Question Topic. Institutional Equity Real Estate Performance. How has the institutional market performed over the past year and what are the prospects for the next 2 years or so?
There are two major parts to your question: how has
institutional real estate done lately, and what does it look like going forward two years. I will draw on several factors to answer this question including: my institutional real estate experience from 1987-1999; several surveys of real estate professionals I have conducted; and, the NCREIF return series. As noted in Illustration 1, core equity real estate has taken a major hit over the past 12-15 months. Indeed, the
NCREIF index has reflected values losses over 35% since the peak in 2007. The "good news" is the rate of loss in the 3rd quarter was slower with total returns of -7.2% compared to -9.1% in the 2nd quarter.
Illustration 1: NCREIF Property Index -3rd Qtr 209
While the "good news" has been lauded by some as a signal the institutional real estate market has turned the corner, I do not think it has bottomed out and that additional losses in value are likely. This position is based on several factors. First, the implicit cap rate is some 200 bp below long-term averages. Borrowing on an economic term of "regression to the mean," there has been no structural shift in investment decision-making that would support such a shift. Granted, the market has not been pricing the risk of underlying investments, but that was a temporary --albeit prolonged phenomenon-- that is not being corrected. As noted in Exhibit 2, the long term cap rate is aroung 8% suggesting that once they bottom out, cap rates will surge as they "correct." Second, real estate fundamentals are eroding, with vacancy rates increasing, rents deteriorating, and net operating income (NOI) declining. Third, real estate is not an efficient market, but is driven by investor perceptions and mass behavior which has tended to exhibit a herd mentality. Finally, the impending surge of distressed assets has not yet hit the street. When this surge in properties that will trade at significant discounts begin to trade, appraised values of all properties regardless of property-specific conditions will be dragged down. This will be especially true in mark-to-market accounts which is the underpinning of the NCREIF index.
Illustration 2: NCREIF Property Index -3rd Qtr 2009
Although not receiving much attention in the real estate or popular press, I am concerned about the impact of record low interest rates on asset allocations to real estate. Despite the passage of ERISA in 1974 which pressured pension funds to include real estate, many investors have been reluctant real estate investors due to its capital intensive nature, inherent complexity, idiosyncratic nature, and illiquidity. As noted in Exhibit 3, the NCREIF Open-End Fund Index has underperformed other asset classes for the past 3 years. Indeed, over the past 10 years, real estate equity returns have lagged govenment bonds, despite the defensive nature of the asset class which was used as a hedge against the volatile stock market. Given the lag between real estate performance and the economy, real estate is likely to underperform going forward. This situation is exacerbated by the downside risk that if faces has not yet been fully priced into the asset class. While diversification benefits will offer some insulation from a complete flight of institutional capital, traditional institutional investor appetites are likely to remain suppressed for several years.
Illustration 3: NCREIF vs. Other Asset Classes-3rd Qtr 2009
Category: Institutional Real Estate
Question #: 110 Institutional Equity Performance
Updated: October 31, 2009
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