(Article originally published Summer 2018)
Why agility is key for investors in dealing with new uncertainties
Seattle is the only market I’ve ever seen advance from secondary to primary market status. There are a few other secondary cities that are nipping at its heels, led by Austin, Denver and Nashville in the U.S., and Sao Paolo, Brazil and Montreal, Canada in the Americas. Other cities that are clawing their way to the top include Tampa, Phoenix, Las Vegas, Minneapolis and Bogota, Colombia.
Last year had the lowest overall CRE investment returns since the Global Financial Crisis, with NCREIF reporting a 7% overall return and only industrial, at 13%, exceeding its historic return average. Given the declining return environment, it is no surprise that our soon-to-be-released Americas Investor Intentions Survey 2018 reveals that investors on this side of the Atlantic are racing to find the next Seattle by increasing their focus on the higher-yield potential of high-growth secondary markets. According to the survey, investors are also moving further out on the risk spectrum to look for more opportunistic equity deals.
Markets like Tampa Bay, Nashville, Montreal and Portland all rose substantially in investor interest this year, not only for their superior current yields (higher cap rates) than the majors, but for the single most important factor of
all: higher projected office-using job growth. Investing in markets with the fastest job growth may not only lead to greater NOI growth but to additional cap rate compression even in a rising interest rate environment. The investors we surveyed clearly agree with this assessment, as “strong economic fundamentals driving rental value growth” grew in preference by 47% of surveyed investors in 2018 from 18% in 2017.
The challenge with many of these high-growth secondary markets is size (the inability to get critical mass) and liquidity. The critical mass issue is something that can be solved in the short term by outsourcing many of the property/leasing management functions. The liquidity issue is solved by the time duration of equity capital. I have long believed that the liquidity premium people pay for in major markets vs. secondary markets is a price not worth paying. Yes, you can always get out of an investment in a gateway market, but the cap rate expansion during a period of distress is likely to significantly impair your equity. So, is the liquidity premium worth it? Secondary market illiquidity can be solved by
the time duration/patience of your capital source and the ability to ride out any short-term period of illiquidity. Indeed, our 2018 survey showed exactly this, as the preference
for liquidity dropped to 14% of surveyed investors in 2018 from 44% in 2017. So, my advice is to “lead the money,” don’t follow it.
Although we don’t expect major changes in 2018, there are several risk factors that didn’t exist in 2017. These include a bounce-back in foreign capital sources, though this will not include China, whose capital controls will continue to take a toll on U.S. investment volume. Volatility is back, as evidenced by the U.S. stock market’s recent correction. This may lead to a modest pause in activity until the market finds a steady floor. The stock market downturn has been even harder on REITs, leading some to question whether the inflated cap rates in the implied net asset values of REITs will bleed into the private markets. Our investors our clearly “’watching the tape,” and the number of them who are concerned about a potential “global economic shock” rose to 30% in 2018 from 22% in 2017.
Another potential risk is inflation, as the January jobs report showed the fastest wage growth since 2009. While rising wages are a good thing in the real economy, they are a bad thing in the financial markets since they generally awaken the primal instincts of Federal Reserve hawks, who have been poised to strike since monetary easing began in 2009 and now have their chance. The 10-year Treasury has seen a 50-basis-point rise in the past three months and this is a major concern.
Given these new uncertainties in 2018, the key word for investors is “agility.” Their capital structure needs to be agile in debt by considering longer-term paper, which is what our DSF professionals are advising today. For equity capital structure, investors need to consider lowering their cost of capital if they are going to stay in the same markets/asset classes. The only alternative to maintaining short-term returns will be to move out on the risk spectrum by asset quality or market, which is clearly what many of our surveyed investors in the Americas are considering. Lead rather than follow the money in 2018 and take advantage of any short-term volatility or market dislocation to your long-term advantage.
