Real Estate: ‘The tallest midget in the investment world’

What’s the outlook for commercial real estate investment in the remainder of 2006 and beyond?

A diverse and experienced panel of institutional investors and brokers assembled at the Lodge at Torrey Pines in La Jolla, Calif., outside San Diego recently to assess the state of the industry. Topics included preferred property types among investors, major trends in the retail and office sectors, and the climate for M&A activity.

Moderated by NREI Editor Matt Valley, the roundtable was hosted by the Grubb & Ellis Institutional Investment Group as part of a two-day conference that attracted 80 industry professionals. An edited transcript follows. For more conference highlights, refer to the May issue of NREI.

Grubb & Ellis Institutional Investment Group
Roundtable Participants.
  • Eric Berkman, senior vice president, Institutional Investment Group, Grubb & Ellis
  • Jay Raghavan, executive director & co-head of asset management,
    U.S. real estate investing division, Morgan Stanley
  • Stephen Spey, director and portfolio manager, ING Clarion Partners
  • Stuart Tanz, CEO, Pan Pacific Retail Properties
  • Dixie Walker, senior vice president, Institutional Investment Group, Grubb & Ellis

    Matt Valley, editor-in-chief, National Real Estate Investor, moderator

NREI: Last year set a new record for investment sales activity in the commercial/multifamily sector. Real Capital Analytics reports that sales of all property types exceeded $268.2 billion, up 44% from the previous record of $185 billion in 2004. It’s a great time to be a seller because the pricing is so great, but buying is very challenging. Jay, what property types are you targeting in 2006 and why? Is net operating income (NOI) going to be the real push in the year ahead?

Jay Raghavan: For 2005, we closed about $6 billion of transactions. When we talk about the basic food groups, typically we think about office, industrial, retail, multifamily and sometimes hotel. But we also look at alternative investments. We bought self-storage, for example. We’re looking at medical office buildings and selectively looking at senior living.

Morgan Stanley does feel that cap-rate compression may be about over. We are not going to see that much of it. But we are bullish on NOI growth for the coming years, especially 2007 to 2009 in the industrial, office and retail sectors. Retail is the one property type that we are a little worried about.

But we do think that in the office sector that you need to be careful as an investor. One of the things that we talk about is that there are the “haves” and “have nots” with respect to NOI growth. You have to be careful where you invest. We will be investing in most food groups, but it will be selectively invested in the different markets.

One of the things we’re really focusing on at Morgan Stanley is how you invest. We are really looking more and more at opportunities in which we can employ a big-deal strategy, if you will. We’re talking about $500 million-plus deals, trying to look at public to private, or wholesale to retail opportunities, trying to do a lot more partner deals. In 2005, about 54% of the deals we executed were really off-market deals working with partners.

The last two years we have added about 30 partners to the equation. A lot of it is really trying to figure out how to invest. In the bidding war, after a while we don’t feel comfortable going any further. It’s very difficult to get the [favorable] returns through the bidding war. So, we have found other ways to do the investments, and we hope to continue to do that this year.

NREI: Are you weighting the portfolio this year more toward one property type or another? What are you seeing out there in the marketplace?

Jay Raghavan: We do think that there is going to be NOI growth, but as we all know in office and industrial we actually have leases in place that tend to be long term. So, in office and industrial we see that NOI growth is likely not going to occur until 2008 or 2009. But in the multifamily sector where there are one-year leases in place, we tend to see NOI growth sooner.

So, we probably would invest more in multifamily in the short term, but would not rule out self-storage or medical office buildings. We also might look closely at urban retail and ethnic retail opportunities for investment. We will continue to invest in office and industrial, but on a more selective basis. Our strategy will be more creative in different food groups.

NREI: Stephen, historically 80% of ING’s real estate investments have been in core properties, with the remaining 20% invested in value-add or opportunistic properties. Today, the value-add and opportunistic component comprises a higher percentage of your portfolio. Is that simply a function of the changing investment landscape?

Stephen Spey: Well, I think it’s a function of several factors. This past year, we were still probably 60% to 70% invested in core product, but as a group we’re coming out with a value-add fund, and we’re in the midst of investing money for our opportunistic fund. Some 10% to 20% of investments in our Lion Industrial Trust in any given year are developments with partnerships.

