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Pension Funds Expect Near-Term Lift in CRE Performance

With no interest rate hikes and a rebounded stock market, expectations for CRE performance improve.

Pension funds that are looking to squeeze more yield out of commercial real estate have a more positive outlook for near-term performance.

Results from the second quarter Pension Real Estate Association (PREA) Consensus Forecast show a subtle rise in sentiment regarding total return expectations over the near term. On average, respondents believe the NCREIF Property Index will reach a 6.3 percent total return this year, followed by moderating growth of 4.9 percent in 2020 and 4.2 percent in 2021. The forecast is more optimistic as compared to the fourth quarter of 2018 survey, when respondents anticipated a 5.7 percent total return in 2019 and 4.4 percent in 2020.

This is a reflection of the macro environment, and some fairly dramatic changes that have occurred over the past six months, notes Greg MacKinnon, Ph.D., director of research at PREA. For example, investors that were bracing for higher interest rates are now anticipating flat or even lower rates, given speculation that the Fed will hold or possibly even cut interest rates later this year. Meanwhile, the fundamentals for commercial real, aside from retail, still look quite good. “So, I think that explains this uptick overall in people’s expectations for returns over the next couple of years,” says MacKinnon.

Generally, there is an expectation that returns will moderate as it gets later and later in the cycle, which is already occurring. NCREIF returns have been sliding over the past few years, with total Index returns at 8.0 percent in 2017, 7.0 percent in 2017 and 6.7 percent in 2018—all of which are below the 20-year average of 9.3 percent. However, pension funds continue to view commercial real estate as being a good value relative to other asset classes right now, says Bernie McNamara, global co-head of investor services and solutions at CBRE Global Investors. “The general view is that the asset class continues to perform well for pension funds, both on an absolute and risk-adjusted basis,” he notes.

Increasing allocations to CRE

Pension funds continue to have a strong appetite for commercial real estate. “Broadly speaking, the low interest rate environment has pushed institutional investors to increase their risk tolerance in an effort to hit target returns. As a result, we have seen investors—including pension plans—raise their target allocations to private market strategies, such as real estate,” says Anar Chudgar, a managing director at Artemis Real Estate Partners, a commercial real estate investment firm.

According to the 2018 Institutional Real Estate Allocations Monitor published by Cornell University’s Baker Program and Hodes Weill & Associates, the average target real estate allocation of institutional investors increased to 10.4 percent in 2018, which is up 30 basis points from 2017 and up 150 basis points from 2013.

“In general, allocations from a dollar perspective continue to increase,” says Daniel Walsh, CEO of Citymark Capital, a private equity firm based in Cleveland. That is partly a factor of rising portfolio values from the rebound in the stock market, which means more dollars flowing to real estate to meet the target percentage allocation. “What you’re hearing is that pension funds want to fulfill or increase their allocations, but most of them aren’t hitting their targets yet as equities continue to run and the market remains pretty competitive for real estate,” says Walsh. So, there is still a fair amount of pent-up demand, he adds.

Industrial attracts capital

Investors like the income component of commercial real estate, especially in the current low interest rate environment. The difficulty comes at the next step, which is the conundrum of putting that capital to work, says MacKinnon.

Industrial is a popular target because of the demand drivers from e-commerce. According to the PREA Consensus Forecast, respondents have the highest expectations for industrial performance, with an average total return forecast of 10.4 percent this year and 7.2 percent for 2020. Office is still desirable as a cornerstone of most institutional portfolios, and multifamily is also very popular. The Consensus Forecast predicts returns of 6.0 percent for office this year and 5.8 percent for apartments, while retail is trailing at 3.8 percent.

“We are seeing multifamily and industrial as the most targeted sectors for investment, with retail significantly trailing the other major property types,” says Chudgar. Specific to industrial, Artemis is targeting strategic logistics markets and last-mile distribution facilities that benefit from the shift away from bricks-and-mortar retail towards e-commerce. “For multifamily, we are capitalizing on current trends away from homeownership, investing in rental housing alternatives catering to the middle market, a segment that can be loosely defined as workforce housing” she says.

Although pension funds typically focus on the core four sectors of office, industrial, multifamily and retail, there is growing interest and activity in non-core asset types. In particular, there is interest in those sectors that capitalize on demographic trends at both ends of the barbell—baby boomers and millennials, such as seniors housing, student housing and medical office. Debt strategies is another area attracting more interest.

Pension funds are also adopting more global strategies to real estate allocations.

“We’re seeing more and more investors starting to look at their real estate portfolios like they do their public equity allocations, which have been broadly diversified on a global basis for some years now,” says McNamara. That is true both from the perspective of foreign investors that are expanding outside of their home countries, including into the U.S., as well as domestic investors that are investing internationally. “This year is looking like it will be one of our strongest years for cross-border capital flows,” adds McNamara.

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