In a world devoid of yield, even the lowest-returning real estate is attracting new investors.
A unit of CBRE Group Inc. (CBG:US) is investing $200 million for a group of Asian insurers in core real estate -- typically high-quality, well-leased buildings such as prime office towers, shopping centers and apartments. Blackstone Group LP (BX:US), the largest manager of high-return property funds, is expanding into the core business amid client demand. JPMorgan Chase & Co. (JPM:US) has a waiting list for investors to enter its $21 billion U.S. core fund, the country’s biggest.
Investors flocked to the most stable real estate after the global credit meltdown in 2008 caused the collapse of several high-risk property fund managers that relied on debt financing, including Lehman Brothers Holdings Inc. and Goldman Sachs Group Inc.’s Whitehall unit. While the increased demand may reduce returns, core buildings are now luring more international buyers seeking a haven and investors trying to hedge against inflation.
“There has been a lot of demand for core globally,” said Tamara Larsen, a senior research analyst at Seattle-based asset manager Russell Investments. “Perhaps the low-hanging fruit in the immediate aftermath of the financial crisis isn’t nearly as plentiful as it was before, but there’s still potential to find compelling investment opportunities.”
The benchmark Open-end Diversified Core Equity Index measuring real estate returns had a 12.5 percent annualized three-year net return through 2013, well above the roughly 8 percent average in the past four decades, according to the National Council of Real Estate Investment Fiduciaries, which compiles the index. The gauge is known by the acronym ODCE, pronounced “odyssey.”
By comparison, the Moody’s Baa corporate bond index, a fixed-income benchmark that many investors view as having the same moderate risk profile as commercial real estate, yielded an average of 5.2 percent during the same three-year period.
Core funds continue to attract net investment, according to NCREIF, the Chicago-based trade group for real estate investment managers. The 21 funds in the benchmark ODCE index saw net inflows of $2.7 billion in 2013, after net increases of $5.6 billion in 2012 and $7.1 billion in 2011, according to NCREIF. The rebound followed net outflows in both 2008 and 2009 totaling $5.2 billion.
Many investors also are adding so-called core-plus assets, which refers to buildings that might require a little extra work but are still viewed as much lower risk than distressed properties. The Asian clients of CBRE Global Investors are seeking to make mezzanine loans as well as acquire equity stakes in properties, said Matt Khourie, chief executive officer of the Los Angeles-based unit of CBRE Group.
“The interest has not really abated from the Asian or the European investors,” Khourie said. “There’s a greater focus on certainty from Asia and parts of Europe. Current income is the big driver there and getting a 5 percent plus-or-minus current return is a very attractive element.”
The 5 percent to 6 percent yield from income alone that a typical core building generates is more attractive than the roughly 2.8 percent return of the 10-year Treasury note, Khourie said. The separate account with Asian insurance companies will invest in the U.S. and Europe.
A group of Korean investors led by Korea Post bought the 49-story office tower at 161 N. Clark St. in Chicago last October in the Seoul-based postal system’s largest overseas real estate purchase. CBRE Global Investors acquired the building on behalf of the investor group. The seller was Tishman Speyer Properties LP.
Core buildings usually carry debt levels of about 40 percent or less, whereas a typical opportunistic asset might have debt of 60 percent or more. At the opposite end of the risk/reward continuum, real estate opportunity funds aim for returns of at least 15 percent by using large amounts of debt to buy assets in need of turnaround.
In addition to forming separate accounts with clients, both CBRE Global Investors and New York-based Blackstone are among the firms raising or planning to raise new funds for core and core-plus real estate. CBRE got a $125 million pledge from the Illinois Municipal Retirement Fund last October for its CBRE U.S. Core Partners LP fund, according to the pension fund’s website. Khourie declined to comment on fundraising.
The real estate investment universe is enormous, representing almost $29 trillion of value, the vast majority of which are core assets. The U.S. accounts for about a fourth, or $7.3 trillion, of the worldwide total, said Doug Herzbrun, global head of research at CBRE Global Investors.
“It’s a huge asset class,” Herzbrun said. “Buildings shift in and out of the core category depending on their leasing profile.”
To be considered core, a property generally has to be readily re-leasable and be at least 85 percent occupied for an office building and 90 percent for retail, apartment and industrial buildings, Herzbrun said. Core returns are largely generated from rental income, rather than price appreciation. The U.S. office occupancy rate averaged 83.1 percent in the fourth quarter of last year, while apartment occupancies averaged 95.9 percent, according to Reis Inc., a New York-based property research firm.
The renewed popularity of core real estate has made some investors move to higher-risk investments as property prices rallied, said Russell’s Larsen. Just 5.2 percent of last year’s 13.9 percent gross return in the ODCE Index came from income, with the bulk from property price appreciation, a reversal of the historic pattern, where income provided most of the return.
“We expect to see positive returns but not as strong as they have been,” said Larsen. “The last few years was a great time to invest in U.S. core and now we’re seeing investors, including those making initial allocations, move up the risk spectrum or consider other markets that might offer a better fit.”
Commercial property prices in the U.S. jumped 13 percent last year to just 8 percent below their November 2007 peak, according to an index by Moody’s Investors Service and Real Capital Analytics Inc. In major markets -- which have the most core real estate -- prices climbed 2.5 percent above their previous highs.
Investor demand for core real estate is partly being driven by a perception that such assets offer a hedge against inflation, a desirable quality as the economy expands and interest rates climb, said Michael Acton, research director at AEW Capital Management in Boston, a real estate investment manager. The firm oversees about $27 billion.
Increases in the cost of land and development boost replacement values, bolstering existing real estate. A stronger economy also tends to translate into higher rents. The flip side is rising interest rates increase borrowing costs, reducing what prospective buyers are willing to pay, and some landlords might not see the benefit of higher rents if they’re locked into long-term leases.
“Bonds might not help investors in an environment where interest rates increase or inflation goes back to normal levels,” Acton said. “High-quality commercial properties might be generating a 5 percent current yield and investors can’t find that in anything that feels really safe. The whole point of the core strategy is it’s the portion of real estate that’s not going to keep them up at night.”
Blackstone made its first core real estate purchase in December, buying a 29 percent stake in Edens, a South Carolina-based shopping-center landlord, for $718 million. It plans to invest $250 million on expanding the company.
As the largest company in private-equity real estate, Blackstone sees many potential investments whose likely returns, duration, debt levels or other characteristics don’t fit the requirements of its opportunity funds, said Peter Rose, a spokesman for the firm. A.J. Agarwal, a senior partner who previously worked on U.S. acquisitions for the opportunity funds, is overseeing the new core business.
The move into core real estate is part of a rapid expansion by Blackstone’s property unit. The division started a real estate debt business after the credit crisis that it has built up to more than $10 billion of assets and expanded in Asian and European property investments. It manages about $79 billion in real estate assets.
Core funds charge lower fees than opportunity funds. They also tend to be open-ended vehicles such as mutual funds that investors can exit quarterly. Opportunity funds, by contrast, have a finite life and investors are locked up for terms of about 10 years.
JPMorgan’s Strategic Property Fund last year acquired two core buildings in New York, the 31-story office tower at 425 Lexington Ave. and a majority stake in 195 Broadway in lower Manhattan, with a combined value of more than $1 billion.
“Overall the world is starved for yield,” said Mark Zytko, co-CEO of Mesa West Capital, a Los Angeles-based real estate lender. Given the combination of current income and value protection, “globally, core real estate is viewed as an attractive place to be.”
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