And it’s also a factor of what our clients are looking for: higher returns and greater opportunities for those returns. Clearly, you can go into Washington, D.C., and you can buy a core building and you can be pretty comfortable with it, but your returns are not going to be as aggressive as if you go into some of these other areas.

We’ve started to look at hotels, redevelopment of hotels, partnerships with value-add plays in hotels. We’re looking at self-storage and have invested in that, both in our core funds and in our value-add funds. We’re looking at things like parking garages. We’re looking at land development. We’re doing what we think prudent investment advisors should be doing when core returns are as low as they are. Yet, we see opportunities out there, and have investors that want to pursue some of those opportunities.

NREI: What are the returns that you expect today on core vs. value-add vs. opportunistic?

Spey: For us, core returns are in the 7% to 8% unlevered range for internal rates of return (IRRs). When you start to put leverage on, and start to put a value-add fund together, you’re looking at returns in the low to mid-teens. In our opportunistic fund and for our separate account investors that go into direct opportunistic investments, you’re looking for levered returns close to 20%.

NREI: Jay, any input on return targets?

Raghavan: It’s amazingly similar. In terms of opportunistic investments, we’re probably looking at a little over 20% [for levered returns].

NREI: Stephen, Hilton Hotels Corp. in late January announced groundbreaking for the Hilton San Diego Convention Center, which is a 30-story, 1,100-room hotel on the edge of San Diego Bay that will connect directly to the convention center. ING Clarion is a joint partner in that deal, and is expected to invest $350 million. Can you talk a little bit ING’s role and why you got involved in that project?

Spey: Sure, it was actually a project that I worked on. We have some separate account investors that will move into opportunities like that and take the risk, especially if we can find a good partner.

This is a deal that will be basically 60% our investors, 40% Hilton. The construction period will be about 2.5 to 3 years. It’s a property that’s adjacent to the convention center on the south side, right on the inner harbor near the new stadium, and within a few blocks of the Gas Lamp District.

As you go into hotel investments, you’re looking for something that gives your hotel investment a little bit of an edge. San Diego is a great convention city. It’s a year-round convention city. The research that we and Hilton conducted showed that that there was a need for another convention center hotel. So, it was just a matter of putting the pieces together.

Yes, you’re taking a little more development risk, but you try to control that through guaranteed maximum price contracts, buying caps on your interest rates, that type of thing. We feel the return can be substantial if it hits on all the cylinders.

NREI: Stephen, you just returned from Mexico City. Can you give us some insight into ING’s entrance into Mexico?

Spey: We started going into Mexico with our Lion Industrial Trust, which is a $2.5 billion industrial fund that is open to investors. The trust is looking for higher returns, and is actually headquartered in Texas.

I think there’s probably a very good chance that we’ll have a Mexico fund open to some of our investors later this year. We’ve had acquisitions teams and research teams in Mexico working to develop relationships with some local partners —potentially retail-oriented, but there could be other product types in there. Clients are looking for opportunities, looking for diversification, looking for a little higher yield.

Right now there are higher yields in Mexico, and there are obviously higher risks associated with those higher yields. You try to mitigate those risks and put the pieces together so that you can offer your clients an additional investment opportunity. So far, at least some of the core clients we’ve talked to have an appetite to put some money into Mexico and gain some of that diversification.

NREI: Stephen, last year in the major markets, revenue per available room (RevPar) in the hotel sector rose 11.4%. This year it’s projected to grow about 4%, so the industry has moved from recovery to more stabilization, and yet you see this wave of investors coming into the sector. With so many investors targeting hotels, do think the window of opportunity will close in the near future?

Spey: Well, there’s certainly a lot of money going into hotels. There are funds and individual investors. Hilton, interestingly enough, has been selling some of its core properties —taking advantage of some of these 5% to 6% cap rates that historically are extremely low for hotels.

But at the same time, Hilton has put together its international expansion and bought up the Hilton International Group. Similar to other product groups, you have to be very selective. You pick your markets. You try to put together partnerships with the right groups. The idea of buying one more hotel at an intersection where there are already three others is not as interesting to us as a convention center hotel in San Diego, or a boutique renovation of a hotel in Washington, D.C.

