billion in domestic CMBS issued in the first quarter represented a nearly 50% increase from last year. Non-U.S. issuance was modestly higher as well but fell short of many analysts’ expectations. Investors, however, seemed unconcerned by the increased issuance volume. After widening at the end of last year, CMBS spreads over 10-year Treasury yields and swap rates narrowed in the first three months of 2006.
The spread compression was most pronounced in the lower investment-grade tranches where, not coincidentally, spreads had widened the most.
Although average spreads for most investment-grade tranches have widened somewhat since a year ago, spreads for the higher yielding, below-investment-grade tranches have narrowed.
Increasing demand from B-piece buyers, many of whom repackage the securities in collateralized debt obligations (CDOs), undoubtedly has contributed to the narrower spreads.
The real estate CDO market has grown rapidly over the last two years, adding more leverage and complexity to the real estate debt market and depriving the CMBS market of a once-potent source of discipline. Not long ago, the paucity of B-piece buyers allowed the few active players to effectively dictate underwriting standards through their ability to kick out the riskiest loans from mortgage pools being readied for securitization. Now we can only hope that increasing demand for higher-yielding paper is not encouraging lenders to take more risk.
It’s a little early to know for sure whether origination and securitization activity this year will eclipse the record volumes in 2005. However, current conditions and near-term trends in the real estate property and capital markets leave little doubt that 2006 will be another blockbuster year in the debt markets. Rising long-term interest rates could dampen borrower demand over the remainder of this year. But with mortgage spreads still very tight, loan terms still very favorable for borrowers, continuing (though slowing) appreciation and a booming transaction market, the chances of a sudden slowdown seem remote.
Indeed, while it might seem that the real estate debt markets are overdue for a slowdown after the exhausting pace of the last several years, we see little reason why activity will or should moderate over the next year or two. The U.S. real estate market has come through a severe recession in the corporate economy that sent vacancy rates in the office, industrial and apartment sectors soaring to levels not seen since the early-1990s market crash. Yet the debt markets barely flinched. Delinquency rates among seasoned CMBS peaked at less than 2.5%, according to Morgan Stanley, and data from the American Council of Life Insurers shows that delinquencies in life insurers’ commercial mortgage portfolios never strayed above 0.4%. The recent property market downturn clearly bears no resemblance to the early-’90s collapse, when the CMBS market barely existed and life insurers’ loan delinquencies spiked to more than 7%.
With national vacancy rates falling across all property types, increasing signs of rent growth and new supply in most property sectors still years away, this hardly seems like the time for lenders to retrench. To be sure, the spreads that lenders and investors earn today have narrowed considerably from the generous levels of just a few years ago. But it’s still a relative game for both originators and the growing ranks of investors with an appetite for whole loans, CMBS and, most recently, real estate CDOs. On a relative basis, real estate’s credit performance over the last few years, while the property markets were struggling with rising vacancies and falling rents in most sectors, is hard for most fixed-income investors to ignore. Not only are delinquencies and defaults at very low levels and, by all appearances, headed lower, but mortgages and CMBS still appear relatively attractive compared with most investment-grade corporate bonds and longer-term Treasurys.
While liquidity in the real estate debt markets should remain high and near-term risks seem fairly benign, regulatory agencies, including the Federal Reserve, FDIC and Treasury Department, have expressed increasing concern about banks’ exposure to commercial real estate loans. In January, regulators requested comments on proposed guidance regarding commercial real estate loan exposure and risk management practices that could constrain some lenders’ appetite for commercial real estate. Although the potential impact of the proposed guidelines is not yet clear, local and regional banks in particular could face tougher guidelines that might limit the availability of capital for activities such as development.
More importantly perhaps, the agencies’ apparent nervousness about banks’ exposure to real estate loans, despite the low delinquency and default rates, highlights the tension in the real estate debt markets today between the generally healthy fundamentals and optimistic economic and property market outlook and the potentially severe consequences if something goes wrong. Leverage has continued to creep higher as valuations have climbed and the debt markets have grown more complex. Innovations such as real estate CDOs, which are frequently characterized as financing “technology,” have added a new and untested dimension to the debt markets that at the very least render historical precedence less relevant.
With more capital sources converging on the real estate industry, borrower demand seems to be the only potential constraint on the flow of debt capital today. While rising interestrates and lower yields on property might weaken borrower demand, the real estate industry has apoor history of self-discipline when capital has been readily available. So far, the liquidity in theprivate equity markets has been more than enough to cure any problems that have arisen withloans. But if private equity dries up or something else goes wrong in the real estate or broadercapital markets, conditions could change quickly.
