On/Off Switch

Broadly speaking, the NPI is characterized by high-quality (i.e., institutionally owned) properties. So, the “flight to quality” that occurs in most downturns (real estate or otherwise) is not observed in these data. While reliable data on lower-quality assets—those often found in non-core funds, often referred to as “transitional” properties—are difficult to come by, it is generally believed that lower-quality properties fell even further during the market corrections in the late 1980s and early 1990s, and in the mid 2000s.

Similarly, the red line in Exhibit 1 indicates the growth in (restated) net operating income assuming US$100 of income² in 1978 over the same period (it is also indexed to the left-hand vertical axis). Given a time series of property values and income levels, a time series of capitalization rates is constructed; these rates are shown by the top line of the green-shaded region (and are indexed to the right-hand vertical axis). The green dashed line indicates that capitalization rates have averaged approximately 6.7% over this nearly 45-year period. In general, the time-series path of capitalization rates has been downward sloping. Possible explanations include a generally declining path of interest rates and the growing acceptance of commercial real estate as an institutional asset class.

ANGST ABOUT PRICING

Not surprisingly, this group of 111 global respondents—each representing the point of view of their respective organizations—listed inflation, geopolitics, war, and interest rates as their greatest investment threats. But at the same time, they are also able to extract opportunity from these seemingly unprecedented challenges.

Whatever the reasons for the downward trend, cap rates cannot endlessly decline—there needs to be some bottom, if not a rebound. And to that end, the current pricing of US commercial real estate ought to give investors pause. For example, today’s prices for core properties in the primary markets are more than 50% higher than before the Global Financial Crisis (GFC), and today’s cap rates, approximately 3.8%, are the lowest in the NCREIF history.

While discussions about and definitions of “bubbles” are fraught with imprecision, Greenspan—reflecting on the GFC—indicated what he thought the signs of a bubble to be [emphasis added]:³

. . . I define a bubble as a protracted period of falling risk aversion that translates into falling capitalization rates that decline measurably below their long-term, trendless averages. Falling capitalization rates propel one or more asset prices to unsustainable levels. All bubbles burst when risk aversion reaches its irreducible minimum, i.e., credit spreads approach zero, though analysts’ ability to time the onset of deflation has proved elusive.

If we take Greenspan’s definition to the NCREIF data, we see that today’s capitalization rates are nearly 340 BPS lower than their long-term average:

Cap Rate Comparison
Current Cap Rate: 3.68%
Long-Term (Trendless Average): 7.05%
Difference: 3.37%

This difference represents the greatest disparity between the current capitalization rate and the then-current long-term trendless average of prior capitalization rates in the NPI history.

RISK-ON/RISK-OFF INVESTING

Since we are in the real estate investment business, most of us can’t “go to cash” and wait for a price correction. It may never come. Instead, shrewd investors often employ a “risk on/risk off” approach to investing. Following an event such as the GFC, when investors’ risk aversion is quite high, the smart money invests aggressively (i.e., “risk on”). However, as memories of the adverse event fade and risk aversion diminishes dramatically, the smart money invests conservatively (i.e., “risk off”). In the latter period, investors aren’t paid much for taking risk; moreover, and assuming the adverse financial event arrives, the low-quality assets are most-harshly valued downward (i.e., there’s a “flight to quality” in the downturn).

Perhaps Warren Buffett best summarized this approach: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.“⁴

While the signs for such market extremes are imprecise, investors often look to telltale signs in both the credit markets (such as credit spreads, available leverage ratios, severity of loan covenants, etc.) and the equity markets (such as cap rates vs. risk-free rates, ease of fund-raising, the amount of “dry powder,” governance provisions in fund and/or joint venture documents, etc.), the strategy can be generally described with what we see in Exhibit 2:

Thus, risk-on/risk-off investing is intended to tactically respond to current market conditions. Following some sort of market correction (e.g., the GFC), the risk-return continuum is typically elevated and steeply sloped. However, as the market’s collective reaction to that correction wanes (e.g., more than a decade has passed), the continuum sinks and is shallowly sloped. In the former state, the expected to rewards to risk-taking are significant; in the latter state, the expected to rewards to risk-taking approach insignificant.

That said, de-risking depends on each real estate investor and fund manager. Very few investors have broad discretion. Most investors—and certainly operators and fund managers—have discretion within the confines of a given strategy. As one example, the core real estate manager⁵ might avoid the “style drift” (in this case, a tendency to move towards core-plus and/or value-added strategies) often found in “late cycle” investing, and instead concentrate on best-in-class assets. Such a rebalancing avoids the dilutive effects of the promoted interests paid to operating partners and the increased drag of transaction costs that typically accompany the short-term nature of non-core investments.⁶ Furthermore, investors and fund managers may—where possible— consider lowering the leverage ratio of their investments, thereby reducing the chances of financial distress often associated with significant market downturns. Similar arguments could be made on behalf of non-core managers and strategies.

WHEN THE INCREASE IN RISK DWARFS THE INCREASE IN RETURN

In today’s low-return environment, some investors have moved their real estate portfolio allocations further out on the risk/return continuum, arguing that low-risk strategies provide insufficient rewards. And while it is true that moving further out on the risk/ return continuum increases the investor’s expected return, it does so at the increasing risk of a significant shortfall with regard to the investor’s liability management.⁷ To illustrate this proposition, consider Exhibits 3 and 4:

The first of these two exhibits is meant to convey the general sense of a risk-on market, in which the chances of the realizing a return below the investor’s liabilities or a given threshold are fairly small in comparison to the second of these two illustrations. Exhibit 4 is meant to convey the cost of “reaching for yield” (or, equivalently, “swinging for the fences”) in a low-return/risk-off world; such behavior significantly increases the risk of realizing a shortfall with respect to the organization’s liabilities.

This cost is compounded by the likelihood that a real estate market correction–should it come to pass–will coincide with a similar correction in the broader capital markets, perhaps abetted by bouts of “distress” and illiquidity; all of which greatly worsens the downside of being overly invested in risky assets during a market reversal.

ABOUT THE AUTHOR

Joseph L. Pagliari Jr., Ph.D., CFA, CPA, is Clinical Professor of Real Estate at the University of Chicago Booth School of Business and focuses his research and teaching efforts on issues broadly surrounding institutional real estate investment.

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