NREI: Jay, any insights regarding hotel investment?

Raghavan: I agree that the hotel market has become more stabilized. Going forward, we do think that RevPar will grow 5% per year, but the opportunities are becoming more and more asset-specific. You have to be in the right market, and you also have to get the right asset. It’s also important to have a good operating partner.

NREI: Stuart, in the retail arena traditional grocers are under a lot of pressure, and it’s not just because of Wal-Mart. There are a number of discounters and wholesalers, such as Costco, and there are convenience stores. That grocery dollar is getting fragmented with all the players coming onto the scene. And yet Pan Pacific Retail Properties posted a 5.4% increase funds from operations per share in the fourth quarter of 2005. Pan Pacific’s net income of $38.1 million in the fourth quarter was up from about $24 million during the same period a year ago. Given the risky landscape, how have you been able to be so successful?

Stuart Tanz: Rather than looking at earnings, it’s the fundamentals on the operating side that we really should look at. Same-store NOI actually was the largest increase we’ve seen in the history of the company. Our fourth-quarter earnings showed an 8% growth in NOI year over year.

In terms of our strategy, at Pan Pacific a lot of that success has been built on where we are geographically and what we buy. One of the advantages we’ve had is that we’ve been around a long time, and we’ve really stayed focused on the high- density, high-income metropolitan markets on the West Coast, obviously San Diego being one of those markets.

For us, that’s a key part of our strategy because we’ve had very limited supply in terms of growth in the product type that we operate in. But generally, in all retail, we’ve had a huge demand with very little [new] supply. The number of tenants moving into the market has continued to surge, and we’ve had a number of tenants moving within the market.

Outside of that, we’ve been able to buy really smartly over the years in terms of focusing on very strong assets and great locations. But more importantly, we’ve acquired leases that are well under market [and where there is upside potential].

The other aspect, of course, is to manage the balance sheet. That means churning our capital. We will identify assets that don’t have much growth left or that potentially face competitive threats, and get rid of those assets. We deploy that capital into “A” locations, grocery stores that are primarily No. 1 or No. 2 in terms of local market share. It’s a very simple, straightforward and disciplined strategy that’s really never changed.

NREI: You recently remarked that cap rates in Southern California have fallen about 300 basis points over the past three years for grocery-anchored retail, and are now at about 5.5% to 6%. Are the best opportunities outside Southern California? I know that you have assets in the northern part of the state as well as Washington, Oregon and Nevada.

Tanz: One of the great markets on the West Coast for retail that I think very few people look at or understand is the Pacific Northwest — Seattle, Portland. These are very small markets, but yet very few people look at those markets because they’re so focused on California, and the dynamics of California.

But as a buyer, you do have to be careful. The minute you step out of markets that are very controlled in relation to supply, you hit the Wal-Mart effect. It’s like the political map out there where you’ve got the blue and the red. And in my view, there are some real issues coming down the road in terms of Wal-Mart and its impact.

In Vegas — which is one of the most dynamic markets and one that we’ve been in since the mid-1980s —you have to be very careful today where you go in that market. Because not only do you have the supercenter concept, you’ve got the neighborhood market concept itself penetrating the market. So, in general, when you look at markets today, you have to be very cognizant of the outside influences —Wal-Mart, and then more importantly consolidation with retailers. It’s a landscape that changes every single day.

If you don’t stay ahead of that curve, what you will find is that you could end up buying an asset and be sitting with an empty box, or you could encounter a situation where your cap rate going in may look attractive based on current levels, but the problem with retail is that the room for error is very small. The minute a tenant moves out, or you get some movement in terms of retailing that has an impact on your tenant base, that has a meaningful impact on returns. So, you have to be very careful from that perspective as well. But in general, most markets are healthy.

NREI: Dixie, with the competition among grocers so fierce today and the investor interest in grocery-anchored shopping centers so intense, what advice can you give the institutional investors in the audience today?