REIT Market
Private equity is exerting a powerful influence on the U.S. REIT market as well. Unlike last year, when equity REITs fell more than 7% in the first quarter, REITs trounced most analysts’ total return estimates for full-year 2006 in the first quarter alone. According to the National Association of Real Estate Investment Trusts (NAREIT), the rebranded FTSE/NAREIT Equity REIT Index gained 14.7% in the first three months of 2006, far outpacing the respectable gains for most broad market indexes. Small cap stocks, as measured by the Russell 2000 index, also performed well, delivering a healthy 13.9% first-quarter total return. But the S&P 500 and GMweary Dow Jones Industrial Average each posted more moderate total returns of about 4.2%, while the Nasdaq gained a little less than 6.4%.
REIT performance by property sector varied widely. Apartment REITs surged nearly 20% in the first quarter, followed by office REITs (+17.5%), shopping center REITs (+17.4%), industrial REITs (+13.9%), lodging REITs (+13.5%) and mall REITs (+7.6%). The relatively poor showing by malls, which have been the top-performing sector for the last several years, says a lot about the current environment in the REIT market. Clearly, the well-publicized troubles at Mills, a mall REIT whose share price has plunged more than 30% since the year began, dragged the returns for the sector lower. However, the biggest factor holding the group back this year is that the mall companies generally are unlikely candidates for privatization deals. Mills could prove an exception, but such a scenario is hardly a catalyst for driving share prices higher. Other than the regional malls, potential privatizations at premium prices have been a major driver of share price performance so far this year.
Privatization activity, which has been percolating along for more than a year, accelerated in December 2005 with a handful of deals, including CalPERS $3.4 billion acquisition of industrial REIT CenterPoint; GE Real Estate’s acquisition of office REIT Arden ($3.1 billion); and Morgan Stanley and Onex Real Estate’s acquisition of apartment REIT Town and Country ($1.5 billion). When the privatization deals kept coming in 2006, with Blackstone’s $5.6 billion acquisition of CarrAmerica, an office REIT, and $2.6 billion acquisition of Meristar, a hotel company, and Colony Capital and Kingdom Capital’s acquisition of Fairmont Hotels for $3.9 billion, investors could no longer ignore the huge volumes of private capital hungrily searching for property.
Together, the announced transactions and rumored deals propelled REIT prices higher throughout the first quarter.
The privatization wave is not merely about public-to-private arbitrage opportunities, although the deals clearly would not be happening were it not for the premium that investment properties command in the private markets today. In some ways, it marks a reversal of the IPO boom in the mid-1990s. Many REITs initially went public to take advantage of the premium pricing that Wall Street investors were willing to pay for real estate assets that were very much out of favor in the liquidity-constrained private markets. Obviously, access to capital is no longer a problem in the private capital markets, thanks to increasing demand from equity investors and, more importantly, much broader, deeper and more efficient debt markets. For better or worse, debt capital has always been the preferred source of financing in the real estate business. Because public REITs are constrained by the amount of leverage they can use, as long as debt capital is readily available and relatively cheap, most REITs are at a significant disadvantage when competing for assets today.
The challenges of being a public company in the Sarbanes-Oxley era only compound the unfavorable environment for smaller public REITs. The quarterly time horizon of the publicmarkets is exasperating enough for companies with long-term investment objectives, like REITs,without the cost and headaches of the post-Enron/WorldCom regulatory environment. Forsmaller REITs that trade at discounts to NAV, the privatization case is not a difficult sell. Bytaking their companies private, senior REIT management teams can reward their shareholderswith what usually amounts to a generous premium to the current share price, often while earninga healthy paycheck for themselves, and escape the intense scrutiny of public market analysts andregulators. Most importantly, they can then resume life in the private market where theircompensation can be significantly higher, or at least less well publicized, and where they canspend more time focusing on real estate and less time on compliance issues and hitting quarterlyearnings estimates.
