Is the Era of High Returns Coming to an End?

Is the Era of High Returns Coming to an End?

Is the window for oversized returns on commercial real estate behind us? Quite likely, according to Goldman Sachs, which recently issued a report implying real estate stocks may now be too risky for investors.

Real estate industry experts have mixed views, however, about whether the ship has already sailed for high returns on commercial real estate investments.

“People have read this report as if to say that this is no longer a time to get into real estate. I disagree in the sense that it assumes that people have just one motivation when investing,” says Jim Costello, senior vice president with New York City-based research firm Real Capital Analytics (RCA). “One can have a number of motivations while investing, and different types of real estate and different real estate vehicles can satisfy these motivations.”

Don MacLellan, senior managing partner with Irvine, Calif.-based real estate investment advisory firm Faris Lee Investments, is not seeing evidence of reduced capital allocation for core retail properties, for instance, though he admits that cap rates for core grocery-anchored centers in major California markets are now at record lows—such properties are trading in the mid-4.0 percent.

“I disagree that investors have missed the boat—it is really a function of the market. It’s hard to make such a blanket statement,” he says.

Still, there is a feeling in the air that returns in this cycle will no longer reach the double-digit highs seen in the past few years, according to Andy Moylan, head of real estate products at London-based research firm Preqin. At the same time, he says there is still “plenty of capital” being raised, though the numbers are trailing below last year’s.

Year-to-date in 2016, 122 funds have raised aggregate capital totaling $67.2 billion. In comparison, 252 funds raised aggregate capital totaling $120.9 billion in 2015.

“Over the last three to four years, we have seen really strong returns as a result of returning confidence in the market and increasing asset valuations. Moving forward, we are not anticipating those sorts of returns to carry on,” Moylan says. “But is not all doom and gloom, there is still lots of opportunity, just that pricing is difficult and there is lots of competition for capital.”

“Secondary markets present an opportunity,” he adds.

A recent survey Preqin conducted of 191 private equity real estate fund managers found that 49 percent of them see asset valuations as a primary concern for investors. Sixty three percent of survey respondents saw asset pricing increasing and 35 percent of them view the rise as significant. In addition, 63 percent of private equity real estate fund managers “plan to deploy more capital in the coming 12 months, compared to last year.” Large funds are the most bullish, with Preqin reporting that 80 percent of managers with funds larger than $5 billion said investor appetite increased.

Reduced targeted returns are most common among mid-market managers, according to Preqin data—67 percent of firms with assets between $500 million and 999 million “have reduced their targeted returns, while just 5 percent have raised their performance objectives.” Across firms of all sizes, a total of 51 percent have reduced their targeted returns for funds in the market.

“There are investment opportunities in commercial real estate which might deliver double-digit returns at this point in the cycle, though with additional risks,” says Costello. “Value-add deals where cosmetic improvements allow leasing at higher rent levels and/or leverage strategies pulling equity out of an asset are ways to deliver higher returns.”

However, he cautions that “The real risk at this stage of the cycle where limited cap rate compression puts the brakes on price appreciation is that too many investors try these higher risk strategies, leading to some trouble.”

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