How PREI Views the Outlook for Commercial Real Estate

How PREI Views the Outlook for Commercial Real Estate

If you’re looking for a view from the top of the commercial real estate world, Prudential Real Estate Investors (PREI) is a good place to start.

PREI has been investing in real estate on behalf of institutional clients since 1970 with gross assets under management of $48.6 billion and net asset value of $30.3 billion as of Sept. 30, 2011. Its size and scope gives the company and its managers an unparalleled view of trends shaping the sector across markets and property sectors.

Overall, the firm has more than 500 associates worldwide in 23 locations specializing in fund management, transactions, asset management, research and investment strategies, fund operations, finance, and investment structuring.

It manages a series of funds and buys commercial properties across the globe through a myriad of open-end and closed-end commingled funds and investment vehicles for institutional investors.

The funds pursue core, value-added, opportunistic, and specialized real estate investment strategies. It also offers Real estate securities strategies through individually managed separate accounts, mutual funds and sub-advisory arrangements.

In approaching deals, PREI relies on research to understand market trends. And it works with local partners in many markets and collaborates with third-party developers, operators, property managers and leasing agents. And in purchasing assets, Prudential applies a consistent underwriting process and, since it completes so many deals annually, has a wide pool of transactions to analyze performance and trends.

Like many other investors, PREI has aggressively pursued the multifamily sector, both in acquiring assets and in funding development. For example, in mid-February acting on behalf of German investors, PREI formed a joint venture with Charleson, S.C.-based multifamily developer and investor Greystar to build a 200-unit luxury apartment tower in downtown Charleston, S.C. The project will consists of 200 residential units sitting above 6,887 sq. ft. of ground floor retail and two levels of podium parking.

Recently, the firm announced several changes to its senior leadership team, including establishing a succession plan for its global chief operating officer, naming a leader for the newly formed global client services team and announcing a new head of its U.S. business.

Global COO Dale Taysom has announced his intention to retire at the end of 2012. Eric Adler will succeed Taysom and work closely with him throughout 2012 to transition into the role while retaining his current role as head of PREI’s European business, Pramerica Real Estate Investors.

Among the changes, Kevin R. Smith, who most recently served as senior portfolio manager of PRISA, has become head of the U.S. business.

Smith recently spoke with NREI about PREI’s view of the commercial real estate market and about the firm’s strategies.

An edited transcript follows.

NREI: What’s your opinion on the overall outlook for U.S. commercial real estate? Do you think it’s recovering?

Smith: The short answer is that the market is recovering. The question is the pace of the recovery, especially on the demand side. Until last fall, U.S. job growth was slow. It has picked up so far in 2012. As long as that continues, we will see some confidence return to the overall market and that’s going to translate into more people making leasing decisions on office, industrial and even retail properties.

Job growth is a really important driver. It leads to more confidence and to companies making business decisions. In the last couple years, firms have been hesitant to make long-term commitments. There were lots of renewals in place or extensions for a couple years. That’s not great for momentum.

NREI: For a while there’s been talk about investors having a lot of interest in core assets and then it dropping off in the middle and then picking up again for distress. Some have called it a “barbell”-shaped climate. Is that shifting at all?

Smith: We’re starting to see fattening in the middle of the barbell. Although, I’m not sure the volume at the bottom of the market ever existed to the scale that many hoped. There’s a difference between what people anticipated vs. what actually played out in real transactions.

The top end of the market—the higher-quality, gateway market assets—account for most of the activity. And that persists today. But in the next tier of markets, investors are taking on at least a little more risk and leasing is starting to fatten out.

There’s probably even more investors saying that’s where they want to focus rather than compete on deals on the top. Those have been bid up and the pricing feels pretty aggressive. So a lot of investors say the want to do more value-added deals. And that’s going to translate into more transactions and movement in pricing in other parts of the spectrum.

NREI: How is the state of capital markets affecting the commercial real estate investment?

Smith: Both debt and equity that is focused on the larger markets where people have focused historically and have had success. So that’s the gateway markets. Debt and equity is readily available for those places. Once you go outside the safe zone, the interest drops off and if you combine that with assets that have leasing challenges, it drops off even more.