While the case for remaining a public company is a tough one for many smaller REITs today, it would be a mistake to predict the end of the public REIT market. The liquidity inthe real estate market today is unprecedented and will ease at some point, making theprivatization option less compelling. That said, the REIT market is continuing to evolve. Inaddition to the privatizations, several public REITs have merged, while others have sought toleverage their platforms through activities such as fund management, joint ventures andinternational investments. The ongoing changes are important for (at least) two reasons. First,together with the changes that have occurred over the last 10 years or so, they demonstrate theflexibility of the REIT vehicle. Second, the competitive pressures that are forcing REITs to adaptshould produce “better” REITs that are more effective and efficient at creating value forshareholders. Unlike a few years ago, when several REITs tried to add a “tech dimension” totheir portfolios to attract capital, most of the new activities and strategies that REITs are pursuingare consistent with their core competencies.
In the near term, it seems that the wall of private equity looming over the REIT market has shifted the focus away from traditional REIT market valuation metrics, such as FFO multiples and yield spreads, to net asset value (NAV). At the end of the first quarter, equityREITs were yielding about 4%, or more than 75 bps below the 10-year Treasury, and price-to-FFO multiples were pushing higher into record territory. According to Citigroup, the averageREIT price-to-FFO multiple in their coverage universe, based on 2006 earnings, was 16.1x, wellabove the 12-year average of 11x. However, as the bidding war for apartment REIT Town andCountry demonstrated, REITs still appear relatively cheap compared with assets in the privatemarket, particularly to investors who can take advantage of the borrower-friendly conditions inthe debt markets.
With first-quarter total returns for U.S. REITs well above our forecast range of 7% to 10% for full-year 2006, we are tempted to revise our prediction for the group this year, even after the pullback in REIT shares in early April. Dividends alone should add another 3% or so before year-end, and the long queues of private equity are not likely to recede anytime soon. Over the past few years, more institutional investors and hedge funds have made long-term allocations to the asset class, and with the recent addition of two more REITs to the S&P 500, bringing the total to 11, the investor base continues to broaden. Clearly, the strong first-quarter rally has made privatizations more difficult. However, as long as valuations hold up in the private market, it seems improbable that REITs could give back all of their first-quarter gains without triggering a new flurry of M&A. Hence, while we believe the REIT market will remain volatile this year, private equity should provide a floor under REIT pricing and may even push REIT share prices back above their impressive first-quarter gains before 2006 is over.
Property Market
As the activity in the REIT and debt markets might suggest, the private markets have not slowed since last year, when transaction volumes soared to record levels. Historically, transaction activity has eased in the first few months of the year as investors and lenders recover from the inevitable rush of deals at year-end. This year, however, more than $80 billion in transactions closed during the first quarter, according to preliminary estimates from Real Capital Analytics, roughly on par with fourth-quarter 2005 volume; and anecdotal evidence suggests that commercial brokers’ deal pipelines are filled with transactions that will close before mid-year.
Although the ample liquidity in the transaction market has pushed cap rates to record lows in a growing number of metropolitan areas, the property market recovery and near-term outlook justify some optimism on the part of investors. In most major markets, tenant demand is strengthening amid few signs of new supply. Notably, all sectors are showing improvement at the national level, with vacancy rates in every major property type trending lower from this time last year. Yet development remains largely in check thanks to the high costs for land, materials and labor, which have driven replacement costs up faster than prices for existing assets.
The red-hot residential market bears much of the blame for the sharply higher development costs today. In many cities, for example, demand for sites that will support residential development has caused land values to rise to the point that current market rents simply won’t justify any other use unless the project includes a substantial for-sale residential component. Materials and skilled labor are also in short supply in markets where residential construction has been booming. More developers and investors seem to be talking about speculative development, particularly in the office sector where construction lead times are longer. However, as long as replacement costs remain high, a sudden surge in supply seems unlikely in most markets, especially if lenders face greater scrutiny from regulators.
Mounting evidence that the housing market is slowing has mixed implications for all property types, but particularly for apartments. Apartment market fundamentals have beenimproving for nearly two years as many of the forces that helped create the “perfect storm” in thesector have either dissipated or reversed. The economy has fully recovered all the jobs that werelost during the recession, which has helped fuel demand from the growing numbers of echoboomers entering the labor force. Rising mortgage rates and home prices have shifted theadvantage back in favor of renting in many markets. Occupancies have increased; concessionsare declining; and rents have stabilized and, in some markets, are beginning to improve. Propertyowners still face higher operating expenses for items such as utilities and insurance, but theapartment market clearly has turned the corner.
