27 MAY 2018
As new forms of capital continue to target commercial property, traditional property investors are looking to alternative property assets to generate adequate returns. As investors venture further afield from what is traditionally considered "core" commercial real estate assets, an important question to ask is: How this will affect their risk profile?
Amidst increased capital being directed at commercial real estate from new destinations – both geographical and by type of investor – traditional real estate investors have shown increased interest in less traditional assets. The transactional volumes of assets, such as hotels, student accommodation, senior living and data centres, has risen relative to those of central business district (CBD) office or retail spaces.
As the current global property cycle appears to be entering its later stages, understanding where this money is coming from, why it is being directed at real estate versus other asset classes, and how this has affected traditional real estate investment strategy is vital for effective risk management.
The financial crisis that followed the Lehman Brother’s bankruptcy in September 2008 prompted several responses from policymakers. Nearly 10 years on, one of the policies that continues to have an impact on markets is the monetary stimulus deployed by central banks, whether this is in the form of low/zero/negative interest-rate policies or direct-asset purchases, such as quantitative easing.
Although the debate as to whether these policies were optimal is ongoing, one effect that they have had is the depression of bond yields. This has been particularly problematic for asset managers, specifically pension funds and insurers, who relied on the yield from long-dated assets like government bonds to offset liabilities.
Real estate offered a natural alternative for these investors, offering a yield premium over bonds while being able to match their longer-dated maturities. At the same time, asset managers (particularly those in Asia) are increasing the international exposure of their portfolios. Both Japan and South Korea’s government pension funds, which together manage ~US$2 trillion in total assets, have pledged to increase portfolio allocations to international and alternative assets (including real estate) in recent years. Another example is China’s sovereign wealth fund, China Investment Corporation (CIC), which announced it would increase its overseas portfolio allocation in real estate and other similar assets to 45% from the current 38%.
A lack of data prevents us from making definite conclusions, but anecdotal evidence suggests that it may have had some influence. For one, there does not appear to have been a sufficient supply response to additional demand for investment properties, as shown by cap-rate compression across major global commercial property markets.
Traditional real estate investment strategies generally fit into one of three categories: core, value-add and opportunistic. The major factor that differentiates these are their respective risk-return profile: a core strategy would carry the least risk, but also have lower expected returns than a value-add or opportunistic strategy. A non-traditional real estate investor, or overseas investor, may view these assets differently.
For example, they might incorporate currency risk into their valuations, or be looking at different hurdle rates if the goal is to offset liabilities. This would affect the level of return an investor is willing to tolerate to enter an investment at a given level of risk. For non-traditional or foreign investors, this willingness to accept a lower capitalisation rate could crowd out more traditional real estate investors.
Something that has become more evident as the current cycle has entered its later stages has been "style drift" among real estate investors.
Style drift occurs when the actual investments made by a fund begin to depart from the fund’s main strategy (1). An example of this in real estate can be seen in core-plus funds, which were initially meant as leveraged core funds ("core-plus leverage"), however, core-plus is increasingly being characterised by a minority of the portfolio being invested in riskier value-add or opportunistic assets. Although the goal of adding leverage to a portfolio and investing in riskier assets are both done to increase returns, they affect the risk profile of a portfolio in different ways and, thus, could behave very differently during periods of market stress.
There are indications that such stress may be on the horizon. In many markets, respondents to the RICS Global Commercial Property Monitors indicated that their market was at the peak of the cycle or in the early stages of the downturn. Much of this will likely depend on how real estate responds to higher interest rates. Although the argument is that subdued interest rates are the new normal (2), there are signs that rates will continue to move higher.
The Reserve Bank of Australia's Deputy Governor, Guy Debelle, recently discussed this dynamic in a speech (3), where he highlighted positive net issuance of G3 (US, Euro, Japanese) government bonds, longer maturities on fixed income, and upwards pressure on short-term rates as justifying the outlook for higher global interest rates.
Higher short-and-long-term interest rates should dampen real estate valuations, both through increased discounting, but also reduce the yield premium that real estate holds over other assets. The increased supply of longer-dated bonds should offer insurers and pension funds looking for assets to offset longer-term liabilities more options.
In 1921, the economist Frank Knight distinguished quantifiable risk with that of more uncertain events (4). Four decades later, Daniel Ellsberg formalised this as the "Ellsberg Paradox" – though Ellsberg may be better known for releasing the Pentagon Papers to the New York Times in 1971.
Both Knight and Ellsberg highlight the difference between risks that are more quantifiable (a coin flip, for example), and those that are more ambiguous (trying to pick a red ball from a box with some randomised distribution of red, black and yellow balls).
Some of the risks real estate faces, alternative assets in particular, are more difficult to quantify. This is especially true for something like a data centre, which has yet to go through a full investment cycle. As data on how these assets behave during downturns does not yet exist, there is an additional element of uncertainty when estimating the risk profile for these types of assets.
The distinction between risk and uncertainty also has applications for real estate investors in the longer term. Early on, it is difficult to assess whether the hype surrounding any new trend justifies its actual significance and impact. For example, five years ago, Google released 'Google Glass'; 25 months later, Apple released the 'Apple Watch'. Although both were launched amid significant fanfare, you’re probably more likely to spot the latter than the former when walking down the street.
This is also applicable to real estate. Despite the current demand for data centres, will they be considered a core asset?
This raises a fundamental question in real estate investment: what exactly is a core asset?
Take office space, which is generally evaluated on three characteristics: location, quality, and tenancy. Generally, a core office asset would be an A-grade office building – either new or recently refurbished – in a central business district with stable tenancy.
However, this is a conceptual identification rather than defining these by something more quantifiable. In practice, the differentiation between a core and opportunistic asset is made by the expected return on that asset, which is estimated given a series of underlying qualities. However, because these aren’t formalised, there is some degree of ambiguity when labelling an asset as core. This presents a problem to any real estate investor, as it inserts a degree of uncertainty into a portfolio.
When a government or company issues a bond, there is a more formalised process in place to define its characteristics. Independent companies analyse the issuer’s creditworthiness and rate the bond based on an estimate of the issuer’s ability to pay back the principal and interest. The appropriate yield on the bond is then determined by the market based on this level of risk, benchmarking against other bonds with similar ratings.
Such a system does not exist for real estate.
There are obvious challenges here: real estate is relatively illiquid and has unique characteristics, such as equities and bonds. This doesn’t mean that it couldn’t exist, however, real estate assets are already analysed based on underlying characteristics to quantify an expected return.
Standardization of measurements and valuations allow for these characteristics to be formalised in a more transparent manner, which would significantly improve risk management. A core-plus portfolio being composed of 70% A-rated real estate and 30% B-rated or below is much more informative from a risk management perspective than saying the portfolio is 70% core and 30% opportunistic.
Adding risk to a portfolio is not necessarily a bad thing (5); however, this should not be confused with uncertainty. As we enter the later stages of the current real estate cycle, increasing transparency to minimize uncertainty becomes vital to allow investors to adequately manage risks.