Core Is The Way To Go

Despite the slow pace of recovery and trend lines suggesting lackluster cyclical growth ahead, order cash investors should not get sidetracked—now is the time to buy, lend or do preferred equity deals. Dealmakers may not hit grand slams, but the opportunity is there to stroke plenty of singles or doubles and maybe the occasional home-run (it’s spring training time).

Institutional investors continue to gravitate to the handful of core open-end funds, most of which are delivering low-to-mid teen annualized performance. Core funds probably are the best deal in town—investors immediately access pools of well-leased properties and avoid the wait for advisors to find suitable acquisitions over potentially extended commitment periods, missing out on the ongoing recovery.   These open-end funds were written down and then some in 2008-2009, they tend to be invested in higher quality commercial properties in better markets, and now benefit from value upticks especially in gateway cities. These funds also are a long way from returning to peak values, but could hit low double digit returns again in 2011 before settling for a while in the high single-return range. Sounds like what real estate was always advertized to deliver—fairly dependable, solid, risk-adjusted returns.

Investment managers without core funds have a problem. Their old value add and opportunistic formulas don’t work particularly well in the current environment–they can’t promise to deliver much more punch than lower-risk core accounts are already registering right now without larding on the leverage. And leverage doesn’t turn on investors–burned pension funds are leery about higher loan to values. It also doesn’t work for lenders and their regulators—they resist facilitating high debt strategies.

A select few major brand private equity players appear to raise money for next generation real estate opportunity funds, but many smaller managers stumble over their past compromised track records. Then even if they can raise money and put it out, they may be frustrated about tamped down returns that won’t provide them the big promotes they got used to in halcyon pre-crash times.

Advisors who rely on debt also need to worry about the specter of rising interest rates, which will make leverage strategies more expensive. Rates have begun to edge higher and as we have said before have nowhere to go but up.

Inflation fears also begin to ramp up—commodity prices across the board appear to increase from increasing worldwide demand. Inflation is usually viewed as positive for hard assets like real estate, but if demand for space doesn’t kick into gear, investors won’t gain as much—it’s hard to push up rents when nobody is willing to pay them. Higher food and energy prices could dampen U.S. economic prospects as already hamstrung consumers are forced into further belt tightening before the unemployment picture can improve.

Clearly cash investors retain the upper hand—they can still pick up better properties in better markets or take preferred equity positions to help existing overleveraged owners refinance holdings that lost value.

We’re still near market bottom—if investors are willing to hold for a while, they should be rewarded with decent long-term returns. In the mean time, we’re a long way from returning to the trade-and-flip bazaar… a long way.

That’s not what my value-add and opportunity friends want to hear.(credit j. miller, globe st)