While these trends obviously are welcome news for apartment investors, a slowdown in thehousing market could lead to increased supply of rental units and weaker asset pricing.According to Real Capital Analytics, apartment transaction volume surged more than 70% lastyear, with condo converters accounting for much of the increase. The group spent about $30billion last year to acquire more than 190,000 units, more than double the volume in 2004,making them the most potent and aggressive source of capital in the apartment sector. Theirwithdrawal from the market would effectively amount to an increase in supply, since fewer unitswould be removed from inventory, with potentially less downward pressure on cap rates.
So far, improving apartment market fundamentals and the favorable outlook for the rental marketappear to be prevailing over reduced demand from condo converters. Although apartment sales are attracting fewer bids from condo converters, investor interest and pricing have remained surprisingly strong. Whether this can be sustained depends on how the slowdown inthe housing market affects development. If the economics for new development of rentalapartments become more attractive, the supply pipeline could ramp up fairly quickly in marketswith fewer barriers to entry.
The retail sector has considerably less to gain from a slowdown in the housing market. Home equity loans and cash-out refinancing have been a huge source of funding for consumer spending in recent years. Whether home prices fall, flatten or continue to climb, today’s higher interest rates will make it more difficult for consumers to continue financing their spending habits, particularly if energy costs remain elevated. Job growth, consumer confidence and U.S. consumers’ apparent natural predisposition to spend seem to be supporting retail sales thus far, which, in turn, have continued to support demand for retail space. Retail leasing activity remains robust. However, transaction volume and cap rate compression moderated in the second half of last year, according to Real Capital Analytics, and data available through February suggests retail transactions have slowed further this year.
While retail market fundamentals remain healthy and should not deteriorate much, if at all, as long as the economy continues to expand, the sector offers less upside than the other major property types. Lifestyle centers continue to draw investors’ and retailers’ attention, andshould offer attractive development opportunities over the next few years as the format matures.But the most interesting dynamics and, potentially, the biggest risks are in the grocery-anchoredshopping center segment. The grocer landscape has changed radically since the early 1990s. In arecent presentation at an ICSC conference, a Wachovia Securities analyst showed that only fourof the top-10 grocers in the U.S. last year were ranked among the top 10 in 1993, before Wal-Mart launched its assault on the grocery business. While Wal-Mart clearly dominates thebusiness today, the industry has become far more concentrated as more grocers haveconsolidated while others simply have failed. The changing dynamics of the grocery businessunderscore the potential risk in shopping centers anchored by grocers that either do not dominatetheir local market or do not occupy some market niche, such as organic or ethnic foods.
The privatizations of office REITs Arden and CarrAmerica, for a combined price of more than$10 billion, and reports that two midtown Manhattan office buildings could trade at cap rates inthe 4.25% to 4.75% range, provide fairly convincing evidence of the increased investor interestin the office sector today. Investors have been boosting office allocations for more than a year in anticipation of the recovery, and now that market fundamentals and tenant demand are clearly improving, investor demand has intensified. According to preliminarydata from Torto Wheaton Research (TWR), office vacancy rates continued to improve in the firstquarter, albeit at a slower pace than in recent quarters. The average office vacancy rate in the 50-plus markets in TWR’s coverage universe declined to about 13.3% at the end of March, about 20bps lower than at the start of the year and 160 bps lower than at the end of first-quarter 2005.
Although the first-quarter data indicates a slowdown in office leasing activity, the slower pace was not surprising. Office absorption last year outpaced job growth, presumably as more price sensitive tenants moved to lock in space at the bottom of the rent cycle. The magnitude of the improvement in vacancy rates since this time last year is impressive, however. Coastal and southern growth markets continue to lead the recovery. For example, vacancy rates in Miami,
Phoenix, Orlando and Tampa declined by an average of 385 bps year-over-year. But many of the tech markets – Austin, suburban Boston, Northern Virginia, San Francisco and Seattle – also have rebounded strongly over the past 12 months as that sector of the economy finally begins to recover from the meltdown of a few years ago.
Even with a slowdown in office leasing this year, improving market fundamentals should lead to opportunities for modest rent growth in an expanding number of markets before the supply pipeline restores some leverage to tenants. Near-term rent spikes look increasingly likely in select markets where supply is constrained and where vacancy rates already are in the single digits, such as midtown Manhattan and Washington, D.C. However, the flat yield curve and higher long-term interest rates likely mean that the cap rate compression cycle will slow, and future value gains will stem from improving occupancies and property income. This shift poses a much greater risk for investors in secondary office markets that have benefited most from the abundance of capital in recent years, particularly if the housing market cools and office development becomes more attractive.
