Morning Star -Peter Grant - 7 February 2017
Some prominent real-estate investors are reducing their holdings and getting more selective about new deals, in a sign that the eight-year bull market for U.S. commercial property is coming to a close.
Asset managers at pension funds and endowments, as well as private-equity firms and other big investors, are throttling back on new acquisitions, selling more assets and shifting to less risky strategies as a way to protect against potential losses in a downturn.
Additional selling could put stress on the market because demand for property has started to flag, especially at current price levels. Deal volume decreased by $58.3 billion, or 11%, in 2016, the first annual decrease since 2009, according to data firm Real Capital Analytics, a sign that investor appetite is waning.
Investors that have picked up the pace of selling to lock in profits include private-equity firm Blackstone Group LP, real-estate giant Brookfield Asset Management, United Parcel Service Inc.'s pension trust and Harvard Management Company, which manages Harvard University's endowment.
When these big investors do buy, they are focusing more on niche properties such as self-storage warehouses and biomedical facilities, which haven't seen the sharp price rise of trophy office buildings and rental apartments.
"We definitely have a risk-off mentality," said Judy McMahan, a portfolio manager for UPS's $32 billion pension trust. "We're being careful." The pension trust sold more property than it bought last year, and its new acquisitions included senior housing and industrial space in the U.K., said Ms. McMahan.
Brookfield also increased the pace of its selling, unloading about $3 billion in property in 2016 compared with about half that much in 2015. The company recently put on the block a 49% stake in its sprawling Brookfield Place complex in Manhattan. The complex just finished overhauling its retail space and filling the 2.5 million square feet of office space emptied in 2013 when Bank of America Corp. moved out.
"We think now is an opportune time to reduce some of our exposure to that asset," said Brian Kingston, Brookfield senior managing partner. "We can recycle the capital into higher returning investment opportunities."
Caution among investors in the $11 trillion U.S. commercial property sector is being driven by lofty prices, the length of the market cycle so far and the recent rise in interest rates, which makes bonds look more attractive compared with commercial property. Also, developers are adding new supply of some property types at the fastest rate since the recovery began.
Few investors predict a crash along the lines of the 2008 downturn because debt levels aren't nearly as high and the economy continues to show signs of strength. Some believe office buildings, malls, apartment buildings and other commercial property will continue to enjoy rising rents and occupancy rates if President Donald Trump's pro-growth economic plans work as intended.
Since 2009, investors have been handsomely rewarded for purchases of office buildings, warehouses, apartment buildings and other commercial property. Thanks to low interest rates and the improving U.S. economy, a valuation index published by Green Street Advisors has increased 107% since hitting its crash-era low in May 2009. But that rocketing growth is slowing. The Green Street index, which focuses on top-quality U.S. property owned by real-estate investment trusts, has stayed flat since mid-2016, according to Green Street.
Another closely followed metric -- an index compiled by the National Council of Real Estate Investment Fiduciaries -- showed total returns from commercial real estate rising 9.2% in the year ending Sept. 30, 2016, a sharp decline from 13.5% for the 12 months ending in the third quarter of 2015 and growth ranging from 11% to 14% in each of the previous five years.
Fund investors are pulling back as well. Quarterly distributions and redemptions from open-ended funds that buy low-risk properties, a popular investment vehicle among institutional investors, doubled during the first nine months of 2016, after ticking up just 11% in 2015, according to the council.
Much of the bull market has been fueled by low interest rates, which encouraged investors to forsake bonds and stretch for more yield. But rates have jumped since Election Day. Real-estate investment trusts took the first hit, with equity REITs declining 2.9% in the fourth quarter of last year compared with a gain of 5.3% for the S&P 500, according to Green Street.
So far this year, equity REITs have had a total return of only 0.38%, compared with 1.9% for the S&P 500, Green Street said.
Also, until recently, the rise in property values was fueled by developers keeping new supply in check. But that, too, is beginning to change with certain property types. For example, more than 378,000 new apartments are expected to be completed across the country this year, almost 35% more than the 20-year average, according to real-estate tracker Axiometrics Inc.
Private investors say the real estate they are chasing these days often is either real estate that's less risky or properties that can be improved and sold quickly, rather than those -- like developments -- that might not be finished until the economy is well into the next down cycle.
For example, private-equity giant KKR & Co. moved quickly to find a buyer last year after it purchased the landmark Sullivan Center in the Chicago Loop for $267 million. A few months after the deal closed, KKR sold the retail portion of the 946,000-square-foot building to Acadia Realty Trust.
"Given we are in the later stage of the real-estate cycle, we have been focused on business plans that require less time to create value," said Chris Lee, chair of KKR's real-estate valuation committee.
Blackstone sold more property than it bought last year, according to Kenneth Caplan, the firm's chief investment officer for real estate. Sales have included more traditional property types such as apartment buildings and hotels. One of its biggest buys last year was BioMed Realty Trust Inc., which leases offices to the life science industry. "It's later in the cycle where you have to be more targeted," Mr. Caplan said.
Harvard's endowment is among the big institutions that sold more property last year than it purchased, according to people familiar with the matter. A spokeswoman for the endowment declined to comment.
Institutions that sell property acknowledge values could keep rising, but said they want to play it safe.
"Some of the investments we disposed of, if we held on to them another year or so, it's possible we'd make more money," said Ms. McMahan of UPS. "However, we felt it was the appropriate time to monetize our gains."