Dixie Walker: Some of the things that Stuart just hit on are important. You have to be really careful of where you pick your [spots]. As you mentioned, the competition for the grocery dollar is really being fragmented. If you look at the Southern California marketplace, on the value side you’ve got Wal-Mart, obviously the big gorilla, but you’ve got Costco, you’ve got Sam’s Club, you’ve got Target now putting 40,000 to 50,000 sq. ft. grocery segments in their new product. So, you’ve got those big guys that are just a dominant force in the marketplace. That’s on the value side.

Another component competing for the grocery dollar is on the higher-end, specialty side —the Trader Joe’s, the Whole Foods. And there’s a third component now, and you’ll see this more in Southern California and across the country. There is the ethnic grocer. For those of you who don’t know Southern California, Superior Foods is an example. Twenty-four stores are open now and three more are coming. And then there’s Gigante Supermarkets, which is also seeking a piece of the grocery dollar.

So the best advice is basically what Stuart is saying. You stay in where you can get the No. 1 or No. 2 grocer in the market, and you look at your supply constraint factors. What’s buildable around it?

Mergers are another aspect of this discussion. Supervalu Inc. bought Albertson’s, which is another dynamic that you can’t project. (Supervalu will become the nation’s second-largest traditional grocery chain as part of a $9.7 billion buyout of Albertson’s.) But the answer is not to do what Albertson’s did, because Albertson’s didn’t find a niche in the marketplace. The chain couldn’t keep itself competitive, and it literally got run out. So, it’s very delicate when you’re making those decisions.

NREI: So, if Wal-Mart and others dominate the value space, where are the opportunities with grocers that provide more service?

Walker: I read an article about Cub Foods in the Minnesota market. The article focused on the concept of the fragmented grocery dollar today. It used to be that a grocery store was a grocery store. Then it became a grocery store with a pharmacy. Then it evolved to a grocery store with a coffee shop, flowers, dry cleaners and video. Cub Foods has opened up medical clinics in its stores. For $35 a pop, you can go in and get treated for ailments, such as the common cold or ear infection, and that’s added $4 million to Cub Foods’ revenue line.

Fuel operations are another service grocers are providing. So, the concept for grocers is that as soon as you get the consumer close to your site, you grab any nickel out of their pocket that you can while they’re there. The service end of things is where the trend is really going to be.

Smith’s Food & Drug Stores came in from Utah into Southern California with that concept of having all these services under one roof, and they didn’t make it. But that’s a morphing, if you will, of what’s happening in the grocery store business because it’s so competitive.

Question from audience: Are the fuel operations at the grocery stores loss leaders for the grocers?

Walker: Yes, I don’t have accurate data on that, but I’ve heard the same thing. The fuel service is just to get them to the site and spend money at the store. The interesting dynamic of this encompassing service is that if you look at the standard neighborhood center, usually you have a 100,000 to 120,000 sq. ft. footprint: a 40,000 to 50,000 sq. ft. grocery and then ancillary shops. Well, a lot of these shop tenants are being sucked into the store. So, the whole concept of the cookie-cutter neighborhood center may also be changing as we move forward.

Tanz: Fuel stations add about 10% to 15% in sales because they bring in a lot more foot traffic. Most retailers have seen that much increase in sales when they add the fuel component.

NREI: Stuart, what exposure does Pan Pacific have in its portfolio relative to Albertson’s?

Tanz: Albertson’s accounts today for about 1.2% of our annualized base rent. It is a conventional supermarket chain that has not been able to redo its business model in terms of the competitive landscape over the past three to five years. So, Albertson’s decided to leave the party, as we say.

When you analyze Albertson’s, you have to break out two components. One component is the drug store business, which is Savon. That accounts for seven out of the 21 units that we own as part of Albertson’s. So, when you take Savon out of the equation, we’re down to less than 15 retail units. We’ve got three Albertson’s in Northern California, about five in Southern California, and the balance scattered through the Pacific Northwest.

The real question mark is Supervalu and its approach. In my view, Supervalu is going to have to reinvent its model relative to the retail component. Supervalu is big in distribution. It’s got a couple of retail operators in the Midwest and further east. However, the West is a lot different than the Midwest and the East.

In the long term, if Supervalu is going to be successful in terms of what it’s buying, and running the prototype that currently exists as Albertson’s, it’s going to have to move in two directions: either to the upscale format, or to the discount side.