Tenant demand for industrial properties continues to strengthen as the corporate economy expands and consumers keep consuming. According to the Institute for Supply Management’s (ISM) manufacturing index, manufacturing output expanded for the 34th consecutive month in March as business investment remained strong. In fact, while manufacturing job losses and the yawning trade deficit dominate most conversations about U.S. manufacturing and trade, imports and exports are running at or near record levels, which means more goods moving through the U.S. economy and through ports in particular. Warehouse users have always favored markets that offer excellent access to transportation nodes and proximity to major population centers.
However, increasing transportation costs due to higher fuel costs and capacity constraints, especially in the trucking industry, have forced businesses to focus more intently on supply-chain management. Warehouse markets in and around ports and at the nexus of major highways and rail corridors have been the primary beneficiaries of current dynamics, capturing a disproportionate share of tenant and investor demand.
As in the office sector, while industrial vacancy rates have improved significantly over the last 24 months, absorption slowed in first-quarter 2006. According to preliminary data from TWR, the average industrial vacancy rate declined to 9.8% at the end of March from 11% a year ago.
Unlike the office sector, however, new supply narrowly outpaced absorption in the first quarter, leaving the vacancy rate unchanged. The increased supply underscores the strong investor demand for industrial property today. The limited supply of modern warehouses in the markets that investors prefer has allowed developers to pre-sell spec buildings with no pre-leasing requirements. So far, increasing tenant demand has more than kept pace with supply. However, the responsiveness of the warehouse supply pipeline to investor or tenant demand poses a risk for investors whose underwriting assumptions include strong rental growth to achieve their target returns.
Market fundamentals in the lodging sector remain extraordinarily favorable, unless you’re trying to find a room. The sector has seen very little new supply for several years, and in a few major urban markets like Manhattan, room inventory has been shrinking as more hotels have been converted to condos. According to Smith Travel Research, room supply grew by just 0.4% in 2005, while room demand increased 3.3% as business travelers returned in full force. The average occupancy rate at year-end 2005 was 63.1% versus 61.3% at the end of 2004, and revenue per available room (RevPAR) increased 8.4%.
As anyone who has traveled recently can confirm, hotel operators have regained pricing power, which means that increases in average daily rates are driving improvements in RevPAR. In February, RevPAR was nearly 9% higher than last year, thanks to a 6.2% increase in the average daily rate. Although demand for rooms continues to outstrip supply, a recent study by PricewaterhouseCoopers cited in The Wall Street Journal predicts a 45% surge in room supply this year, mostly in suburban areas. While operating fundamentals should remain strong in the near term, capital flows into the sector have made buying properties even more difficult than it was already. Though scarce, the best hotel investment opportunities continue to be in the luxury and upscale segments in urban markets with high barriers to new supply.
Finally, the self-storage sector remained in the spotlight in the first quarter with the announcement that Public Storage (PSA) would acquire fellow public REIT Shurgard in a deal valued at about $5 billion. Despite the merger, which further solidifies PSA’s dominant position in the industry, the self-storage sector remains highly fragmented and ripe for consolidation.
Growing investor interest in the sector has narrowed the yield gap significantly, however. According to estimates from Green Street Advisors, the implied cap rate for the Shurgard portfolio was a little less than 6%, sharply lower than cap rates at the start of last year. Although new development increased in 2005 and could go higher still this year, demand for self-storage units continues to outpace supply. According to Citigroup, the average occupancy rate among the public self-storage REITs last year was just shy of 90%, and NOI growth averaged 5.7%. With most of the self-storage market still owned by private individuals, the sector should remain attractive for investors seeking relatively high cash yields and greater opportunity for further cap rate compression.
The continued strength in the transaction market suggests that private real estate investment should post solid gains in the first quarter and for the year overall. While transaction activity should remain robust, at least throughout the first half of 2006, the pace could slow by year-end.
Rising prices and interest rates and, perhaps, a little buyer fatigue seem to have thinned the ranks of bidders on many transactions. Increasingly, we hear that buyers are pushing back somewhat in negotiations. Although their efforts so far appear to have gained them little or nothing, the mere act of questioning transaction terms was unthinkable last year and almost certainly would have immediately disqualified the bidder from the pool of potential buyers. Still, we see no reason to revise our forecast range of 12% to 15% total returns for the NCREIF Property Index this year.
*Published with permission of Pramerica Real Estate Investors U.S.
