Jones Lang LaSalle
When Is a Core Investor Like a Drunken Townie?
Jim Costello, Senior Economist
jcostello@tortowheatonresearch.com
During a recent mission in Canada—Rick Brace, David Ingram and I went there for CB Richard Ellis' Global Research Conference as well as for the opportunity to meet with several of our clients north of the border—the long car rides incubated a lively debate as to which investment strategies face more risks in the current environment. The long trip eventually made me want to take some time off though, and got me thinking ahead to Memorial Day.
The conversation was sparked by information in the 10th annual Plan Sponsor Survey from IREI, which noted a shift in investor preference regarding investment strategies—a shift, by the way, that TWR's ISS group has been championing for a while now. The report suggests that, for 2006, institutional investors are more heavily focused on value-added and opportunistic strategies than they are on core plays. For the first time in the history of the survey, in fact, more capital is allocated to the value-added and opportunistic strategies.
The question to ask, though, is "who is facing more risk in the current environment, these value-added players, or those focused on core strategies?" One way to address the term "more" is to identify which strategies face risks that are the least manageable, which is to say, risks beyond the control of anybody in the investment management business.
While we hashed through some elements of strategy and risk, I started slipping and thinking ahead to vacation time and the upcoming Memorial Day weekend. It got me thinking back to a Memorial Day weekend in the early-1990s and a trip to the Garden of the Gods in Shawnee National Forest in Southern Illinois. This park has some great hiking trails winding through weathered rock formations carved out by millions of years of erosion. For some folks though, while the facilities are not set up for it, climbing these formations is the main focus.
I knew my visit to the Garden of the Gods was going to be interesting when two guys with mullets peeled into the parking lot in an El Camino, blasting Lynyrd Skynyrd from their stereo. The driver hopped out, chugged his beer, slammed the empty to the ground and yelled to his buddy, "let's climb some rocks!" A head full of beer can make one feel invulnerable and take risks that are really inappropriate.
Underwriting purchases with assumptions of 20% per year rent growth can also make one feel invulnerable. With the high prices and low cap-rates applied to the purchase of core assets in the current market, the only way to get a core strategy to deliver strong returns today is to make heroic assumptions about future growth. This is a strategy that hopes everything outside the investment process goes better than what seems reasonable to expect, just like the guy with no safety rope hanging onto a weathered limestone ridge miles from any emergency medical care.
The returns that core strategies achieved through the cap-rate compression seen in recent years came about due to conditions outside of the control of anybody involved in the investment management process. However, one can no longer count on falling cap rates. In fact, the transaction cap-rates from NCREIF came in flat in the 1st quarter of 2006, suggesting that this game is over.
Now, however, there are investors and market boosters out there arguing that we will begin to see outsized rental gains well beyond anything expected in TWR's Office Outlook. In our view, the office markets will generally not hit the same low vacancy rates seen during the Internet boom. Combine a somewhat looser market with a moderating pace of job growth and there just will not be enough juice to drive years of rent growth like that seen during the 1990s.
None of this is to say that core strategies are bad; it is just that investors should not expect these strategies to deliver returns in line with what was seen in recent years. The core investor should not hope for outside factors of either cap-rate compression or rent spikes to drive outsized gains.
Perhaps, ironically, it is the value-added and opportunistic players that face risks that are more manageable, as the success of these strategies relies on the expertise of the actors involved in the investment management process. A value-added strategy, wherein underperforming assets are revitalized and brought up to market rents and occupancy levels, requires the expertise of good asset management and leasing teams. The modest upswing in fundamental office market conditions that TWR is forecasting will aid these strategies as well.
In fact, to turn the original premise on its ear, more capital is flowing to value-added and opportunistic strategies, not because they face fewer risks; rather, taking a very non-research mentality, these strategies present the best opportunities in the market today. Real estate investors facing healthy but more modest rental gains can achieve above-average improvements in income returns when pursuing these strategies. These strategies work because one does not buy expecting to get the market average, rather, one buys with the expectation of getting above-market improvement through the best use of one's real estate team.
Also, an opportunistic strategy may work by understanding that idiosyncratic tenant needs have not been met in a market. Talking with some of the CBRE professionals in New York for instance, I learned that while TWR does not see conditions leading to a resumption of the rent growth seen in the late-1990s, there is an unfilled need for large-floorplates in Manhattan at the moment. Stacking plans are horrible in many assets in Midtown Manhattan and, with leases rolling over from rents negotiated at the low levels of the early 1990s, some of the new large-flooplate space coming to market in Lower Manhattan will be in great demand and should produce outsized gains in rental income.
These value-added and opportunistic strategies do have their own risks, however. If one buys a largely empty asset while assuming that its vacancy was due to cyclic reasons, and later finds that the vacancy was due to some structural issues, then this investor may be hanging off a limestone lip without a rope, right next to the core investor hoping for 20 percent annual rent growth over the next five years and our mulleted friend with a belly full of Old Milwaukee tall boys.