Walker: Supervalu is tripling its size with this acquisition, and geographically it’s all over the place. When you triple the numbers of stores that you have overnight [the acquisition totals 1,124 stores], you’ve got some tremendous logistic issues that you have to solve.

When Albertson’s came into Southern California and bought the Lucky chain, it wasn’t sensitive enough to the branding that Lucky had fashioned. Lucky stores that were doing $700 to $800 in sales per sq. ft. went down to $450 to $500 per sq. ft. as soon as the signs changed out front. So, how Supervalu handles this transition is going to be very interesting to watch.

NREI: Let’s talk about a few other important trends in retail. There are some rumblings that the lifestyle center format may be getting over-saturated. Do you agree or disagree and why?

Walker: Yes, the lifestyle segment is getting built up, but the issue there is that it’s tenant driven. The tenants are trying to tap into those demographic niches that they can’t get into by having their locations in a mall. A perfect example is Talbot’s, historically a mall tenant. Some 60% of its new store openings are going into lifestyle centers. So, it’s a huge change that’s going on. There is the definite chance for overbuilding. But again, that’s a real rifle shot target market that they’re trying to reach.

A lifestyle center can range from 150,000 to as much as 800,000 sq. ft. The problem is that there’s only a limited band of tenants. If you build too big, you start to backfill with non-traditional tenants in the lifestyle center. Then, if that segment of your tenant base starts to fail, whom are you going to replace those guys with?

NREI: Another timely topic is the role of retail in a mixed-use development. Dixie, what advice would you give investors today about the risks and rewards of the mixed-use landscape?

Walker: With the urbanization and demographic shift that’s occurring nationally, to me it looks like a concept that’s definitively here to stay. It’s a very valid place to invest.

You always have to watch the supply and demand issues, of course, in any situation to avoid overbuilding. But in the case of urban mixed-use, you’ve got a limited amount of available land, leading to higher densities. The development scenario is interesting because you’re doing adaptive re-use, which can add a lot of value in certain areas where land values are very high.

So you’ve got a really interesting combination of demographics coming together to make these developments work: Baby boomers who are downsizing and traveling more want to have a place in town, and upwardly mobile career-oriented people want to be in that urban environment.

Mixed-use projects that combine only residential and retail elements seem to be a safer bet. As you start to expand into office, you start to add another component to the mix. From a management perspective, it becomes a lot more difficult to try to lump all those uses together. But I think mixed-use makes sense given the evolution of our culture.

NREI: Stuart, do you envision Pan Pacific branching out into alternative formats beyond the traditional grocery-anchored shopping center?

Tanz: Many real estate owners in high-density markets are looking at repositioning their assets, or finding alternative uses. A retail center in San Diego today may be worth ripping down to make way for residential construction in order to achieve the highest and best use from a profit perspective.

When you look at a lot of high-density, urban infill markets, many of them are very underserved in terms of retail. Much of the absorption and new supply have been on the outskirts of these markets for years. So, there is huge pent-up demand. So I do believe that this mixed-use alternative is becoming very popular for two reasons: (1) cities are encouraging developers like Pan Pacific and others to come in and do these types of projects because they really need the housing component; (2) on top of that, these markets are so underserved in terms of retail.

You put those two together and you have what I believe today is a pretty successful formula for an alternative strategy. You just have to be careful about land costs and project costs. Also, you may hit the residential market in the wrong side of the curve and that may have a huge impact down the road when you look at timing.

NREI: OK, let’s turn our attention now to the office market. Eric, given the significant cap-rate compression that we’ve witnessed, are the better investment opportunities today in the second- and third-tier markets?

Eric Berkman: Secondary markets still are a great opportunity. A year ago, we had just started approaching the secondary markets. We thought that was a great opportunity based on spreads of maybe 150 to 250 [basis points] between a core market like Washington, D.C. and some of the secondary markets like Raleigh, St. Louis, Kansas City, and Columbia, S.C. We started taking properties in those cities, and we had a tremendous amount of institutional activity.