The CMBS market, which traditionally soaks up the riskier loans in secondary markets or on assets that have challenges, has not come back in the same way. We don’t have the volume we need there. Until the CMBS market comes back in a broader fashion, it will remain like this.

So overall, for things that are in favor amongst the lenders, there is a lot of competition. Once you move away from that, it gets more difficult.

NREI: What’s PREI’s approach to leverage given the financing conditions?

Smith: The funds we manage are pretty conservative in their use of leverage. We do engage in development, apartments mainly, and for the right sponsor and the right project with our involvement we tend to get a good reception from construction lenders. That’s been pretty consistent. But apartment development is really the only property type where you’re seeing development and seeing construction lenders vying for the best parts of that business.

NREI: Has PREI’s investment strategy changed at all? You manage a variety of funds and invest in a lot of areas geographically.

Smith: We manage core, core-plus, value-add and some niche funds. So we have capital to address a variety of different pieces on risk spectrum. We’re trying to make intelligent calls across the board. So we’re not saying “We should only be here.”

For those looking for yield, core—even aggressively-priced core—still looks relatively attractive. We want to have an outlet to fill out that core strategy while we pursue value-add investments for some of our other funds. We see opportunities, but they are difficult to come by. Also, transaction activity thus far in 2012 has been a little lower than we would have thought or hoped.

NREI: Why do you think the market has been slower than you anticipated?

Smith: Some of it may be the traditional early in the year, “get our business going” lag. And that may play its way through. But it also may be a timing issue. I think people have been trying to watch the same economic indicators and get a better sense of where the economy is heading in 2012. Are other investors buying or selling? What are they selling and buying?

When you talk to the major real estate brokers, they talk about a lot of things that will be coming to the market. But that volume has been slow to manifest so far.

NREI: Can you talk a bit about your views on the main property types?

Smith: We are investing across the board. But by number and by dollar volume, most of our investments are in multifamily. We’re purchasing completed assets (although those can be very expensive) and we are sponsoring apartment development. That’s where the development activity is concentrated.

Apartment fundamentals continue to be pretty excellent based on demographics, the pace of job growth and pent-up demand. There is a generation of new renters who are not particularly enamored with home ownership at this point. We see that continuing for the next several years.

In terms of development, there will be more supply coming on, but generally we don’t think it will be as great a number as some people may fear or forecast. It’s still hard for developers to get a lot of these projects going. Lenders are more demanding and getting sites entitled is difficult.

The office sector can be attractive, but is mixed. We’re focused mostly on markets that are seeing more job growth—tech cities in particular like Austin, Raleigh, N.C., San Francisco and Seattle. And we still have a large office exposure and commitment to New York City. The office story is very directly related to job growth. We think that will come.

For example, we recently purchased on office in Seattle that was about one-third leased when we bought it. We think it will be a good play. There are good drivers in downtown Seattle, like Amazon. We felt good about taking the leasing risk and think we will be able to get paid for that risk in several years time.

As far as retail goes, those values have not bounced back the way office and apartment values have bounced back from bottom. Returns on relative basis are still generally better and that has led us to purchase some grocery-anchored centers for various portfolios. Still, a lot of shakeout has yet to happen in the fashion world. So if you’re not in a fortress mall, there’s a lot of vulnerability to the fashion world that would give us pause about some regional malls.

NREI: What about internationally? What do you see outside the U.S.?

Smith: Outside of the U.S. we have operations in Europe, Asia and Latin America. Currently in Europe we see big opportunities in distressed debt and mezzanine lending in terms of recapitalizing projects.

Smith: Outside of the U.S. we have operations in Europe, Asia and Latin America. Currently in Europe we see big opportunities in distressed debt and mezzanine lending in terms of recapitalizing projects.

NREI: There were recently a series of promotions for PREI’s management. What do the changes mean?

Smith: It really is about careful succession management. It’s interesting that not only we thought about all this, but that it’s what our investors took away from this. Both the changes in the U.S. and changes globally were very much in the pattern of planning and working with people and giving them new opportunities.

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