When Is a Core Investor Like a Drunken Townie?
Jim Costello, Senior Economist
jcostello@tortowheatonresearch.com
During a recent mission in Canada—Rick Brace, David Ingram and I went there for CB Richard Ellis' Global Research Conference as well as for the opportunity to meet with several of our clients north of the border—the long car rides incubated a lively debate as to which investment strategies face more risks in the current environment. The long trip eventually made me want to take some time off though, and got me thinking ahead to Memorial Day.
The conversation was sparked by information in the 10th annual Plan Sponsor Survey from IREI, which noted a shift in investor preference regarding investment strategies—a shift, by the way, that TWR's ISS group has been championing for a while now. The report suggests that, for 2006, institutional investors are more heavily focused on value-added and opportunistic strategies than they are on core plays. For the first time in the history of the survey, in fact, more capital is allocated to the value-added and opportunistic strategies.
The question to ask, though, is "who is facing more risk in the current environment, these value-added players, or those focused on core strategies?" One way to address the term "more" is to identify which strategies face risks that are the least manageable, which is to say, risks beyond the control of anybody in the investment management business.
While we hashed through some elements of strategy and risk, I started slipping and thinking ahead to vacation time and the upcoming Memorial Day weekend. It got me thinking back to a Memorial Day weekend in the early-1990s and a trip to the Garden of the Gods in Shawnee National Forest in Southern Illinois. This park has some great hiking trails winding through weathered rock formations carved out by millions of years of erosion. For some folks though, while the facilities are not set up for it, climbing these formations is the main focus.
I knew my visit to the Garden of the Gods was going to be interesting when two guys with mullets peeled into the parking lot in an El Camino, blasting Lynyrd Skynyrd from their stereo. The driver hopped out, chugged his beer, slammed the empty to the ground and yelled to his buddy, "let's climb some rocks!" A head full of beer can make one feel invulnerable and take risks that are really inappropriate.
Underwriting purchases with assumptions of 20% per year rent growth can also make one feel invulnerable. With the high prices and low cap-rates applied to the purchase of core assets in the current market, the only way to get a core strategy to deliver strong returns today is to make heroic assumptions about future growth. This is a strategy that hopes everything outside the investment process goes better than what seems reasonable to expect, just like the guy with no safety rope hanging onto a weathered limestone ridge miles from any emergency medical care.
The returns that core strategies achieved through the cap-rate compression seen in recent years came about due to conditions outside of the control of anybody involved in the investment management process. However, one can no longer count on falling cap rates. In fact, the transaction cap-rates from NCREIF came in flat in the 1st quarter of 2006, suggesting that this game is over.
Now, however, there are investors and market boosters out there arguing that we will begin to see outsized rental gains well beyond anything expected in TWR's Office Outlook. In our view, the office markets will generally not hit the same low vacancy rates seen during the Internet boom. Combine a somewhat looser market with a moderating pace of job growth and there just will not be enough juice to drive years of rent growth like that seen during the 1990s.
None of this is to say that core strategies are bad; it is just that investors should not expect these strategies to deliver returns in line with what was seen in recent years. The core investor should not hope for outside factors of either cap-rate compression or rent spikes to drive outsized gains.
Perhaps, ironically, it is the value-added and opportunistic players that face risks that are more manageable, as the success of these strategies relies on the expertise of the actors involved in the investment management process. A value-added strategy, wherein underperforming assets are revitalized and brought up to market rents and occupancy levels, requires the expertise of good asset management and leasing teams. The modest upswing in fundamental office market conditions that TWR is forecasting will aid these strategies as well.
In fact, to turn the original premise on its ear, more capital is flowing to value-added and opportunistic strategies, not because they face fewer risks; rather, taking a very non-research mentality, these strategies present the best opportunities in the market today. Real estate investors facing healthy but more modest rental gains can achieve above-average improvements in income returns when pursuing these strategies. These strategies work because one does not buy expecting to get the market average, rather, one buys with the expectation of getting above-market improvement through the best use of one's real estate team.
Also, an opportunistic strategy may work by understanding that idiosyncratic tenant needs have not been met in a market. Talking with some of the CBRE professionals in New York for instance, I learned that while TWR does not see conditions leading to a resumption of the rent growth seen in the late-1990s, there is an unfilled need for large-floorplates in Manhattan at the moment. Stacking plans are horrible in many assets in Midtown Manhattan and, with leases rolling over from rents negotiated at the low levels of the early 1990s, some of the new large-flooplate space coming to market in Lower Manhattan will be in great demand and should produce outsized gains in rental income.
These value-added and opportunistic strategies do have their own risks, however. If one buys a largely empty asset while assuming that its vacancy was due to cyclic reasons, and later finds that the vacancy was due to some structural issues, then this investor may be hanging off a limestone lip without a rope, right next to the core investor hoping for 20 percent annual rent growth over the next five years and our mulleted friend with a belly full of Old Milwaukee tall boys.
posted by Jones Lang LaSalle NJ News Blog at 1:59 PM
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