A lot of the properties in those cities had been marketed by local firms that tended to not see the wave. I’m not deriding any of the local offices, but they don’t see the national trends. We saw that a lot of institutional people were finding it very difficult to deploy capital in the core markets. So, they were looking at these secondary markets with higher yields.

We sold deals in Kansas City last year at prices per square foot higher than sellers had seen. In Raleigh, we were able to underwrite vacancy. We have a saying in Washington — it’s ridiculous, but it’s true —“Why encumber your building with leases?” We took that concept to the secondary market and said, “Look, vacancy is a good thing because you’re selling the dream, you’re selling what’s going to happen.” And actually you can really sell that idea because those markets all over the country —strategically placed assets, of course —are tightening up.

I think it’s a tremendous opportunity, and should not be passed over, to be looking selectively in secondary markets. The key is to look for economic generators. State capitals are always a good place to look. The re-urbanization of downtowns is also an important factor.

We sold a deal in Clayton right outside of St. Louis. When we went out there to look at the property, the local broker commented that the market was flat. We visited the property and looked out the window and saw a long line of construction that went from the horizon right past the building, and I asked what was under construction. They said, “It’s the metro [rail system] coming here.” And I pointed my finger again and asked, “What’s that?” And they said, “That’s nothing. It’s just some 24-hour type of residential and retail going in over there.” And then I pointed my finger again, and they remarked, “That’s nothing, that’s just some restaurant pads.” So, the ingredients were there for a tremendous revitalization of this property. This is just one example of identifying and applying trends in core markets to secondary markets on a selective basis.

NREI: In preparation for this roundtable, you and I talked about some of the frothiness coming out of the major office markets. Can you define that observation more fully for the audience?

Berkman: I can’t really define it. It’s an instinct. On core assets, anything core and above, there is absolutely no change in the bidding for assets. A deal went firm yesterday at a 5.6% cap rate. It’s an industrial deal with a high investment-grade credit.

So, on core real estate up to trophy assets there’s absolutely no letup. With the bidding in Washington, you’re seeing cap rates in the 5% range downtown, and in the suburbs you’re still seeing just insane bidding on anything that has long, stable leases in place. However, instinctually, something feels like we’re pulling back on the core-plus and below deals. There’s been a major disconnect over the past couple of years between the sales side’s underwriting of an asset and the reality. And we used to take leasing people in on all our presentations so they could talk about the market. Well, that stopped about two years ago when we were projecting one thing and they were talking about something different.

What I’m sensing is that there’s some pullback on those over-achieving underwriting assumptions on difficult assets. So, I’m qualifying quite a bit there. But it may be the precursor of something. And again, it’s intuitive. And it’s not only me. I’ve talked to my colleagues in my market and around the country. In the core markets, there may be just a little bit of a pullback to reality on some of the assets that are core-plus and below. Maybe that’s just the fundamentals of the underwriting of the vacancy, and the lease-up assumptions moving more toward reality.

Walker: In the retail segment, I would agree with virtually everything that you just said. The amount of discretion and discrimination that the buyers are applying to those assets that are not pure core product is really changing. And if you’ve got core assets, they’ll chase it and chase it hard.

NREI: Eric, office technology has made great strides. Will the use of personal data assistants, laptops and cell phones mean less dependence on the use of office space going forward? Is it fair to say that the office recovery may be delayed or prolonged because of these technological advances? It’s my observation that the office recovery has been very choppy nationally.

Berkman: It’s a little difficult for me to comment on that because we’re kind of living in an isolated bubble in Washington. But [real estate magnate] Sam Zell came to Washington about a year and a half ago and gave a speech about the migration of population. This runs a little counter to what I said about the secondary markets, but not really.

Basically, his theory is that when people of his generation graduated college, they were married and moved to the suburbs. They worked for their corporation and they had their kids. That trend has changed. The percentage of people coming out of college now that are married is tremendously small. In fact, I have some young people now working for me. The average age of marriage now is 30 or even higher. And these people want to live in an exciting environment. And they’re not living in Appleton, Wis. They’re living in Chicago. They’re living in the 24-hour cities: Washington, San Francisco and Los Angeles.

