It’s no secret among professional investors and laypeople that the global economy is in a state of volatility, but experts say that doesn’t mean one should wait for the bad times to pass. Making investments in core properties located in high-traffic economic zones is preferred, and taking advantage of low interest rates to hedge against uncertainty is not always an unwarranted risk. Many analysts still prefer the multifamily sector over other real estate niches because of continued demand there, although keeping an eye on the other sectors and secondary markets is always a good idea, especially for the purposes of portfolio diversification. For more on this continue reading the following article from National Real Estate Investor.
The investment world is still characterized by a significant amount of risk aversion and conservative behavior since the Great Recession. Most investors continue to want to play it safe by keeping large allocations in cash, treasuries and core real estate.
Yet despite the trend to play it safe, there is a global demand for yield, which further increases the demand for core, income-producing real estate. The world seems like a volatile and risky place with the massive daily swings in the stock market, rising energy prices, approaching fiscal cliff, slump in commodities, ongoing European Union debt crisis and omnipresent geopolitical risks flaming up and pushing already weak U.S. and global economies into recession once again.
Despite these concerns and the general climate of uncertainty, now is not the time to stick one’s head in the sand and wait for the scary times to pass; instead, it is time to actively manage one’s portfolio in terms of markets, strategies and sector diversification.
More than ever, it is advisable to be in robust economic locations with fundamentally strong, deep and diversified real estate markets. Secondary and tertiary markets must still be treated with caution as this anemic recovery has yet to reach many of these markets. Real estate is, and will always be, a derivative of the economy in which it resides, with the local economy playing the most significant role. I favor large, gateway cities that have seen above average economic and job growth.
These metros are characterized by deep, dynamic economies that provide some degree of insulation from the vicissitudes of specific industry and firm decline. The global gateway economies that have experienced higher growth and have generally proven to more resilient during the last downturn are the usual suspects: Boston, New York, Washington, D.C., Houston, Dallas, Los Angeles, San Francisco and Seattle.
Economist Harry Markowitz’s advice concerning diversification is more relevant than ever. Fortunately, there are greater diversification options than ever before. Real estate markets are larger, deeper and more diverse in the U.S. and as well the globe.
There are many more investable global markets now and this will only increase. Institutional investors can invest beyond the developed economies in Europe and Asia (Australia and Japan) into markets in Eastern Europe, China, India, Brazil, Mexico and many other high-growth countries. During troubling times, investors tend to stick to their home base, but the world will continue to grow and much of the higher-growth, high-return opportunities will be outside of our borders. If you are a long-term investor, now is a good time to diversify internationally.
Debt is not a dirty word
I am not advising investors to over-leverage properties, but at the current rates and terms, taking on long-term, low-rate debt is one way to hedge volatility and lock in potential appreciation. However, leverage levels should maintain a margin of safety and not approach the 80 percent to 90 percent levels of the end of the last cycle. Debt rates are at historically low rates for high-quality credit borrowers.
Despite very low cap rates and significant competition for these apartment assets, I still like multifamily due to continuing strong demand factors, but I would advise rotating into industrial and necessity retail as the economy gradually improves and consumers gain more confidence. Though office is historically the lowest returning and highest volatility sector over the long term, CBD office in major metros can still be purchased below replacement cost. There is rising demand in some gateway CBDs such as San Francisco and there is been very little new inventory over the last 10 years.
Despite the tepid economy, lower incomes, growth of internet shopping and ongoing pessimism about the economy, Americans will continue to shop, but the patterns will be slightly different. Necessity retail will continue to be a strong theme and high-quality mall formats to do well. Retail spending, like income, is continuing to look more barbell in distribution—more at the lower and upper ends of the income spectrum.
Retail spending is gradually improving at the bottom (necessity) and high end (luxury malls). Middle segment retail (traditional department stores) is still a challenge and will continue to be so in the foreseeable future. Since mall assets are difficult to acquire (they don’t trade often), the best way to play this niche is through investing in mall REITs. I also like industrial and office because these sectors are coming off severe rent declines and we see strong rental growth on the back of improving fundamentals over the next several years.
Core still makes sense if the property is well located and the price paid is not excessive. However, I still consider it to be an act of courage to buy core class-A buildings in gateway cities at cap rates that are below 4.5 percent. Buying into existing core funds with a substantial part of the portfolio in good vintage years—i.e. pre-2005—is a good way to avoid scarily low cap rates on the open market. I believe we are still in the early innings of long-term office NOI growth.
While cap rates are low, returns are relative in this low-yield world and, by comparison to treasures, CDs and most dividends, they are relatively more attractive. In addition, if we believe that the massive increase in the money supply will eventually lead to higher inflation, there is some degree of long-term inflation protection in core real estate. I like mezzanine and preferred equity because the value decline (for most assets and markets) is behind us and there are relatively good returns for the risk taken going forward.
Development of multifamily looks attractive in some, but not all, supply-constrained markets. Though there is potentially an oversupply in new apartment units starting next year, this will mainly be in suburban or less supply-constrained areas. Value-add repositioning of older multifamily in good primary market locations—that is, upgrading assets from a class-B to a -B+ or -A—continues to make sense to me. I also like the same strategy for infill necessity retail and regional malls. Those are two relatively bright spots in the otherwise gloomy retail picture.
This article was republished with permission from National Real Estate Investor.