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Real Estate – Rates, Rates, Rates

September 30, 2016  | by Paul Von Steenburg

Investment Strategy | Real Assets

“There are three things that matter in property: location, location, location”. While the age-old adage still holds in many respects, real estate risks, as with the risks associated with all asset classes, evolve and change over time. Over the last six years, U.S. real estate markets have been buoyed by positive economic growth, muted supply growth, strong employment gains, significantly positive foreign capital flows and declining interest rates – a goldilocks scenario for the asset class. As a result, prices paid for real estate properties have reached all times highs. The most commonly used valuation tool for stabilized real estate assets, is the capitalization rate or “cap rate.” A cap rate is the ratio of net operating income to a property’s asset value, effectively how much an investor is willing to pay per unit of income generated from a real estate investment. It is akin to the equity markets earnings yield. The lower the cap rate, the higher the price being paid for the property. Capitalization rates have declined below levels last seen in 2007, directly preceding the Global Financial Crisis (“GFC”).

img_charts_re_cap_ratesThese historically rich valuations might seem to signal bubble-like conditions ripe for a correction. However, there are some important distinctions to be drawn between this cycle and the one that preceded the GFC. First, leverage use remains lower and lending standards have remained tighter. Second, supply of new real estate product remained subdued until very recently. Finally and most importantly, while capitalization rates have declined to new lows, so have interest rates. In 2007, spreads (capitalization rate minus 10 year treasury yields) reached 137 basis points, approximately 200 basis points lower than the 15 year historical average, while the current spread is approximately 475 basis points, or nearly 80 basis points wider than its historical average. This is important for two reasons: First, the use of leverage remains substantially accretive to real estate equity investor returns. Second, should interest rates rise, there remains some cushion before there is upward pressure on cap rates and, therefore, real estate prices.

At Commonfund, we expect the positive dynamics of the current cycle to continue for some time but are cognizant that we are in the later innings of the cycle. As a result, we are adjusting our real estate exposure to focus on sectors and strategies we expect to reduce economic cyclicality, benefit from positive demographic tailwinds, and generate higher cash flow yields which should provide a buffer against rising interest rates.

Authors

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Paul Von Steenburg is a member of the Commonfund Asset Management Investment team and is primarily responsible for asset allocation, manager sourcing, due diligence, and investment monitoring for investment portfolios with a focus in real asset strategies and private real estate investments. He serves as a member of the Commonfund Asset Management Investment Committee. Paul also serves on advisory boards of the firm’s investment managers. Prior to joining Commonfund, Paul was a Vice President in the consulting division of Wilshire Associates, where he advised institutional investors. Paul was also the Chair of Wilshire’s Hedge Fund Committee, where he was responsible for conducting research and providing advice on the selection of hedge fund managers. Prior to Wilshire, Paul worked in equity research for Waddell & Reed Asset Management. He also spent five years with the Instinet Group as Manager of the Global Correspondent Trading Group. Paul earned a M.B.A in Finance from Cornell SC Johnson College of Business and a B.S. from Rutgers University. Paul also holds the Chartered Financial Analyst and Chartered Alternative Investment Analyst designations.
Paul Von Steenburg
Managing Director, CFA, CAIA

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Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.