Even if you’re looking in the secondary cities, what you see is in the core of those secondary cities tremendous redevelopment in the core downtown. And so this migration is bringing the talented workforce back into urban areas. I think that the downsizing we saw in workspace is over. I think these young, creative, bright people want to work in creative, energetic, nice work environments. Our economy is moving from a manufacturing economy to a service sector, and an incredibly efficient brainpower.

You have to provide the environment for these people that’s commensurate with what they expect. So, I don’t really see that the downsizing trend is going to continue in the office space. I think as our economy moves further and further toward an information society, you need to provide an environment for these people that’s going to be acceptable to attract them.

In Washington, we created 75,000 new jobs in 2005, and most of those jobs are not construction-related and not manufacturing. They’re all technology, information-based jobs. High-quality labor is probably the biggest concern going forward. How do you get those people into your environment? You can’t do that by packing them in like sardines.

NREI: Jay or Stephen, any thoughts about the pace of the office recovery and absorption of space?

Raghavan: We just don’t really see the job growth projection in some of these secondary markets, and that’s what we struggle with when we underwrite in some of the secondary markets. The pricing is so competitive in some of the core markets that we do want to buy in secondary markets. But we don’t feel like we’re paid for the risk to go into the secondary markets. We still believe the job growth is going to be more coastal — and perhaps in big cities like Chicago — but not so much in the secondary markets.

Spey: From our standpoint, we try to follow employment growth patterns very closely, especially with relation to office investment. Like you said, Washington, D.C. generates 75,000 new jobs almost every year. When you find a market that has solid job growth, especially office job growth, and has an artificial constraint on new supply —which certainly the central business district in Washington, D.C. has —what you end up with is a market that has extremely low cap rates. But it’s also a market that has relatively low risk in terms of vacancy exposure and rental rates that won’t grow.

In fact, if you track rental rates in Washington, D.C., they’ve grown at above inflation levels almost consistently for the past 25 years. So, even if you were buying in the Washington, D.C. market at cap rates that are lower than what you’d see in most areas of the country, you’d come away at the end of the day in a three-year, five-year, 10-year cycle with some very good investment performance.

Our challenge is how to buy into markets like that and get an edge, or an extra return off those cap rates. We recently bought for our value-add fund an office building in D.C. that has the ability to put three floors on it. So you try to buy at X price and add some value by gaining some more square footage in doing that construction project, or buying a property that may have an unattractive mortgage right now, but in three years or four years, that’s going to burn off. And your value is going to be there. If you can ride that cash flow for three or four years, it’ll work. We try to look for those office markets where there’s office employment growth, and to some degree difficultly in building or creating new supply.

NREI: Jay and Stephen, if I’m hearing correctly, institutional investors should just focus on the coasts and forget about the other markets?

Raghavan: There may be some markets in between that may be good. But the Midwest is likely going to be a tough road.

NREI: The 10-year Treasury yield is gradually climbing (as of early May it hovered around 5%). To what level will the 10-year yield have to rise before we see a break from this current pattern of soaring transaction volume and compressed cap rates?

Berkman: As you start to approach a negative arbitrage on cap rates, that’s probably the point where you’re going to start to see cap rates push up, and there’s still quite a gap there. That’s my simple answer.

Spey: We see a very sizable demand of capital flowing into real estate on a global basis. And as interest rates move up, in all likelihood inflation may move up a little bit. You’ll see pricing move up, but the demand to invest money in real estate will still be there. We executed $6 billion in direct real estate deals last year. We have that much appetite this year. Our real estate securities folks who are attracting capital from all over the world have a substantial amount of capital to put to work.

If you invest globally, the United States is still by far the largest real estate market, and a certain percentage of that global flow is going to come to the United States. The nice thing would be is if interest rates moved up a little bit and cap rates did change a little bit, and we could be showing a little higher performance. Most of our clients still look at their real return. What is their return over inflation? And so far, real estate has been able to deliver that. And if interest rates move up a little bit and cap rates move up, I think we’ll still be in that type of environment.

NREI: Are cap rates and interest rates artificially low, or has there been a structural shift in the business? Will there still yet be another shoe to drop?

Walker: In the retail sector, there’s a paradigm shift among the private investors, especially the small private investors. It’s there and it’s real. The issue there is that when you’re making a decision on behalf of your [institutional] investors you have parameters, a point at which you hit a wall and you can no longer do that deal.

