A two-speed real estate market has emerged from the financial crisis. While prices in core, good quality properties across most markets globally have increased substantially, secondary market real estate, which represents the large majority of the total property universe, is still struggling.
“We have this bifurcation in the market between, on one side, the core, safe properties, which are very expensive, and on the other side opportunistic properties, which are very hard to find,” explains Stephen Blank, senior fellow, finance at Urban Land Institute in the US.
A significant number of secondary properties have a very high level of leverage and banks still have a large amount of non-performing loans on their books, which indicate distressed situations in real estate.
Governments in the UK, Europe and the US have not forced lenders to clean up their balance sheets. Financial institutions, for their part, are not taking active action on troubled borrowers, preferring to restructure loans, while being able to borrow from the government at very low rates and build up strength in their balance sheets.
Employment growth will drive prices up for secondary properties but there has to be more capital seeking real estate exposure before secondary properties see a recovery in capital values. This is complicated by the fact that investors are no longer able to finance them with the levels of debt seen in the past. This is the reason non-core properties represent such a good buying opportunity, says Alessandro Bronda, head of Global Property Investor Solutions at Aberdeen Asset Management.
“Most investors are really just focused on low-risk investments, but if they move a little bit more up the risk spectrum, they can pick up good assets at good prices – which still have a good cash flow and long lease terms,” he explains.
In the UK, in particular, the gap between secondary yields over prime assets is larger than other markets. Prime property has repriced more quickly and to a stronger degree, by about 25 per cent over the past 18 months. “One has to be very selective when buying secondary properties, but we see a lot of opportunities in the UK, because the price is very appealing,” says Mr Bronda.
The Barbell approach
When investing in real estate, it makes sense to adopt a “barbell approach,” says Alan Supple, portfolio manager at Urdang, BNY Mellon’s global real estate investment specialist. On one hand, individuals can invest in Reits (real estate investment trusts). These are highly liquid instruments and correlated to the equity market only in the short-term and their bias is generally towards higher quality property. At the other end, higher up the risk spectrum, closed-end, private equity style structures are the most appropriate vehicles to gain exposure to opportunities in the distressed space.
“If you are willing to do without the liquidity, there are going to be great opportunities for people at this stage in the market to make money from these closed-end fund structures, with experts creating value from troubled assets.” In this low interest rate environment, the spread between cash rates and yields on real estate is close to historical highs. That kind of scenario will continue to make real estate attractive from a yield stand point, says Mr Supple.
In core markets, such as the US and Europe, there is already some evidence of better quality income and good yield streams from real estate. The focus must be more on cash flow growth and on taking advantage of rental growth, driven by the relative pickup in economic activity.
“Until we can see a sustained expansion of the economy, it is hard to see a sustained recovery in rents, so that tends to make us gravitate towards the markets which show the most resilience, ie the core markets, which may be more expensive but they are going to offer a level of certainty,” says Mr Supple.
“Today is a good time to invest in real estate, both directly and by way of property stock investing,” states Christian Lange, president and founder of European Investors.
The primary risk for commercial real estate is oversupply and not lack of demand, except for during the recent recession prompted by the financial crisis. Oversupply is not on the horizon because development activity is in a nascent stage, debt financing is scarce and construction costs are higher due to rising commodity prices.
“Commercial real estate should have clear sailing for the next two to three years. We think we will be able to generate returns of 10 to 12 per cent per year in our real estate stocks over the next four years,” says Mr Lange.
