Opportune Time for Longer-term Investors

Why 2021 Might Be A Good Time To Revisit US Core Real Estate

By SABRINA UNGER/Guest Contributor

Investors are faced with the increasingly critical task of finding alternative sources of resilient income to satisfy distribution needs today amidst lacking bond yields globally. With roughly 80% of the asset class’s total returns derived from income, core real estate can serve as a higher-yielding alternative to fixed-income allocations; given the current funding shift towards riskier strategies, now may be an opportune time for longer-term investors to play the market contrarian and consider revisiting the case for U.S. core real estate in 2021.

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What has made core real estate appealing historically?

Although no doubt a simplified list, the below represents the most common rationale for having historically invested in private core real estate:

• Low correlation to other asset classes: Core private real estate has, both over the long term and during the latest cycle, demonstrated a low correlation to REITs, equities, and bonds, serving as a diversifying and thus de-risking agent in mixed-asset portfolios;
• Reliable income streams: With roughly 80% of core real estate’s total returns derived from income, the asset class has offered investors a reliable routine source of income;
• Attractive yields: Private real estate yields have historically offered a higher relative yield spread to government bonds than REITs or equities; and
• Partial hedge against inflation: Because real estate values tend to rise during periods of higher inflation (due to rising replacement costs and strong macroeconomic fundamentals fueling demand), private real estate can serve to partially offset any adverse impacts of inflation in other parts of investors’ portfolios.

What makes core real estate compelling today?

The convergence of three macro forces are likely to reinforce the appeal of core real estate performance in 2021 and in the years ahead:

#1: Low risk-free rates boost core real estate’s relative value.

Private core real estate yields today offer the highest spread relative to long-term government bonds when compared to the spread provided by REITs, equities, and Baa-rated corporate bonds, making them a compelling yield-bearing add-in for mixed asset portfolios (Figure 1). And while expectations are for interest rates to remain low for the foreseeable future, private real estate’s yield spread would be on par with the long-term average even if 10-year Treasuries increased by as much as 50 bps (still offering a nearly 300-bps yield premium) and within normal ranges if the 10YR increased 150 bps.

This of course assumes that private real estate cap rates remain at their current levels and do not increase in tandem with rising bond rates to maintain the proportionate relationship between the two, a retort that has in recent years been used to explain a pullback from core as some investors have tried to call the top of the market. This is where a discussion about capital allocations (greater numerator) and supply (smaller denominator) comes into play.

#2: Widening gap between capital allocations and commitments to core real estate.

The appetite for real estate from institutional investors globally has been on the rise for the last seven consecutive years, with target allocations increasing by 10 bps year over year between 2019 and 2020 (to 10.6% of overall allocations), despite real or perceived impacts from the pandemic. While on a year-over-year basis this may seem a relatively benign increase, the 10-bp increase “implies the potential for an additional $80-$120 billion of capital over the coming years”[1], with the anticipated 2021 targets reflecting a further and even more meaningful increase of 30 bps, putting institutional investors’ target allocations to real estate closer to 11%.

Yet there has been a persistent shortfall between investors’ targets and their committed allocations. As of June 2020 (when equity markets had not yet fully recovered from their March contractions, resulting in smaller AUM denominators), 62% of institutional groups noted they remained under-allocated to real estate relative to their stated targets. With equities today now having handily surpassed their pre-pandemic highs, the denominator has recovered, putting groups even further below target and suggesting further potential for greater appreciation going forward as dry powder seeks deals.

#3: A shrinking amount of core real estate.

One must consider what constitutes core to appreciate why there may indeed be less of it going forward. In short, core properties are characterized as stabilized, cash-flowing assets with minimal repositioning required. Yet there is increasing reason to believe that the disruptions occurring in the retail and office sectors have added operational challenges and strained cash flows to a point where a large chunk of these assets are no longer core. And because office and retail comprise roughly 48% of ODCE fund holdings, there is likely to be meaningful jockeying into the more resilient industrial and multifamily sectors (as well as some other, more specialized property types), creating the potential for holders of core real estate to benefit from appreciating values.

A case for core real estate

With institutions in a seemingly perpetual search for yield, core real estate can provide the necessary income required to cashflow match liabilities consistently, with annualized core fund income returning roughly 4% even throughout the volatility of 2020.[2] Furthermore, with the long-term drivers for including core real estate in mixed-asset portfolios still intact, the current funding shift towards riskier strategies may provide a compelling window for longer-term-oriented investors to play the contrarian and re-up their allocations to core before another wave of risk-aversion kicks in, allowing those investors who are willing to revisit the case for core in 2021 to benefit immediately from current in-place income streams and in the future from additional appreciation.

Sources:

[1] Hodes Weill & Associates 2020 Institutional Real Estate Allocations Monitor.

[2] NCREIF Fund Index – ODCE Quarterly Detail Report Q4 2020. 

About the Author: Sabrina Unger, Managing Director, is the Head of Research & Strategy at American Realty Advisors and is responsible for leading the firm’s research initiatives and working closely with the firm’s Investment and Portfolio Management teams in developing investment analysis in support of new acquisitions and strategy implementation. Unger is also a member of the firm’s Investment Committee. Prior to joining ARA, she was a member of the Global Research team at Invesco Real Estate, charged with developing global portfolio strategies as well as authoring numerous thought leadership papers and contributing to the firm’s House View. Before that, Unger held positions as a member of the research team at Clarion Partners and as a top strategist for a sports entertainment company’s real estate divisions. She has been published in leading industry publications, including Real Assets Adviser, and the research publications of the Asian Association for Investors in Non-Listed Real Estate Vehicles and the Association of Foreign Investors in Real Estate. Unger holds a bachelor’s degree from Southern Illinois University Carbondale and a master’s degree from DePaul University.

American Realty Advisors is an Associate member of TEXPERS. The views expressed in this article are those of the author and not necessarily American Realty nor TEXPERS.

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