The alternative asset sector could grow a bit more crowded this year as institutional investors turn their attention to properties delivering higher yields.
In 2017, institutional investors are demonstrating increased interest in data centers, student housing, seniors housing and self-storage, according to Greg MacKinnon, director of research at the Pension Real Estate Association (PREA), reflecting a strategy shift from years past.
PREA recently released the results of its first quarter Consensus Forecast Survey, which asked respondents about their views on real estate asset returns over the next few years. PREA’s NCREIF Property Index, which is based on the survey results, showed expected total returns (including income) on all property types of 6.6 percent in 2017, 5.9 percent in 2018 and 5.5 percent in 2019. The survey was based on responses from 22 firms, including investment managers, advisors and researchers.
The general consensus, according to MacKinnon, is that returns are trending lower. Everyone is realistic about that and investors are avoiding leveraging up to increase their returns. And as it related to making investment decisions in today’s political climate, “Investors feel they have to keep up with business as usual. There is no way to underwrite what is going on. They can’t predict it so they are trying not to worry about it,” MacKinnon says.
In the following Q&A, NREI speaks with MacKinnon to delve further into institutional investors’ positions on real estate investment this year.
NREI: PREA recently conducted its first quarter 2017 investor sentiment survey. Of the results, what finding(s) struck you the most?
Greg MacKinnon: The consensus forecast for returns [is] lower than the long-term average and decreasing over the new few years as well. Investors expect returns will be subdued for the next three years. Although it’s not shocking based on what we’ve [seen], but it’s the big takeaway.
NREI: How are pension fund investors conceptualizing the current real estate market in terms of returns and growth? How is that reflected in their investment strategy for 2017?
Greg MacKinnon: Investors are very realistic about the returns they are facing and are not expecting some huge updraft, which is a good thing. The main thing they are thinking is: how do you structure a portfolio for returns right now? Institutional investors are looking at how to get into alternative assets.
There is also a move toward more development and build-to-core strategy in major markets. There is very little speculative construction. Domestic investors are also increasingly looking out of the big six markets, exploring Texas and Florida for instance.
Capital will keep flowing into the industrial sector this year and urban industrial for last mile delivery is being explored. Pension fund investors are still trying to figure out how to play it.
NREI: Please give us a few examples of asset types and geographic markets that are growing in favor with institutional investors this year.
Greg MacKinnon: This is not an exhaustive list, but here are a few examples, generally speaking. Domestic U.S.-based investors have looked to Dallas and Houston (in the case of Houston, on the assumption that the oil cycle is at its lowest point and to get in before the market picks up). They are also looking to growth markets that are tech-oriented—Nashville, Portland, Atlanta.
NREI: Are any property types growing out of favor with institutional investors and why?
Greg MacKinnon: Certain types of investors, those whose profiles are less risk-averse, are eyeing repositioning of class-B shopping centers and class-B malls for alternative uses, but for most investors this is still considered more of a speculative, opportunistic play. High-end luxury apartments are overbuilt in some markets, with Manhattan being a prime example.
NREI: Will pension fund investors increase or decrease their capital outlay for real estate this
Year, compared to last year? Why?
Greg MacKinnon: We are certainly seeing institutions intending to increase their allocations to real estate. In terms of this year, there is already a significant amount of dry powder looking to be invested, but it is becoming more difficult to find a place to put it. We expect the allocation to increase over the next two years.
NREI: How has the way that institutional investors perceive the real estate landscape changed since 2015?
Greg MacKinnon: Investors are still as positive about the asset class as before. What has changed is the way they are looking at returns. I don’t hear anyone predicting a major crash, but in general, they are wondering, “When is the peak? When is the turn of the market?”
What we’ve seen in a lot of cases is investors bringing in their time horizons. If you think there will be a turn in 18-20 months, you don’t want to go into a three-year project. So investors are doing value-add plays with 12-28-month timelines. After the bump in the 10-year Treasury, people are cautious about the markets and what the overall effects of interest rate increases will be. Investors are not predicting a crash, but looking at subdued increases in prices and appreciation. I think we are hitting a plateau in values.
NREI: We are in a sensitive political environment for investors. President Trump still has tax reform on the agenda and is now talking about giving a “haircut” to Dodd Frank. Could you speak to both those issues—what would be the impact of each measure on institutional real estate investors if implemented?
Greg MacKinnon: In general, there is no way to tell what the effects will be without clearly knowing the details. In the Administration it is a lot harder to get things done, virtually impossible to predict effects on the real estate market when we don’t want changes. A lot of investors are saying “we can’t underwrite what will happen, so we are just going to look for properties with good fundamentals and try to ignore the day-to-day politics until we see something concrete.” In my opinion, changes to tax reform and changes to Dodd-Frank are going to be a lot harder to implement than we think, so it’s likely any changes won’t be drastic. Investors had largely looked at what they didn’t like about Trump’s plan (tariffs, immigration policy) and what they liked (infrastructure spending, pro-business); the latter could be attributed to why equity markets had a bump.