What's "In" and what's "out" in the Institutional Real Estate investment markets?

As of December of last year, more than $64 billion of new capital was earmarked for new investments, of which 21% was flagged for investments offshore and 48% was flagged for higher risk, higher return oriented strategies.  

Much has changed in the capital markets since then, as contagion from the sub prime residential mortgage market meltdown of last summer continued to spread to other sectors of the capital markets.

Since mid December, for example, the stock market's dismal performance has driven the ratio of real estate investments as a percentage of total assets way up, creating a "denominator problem." Consequently, the gap between real estate target allocations and actual investments has narrowed considerably, reducing the amount of new capital available for investment.

Fears about an impending recession coupled with concerns about oil and commodity price-driven inflation also have been curbing investor appetites for all but the most successful US fund managers' offerings. Investors are particularly leery about core-oriented investment funds. Exit queues appear to be developing in many of the larger open-end funds for the first time in many years -- a clear sign that investors believe that these funds may be over valued in light of current market conditions.

Investor staff resources also are stretched, leading most investors to attempt to consolidate their stables of managers. A year ago, just about any one who could fog a mirror could attract capital to even first time fund offerings. Not anymore. Few if any first time fund offerings will be attracting new capital in today's climate, unless they can demonstrate convincingly how their offerings can add value to the existing portfolio.

In addition, fears that US property market cap rates could rise by as much as 100 to 150 basis points or more effectively have frozen investment allocations to most U.S.-based funds.  For those investors who still are committing new capital, most of that capital now is going to niche oriented investment opportunities that investors believe may be somewhat resistant to upward cap rate pressure, and/or that appear to them to be relatively inflation sensitive,  recession proof, or both.

Offshore investment opportunities, considered to be less impacted by economic events in the US  also continue to attract new capital - at least for now, they do.

With the CMBS market shut down and some portfolio lenders already tapped out, the more leveraged opportunistic funds will face significant challenges replicating past performance in today's markets.  Those with short term debt coming due also will face refinancing challenges that will significantly undercut performance of recent vintage funds that have only started investing during the lower capitalization rate markets of 2005-2007.

A handful of investors have been responding to these concerns by asking investment managers to refrain from calling committed capital until the dust settles. While anecdotal at present, this could become a trend if enough investors become concerned enough about the prospects for investing committed capital prudently in this type of environment.

The bottom line is this:  to attract new capital commitments today, fund managers have to convince investors that the strategies they are proposing a) compliment rather than replicate other strategies already imbedded in the portfolio, and b) are supported by compelling arguments that convince investors the strategy actually can make money in an environment where cap rates are rising, attractively priced debt is scarce, the economy is sagging, and inflation looms.

For the time being, equity capital will be scarcer and more aggressively priced than it has been in the recent past. And with less equity and debt competing for deals in the markets, prices have no where to go but down, at least until the real estate capital market environment strengthens.

The next big thing

Another potential shoe to drop could be a regulator-driven pullback of the banks and life companies - the last remaining providers of debt capital to the markets. So far, the regulators haven't stepped in, but there's no reason they won't. Word on the street is they will, and their actions could be just as restrictive as they were the last time the real estate capital markets collapsed in the early 1990s.

Meanwhile, those who are sponsoring debt oriented offerings should continue to attract capital [my emphasis], and until capital flows from more traditional sources improve, will continue to find themselves sitting in the catbird seat.

In the long run,  the next really big thing will be the reconstruction of the commercial mortgage backed securities market. Don't expect a return to the same kind of multi-tranche structuring that characterized the last wave of securitization, however. Structures in the next wave will need to be more transparent than they have been in the past. But in order for a new regime to evolve, something will have to be done to restore credibility to the asset-backed securities rating process. And so far, no one has any clear ideas on how to accomplish that task.

Meanwhile, distress will spread to the commercial real estate markets as short term bullet loans come due and owners find out that their lenders, not they, will be determining value.  Expect to see this start in the single family residential land market first. (The large pubic homebuilders already are selling off land holdings at deep discounts, while the banks are beginning to foreclose on the landholdings of smaller homebuilders. In the next several months, those lenders aggressively will start moving these REO assets  off their books.

Lenders to troubled commercial property owners -- those with high loan to value short term loans in place  that soon will be coming due -- also eventually will begin taking back the keys or foreclosing on those assets, and this also will be followed by wholesale REO sales.

These sales will accelerate portfolio write downs as the appraisal community picks up on a wave of new comparable sales data, further driving down returns and eventually discouraging the most bullish of real estate investors.

When investor sentiment starts to turn negative on a wholesale basis, that will be a signal that the worst is over and recovery finally is on the way.

The good news is this is nothing more than the cyclical turn in the road most of us have been anticipating for some time. As often happens, the trigger for this turn came from outside the industry when fundamentals at the time remained sound.  Now that the economy is slowing and threatening (if not already in) a recession, those fundamentals already have begun to erode.  At the very least, the deals underwritten to perfection over the last few years will be unable to achieve the proforma rent growth they needed in order to justify the underwriting. At worst, as these assets are
marked to market, they'll start to drag down values for less aggressively underwritten holdings.

The key for everyone to remember, however,  is that a turn in the road doesn't necessarily mean the end of the road, so long as you make the turn. To prosper in these troubling times, it will be critical to recognize that opportunity and risk sets have shifted, and strategies as well as tactics need to be adjusted accordingly.

What is IREI up to these days?

We also continue to follow with products and services where our constituents are leading.

Two years ago, we successfully launched a European edition of our flagship publication, The Institutional Real Estate Letter. We also launched several new conference initiatives (Visions, Insights and Perspectives, for pension funds and their advisors, Dealmakers, for real estate transactors, and Institutional Investing in infrastructure, a global conference for investors committing capital to infrastructure investment funds.

This year, we are in the process of expanding these offerings, and gearing up for the 2009 launch of our newest publication, The Institutional Real Estate Letter - Asia Pacific.

Biography

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Tags: irei, institutionalreal estate, geoffrey dohrmann, lexington corporate properties trust, reo, predictions, portfolio sales, wholesale, cap rates, denominator problem, recession, oil and commodity-driven inflation, sub prime, CMBS, scarce debt, complimenting strategies, equity capital, wall street investment banking house failure, debt-oriented offerings, foreclosure