With the US economy growing at about 3% a year, domestic job creation seeming to have difficulty keeping up with job losses from offshoring and downsizing, and when both interest rates and inflation have nowhere to go but up, this is probably a good time to revisit old assumptions and test their validity for the 21st Century. Anyone who lived through inflation in the 1970’s and 1980’s which spiked up to 20%, with interest rates in the high teens, might have thought that low inflation and low interest rates coinciding was ‘economic nirvana’. Certainly the Fed and ECB have been strongly focused on achieving those ends. But, if you want an annuity for retirement, or are a manager of an endowment fund or foundation, or a pension trustee, and need to match assets and liabilities, the complications of this seemingly favourable circumstance quickly appear.
Sentinel recently launched a fund which is invested in US garden apartment assets and whose structure provides non-US investors a tax efficient vehicle for direct investment in US real estate in partnership with US institutions. Increased allocations by institutional investors to direct and indirect real estate assets and freely available, low cost non-recourse debt financing, have driven down capitalisation rates on real estate assets in general to levels not seen for years. So it is appropriate to review the reasons why we think investing in US multifamily properties is still the right thing to do – and why now is the right time to do it.
We recommend multifamily and industrial or flex space assets to our clients who are looking to make a ‘core’ or ‘core plus’ asset allocation for a number of reasons. There is growing evidence that office rental markets are improving in many regions, and retail sales continue to be buoyed up by the extraordinary efforts of the American consumer. Nevertheless, both asset classes, with their ‘bond like’ income characteristics and long-term lease structures, dependent on small numbers of high value tenants, are vulnerable to short-term rises in interest rates. Where there are vacancy issues in office or retail assets, filling the empty space at attractive rental levels will be challenging, and require substantial capital costs to attract new tenants.
However, in multifamily and industrial assets, leases are typically much shorter and re-price more frequently. The cash flows from any individual project are derived from multiple tenants and are thus predictable in the aggregate. The smaller individual lot size of these assets also permits significant geographical diversification within a portfolio. Even at today’s low yields, the opportunity exists to lock in financing at positive spreads and enhance the net return, which makes the asset class rather attractive.
Historically, investment in US direct real estate in general has shown enviably low levels of volatility compared with publicly-traded assets. Multifamily and industrial assets, in particular, have shown the lowest levels of volatility. The annualised standard deviations of their returns in the NCREIF index for the 10 years through 31 December 2003, were 1.17% and 1.78% respectively, and total average annual returns were 11.07% and 11.47%. These returns compare well with an annualised standard deviation of 4.56% and average annual return of 6.98% for the Lehman Government/Credit Index for the same period.
Past performance does not predict future returns, and expecting high double-digit returns when the going-in yield on an asset is 5-5.5% would be perverse, but we believe that there are several positive elements which a prospective investor should consider:
n In highly competitive markets, where there is an overabundance of capital chasing a finite number of available transactions, the choice of manager is of critical importance. When yields are high, errors in underwriting can be smoothed over, but when yields are low they will stand out like a sore thumb, so experience and skill are important. Equally, a manager who is well known and has experienced acquisition staff will often see ‘off market’ deals before they become part of an auction process.
In business since 1969 and with $5bn (e7.5bn) of assets under management, Sentinel has a management team with unusual longevity and diversity of experience. Sentinel has also developed a successful forward purchase program with several major merchant building firms through which we have completed the purchase of, or have in our pipeline, more than $1.5bn of multifamily assets. These are properties which are never subject to a competitive open market bidding process, which we purchase when they are completed and leased-up to agreed minimum levels at market rates.
n The US is not a homogenous marketplace, and there is significantly greater population movement, as well as a younger population, than in Europe. Demographics are therefore one of the keys to successful asset allocation. In the next 10 years, the combination of birth rate, internal migration and external immigration flow mean that the east coast from New England to Florida, as well as Atlanta, Texas and the south western and western states of Arizona, California and Nevada, will be the likely winners not only in terms of population growth but also in net new job formation. These markets should therefore be the most attractive target areas for investing.
n Although capitalisation rates are currently at secular low levels, they also reflect relatively depressed levels of economic occupancy (ie, physical occupancy adjusted for the costs of incentives to tenants). This creates good opportunities to enhance revenue as interest rates rise by increasing rents and by increasing physical occupancy as leases turnover. Again, the key to success is experienced hands on management that knows how to add value to an asset.
n When rates seem likely to rise and capital values will likely be under stress, getting a large part of your total return as current income is increasingly attractive.
n When absolute returns are at secular low levels, superior execution and structuring of any investment is of critical importance.
We do not believe that it is consistently possible to ‘time’ the market as a whole successfully through the economic cycle. We do believe, however, that it is possible to allocate assets to those regions or metropolitan areas which have the greatest promise, and to be competitive in identifying, underwriting and acquiring assets in all phases of the market cycle.
Finally, for the non-US investor in US real estate, and particularly when the capital gains portion of total return will be relatively less than previously, we cannot overemphasise the importance of investing through a tax efficient structure, particularly for an investor who is not a taxpayer in their home environment. Careful structuring helps minimise withholding taxes on income distributions, eliminates capital gains taxes and, in particular, negates any FIRPTA impact on investment returns.
There is no magic key to investing in US real estate, but experience, discipline, careful structuring and meticulous attention to detail will pay off in a low return environment more than ever. Such an approach will enable you to achieve positive absolute returns which have desirably low correlations to other asset classes, and that can only do a portfolio good.