All this private capital that’s flowing into the marketplace has no firewall. They can do whatever they want. And that’s kind of what’s been happening. They’re buying properties that don’t make any sense. There’s negative arbitrage all over the place. But that kind of demand has been driving it. So that’s here to stay. The individual investors are moving into the real estate sector bigger than they ever have, and I think it’s permanent.

Raghavan: You also have to look at what is the alternative investment. Really, we got spoiled. We are so used to having such high returns on real estate. It [the relatively low yields on real estate] look really bad, but real estate has still outperformed the S&P 500. I do think that we’re getting repriced. Maybe the cap rates will move a little higher, but I don’t think it’s ever going to be where it was before. So, it is to a certain extent a paradigm shift.

Berkman: We’ve been saying that real estate is the tallest midget in the investment world. And as long as we stay the tallest midget, there is just going to be a ton of capital coming into our market. I also want to add that in the 20 years that I’ve been in the business, I’ve seen a major shift in real estate going from individually-owned to institutionally- owned assets. As a result, real estate has really become a very transparent commodity. The information that you can get on a transaction these days between the leases, comparable sales and ownership structure is all public, or most of it is public. You have CoStar (data provider), you have very sophisticated brokerage firms tracking these deals. So, we’ve reached the point where real estate is becoming a commodity, certainly in the major markets. It’s almost as liquid, maybe more liquid, than a bond in some cases, depending on the quality of the asset.

NREI: Jay, we’ve seen in the past year a number of public REITS going private. Do you anticipate that trend to continue? Is Sarbanes-Oxley responsible, or a confluence of factors that’s causing this trend?

Raghavan: I was surprised last year M&A real estate activity was $225 billion globally. Morgan Stanley represented about 25% of that global total, or $54 billion, and $27 billion in the U.S. We just completed a transaction where we took Amli Residential from public to private.

When a company goes from public to private, typically the management gets to stay in place. Also, they don’t have to worry about personal liability, and they don’t have to deal with Sarbanes-Oxley. A lot of the REIT crowd believes that the public markets don’t differentiate between the quality of assets (A vs. B). Also, the public markets penalize development and high leverage.

To be able to use the right leverage, and to be able to develop assets so that you can take it from wholesale to retail is leading a lot of people to believe that private is the right way to go. And because there is so much capital in the marketplace now, people are willing to do that. So, you are going to see more public to private deals.

NREI: Stuart, Pan Pacific is public. Any thoughts on the public-private issue?

Tanz: Valuations of public companies are at all-time highs. To begin with, when you look at M&A activity, you have to understand that when you have valuations and multiples at all-time highs, it does make it a bit more difficult in terms of doing M&A activity.

Putting that thought to the side, though, you’ve seen a lot of multifamily [M&A] activity because there’s a component of those companies outside of management that has some inherited value, whether that’s condo conversions or a development pipeline. There’s this component of value that’s sitting out there that hasn’t been priced into the public markets.

My view is that all this is great for public companies because it’s setting a floor for public companies in terms of these valuations. And if capital keeps flowing as it does, there probably will be more M&A activity in the realm of public companies. However, I think it’s going to be very selective. I think that you’re going to see more in one sector than another because in order to find that additional value, given the high valuations, you’ve got to find other places to capture that value.

And then more importantly, it’s got to make sense long-term. Given the dynamics in terms of the real estate business, if you make the assumption that we’re here to stay and we’re in a new paradigm, then it really all makes sense. But if things do change, then you may have another situation as we saw in the 1990s where suddenly you have all these companies that have gone public to private now turn around and go private to public because capital is so hard to find.

For us, the big advantage of being public is not only access to the capital markets. We haven’t actually accessed the equity markets for almost six or seven years now, because we just don’t need it. It’s the debt side for us. The ability for us to do corporate bonds is a huge advantage for public companies, because no matter what happens out there, no longer are we at the mercy of the banks in terms of accessing debt capital.

But all in all, M&A activity is going to stay quite active. It’s going to be more active in other sectors [outside of retail]. But given the high valuations, it’s going to be difficult. It’s not going to be an easy process.

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