Commercial Real Estate and the Quest for Income

Transcription

1 Commercial Real Estate and the Quest for Income By Indraneel Karlekar, Ph.D., Kevin White, CFA, Maria Luisa Paradinas, and Michael Marohnic May 212 FOR FINANCIAL ADVISOR USE ONLY. NOT TO BE REDISTRIBUTED.

2 The search for stable income returns has become an important theme in the context of increased financial market volatility, declining yields from traditional fixed-income instruments and an aging population that requires increasing cash flows to offset its loss of earning power in an environment of potentially rising inflation. While fixed-income instruments have traditionally been associated with incomegenerating capabilities, commercial real estate has often been overlooked by mainstream investors. This is partly due to this asset class being bucketed in the alternatives category. In the context of a yield-hungry world, this paper argues that commercial real estate can provide a source of reasonably stable income that can play an important role in bridging the income gap in balanced portfolios. Commercial real estate has not only delivered attractive income streams historically but has done so in real terms (exceeding inflation) and should be considered as an asset class to fill the income gap in a balanced portfolio. 1. Source: Moody s Analytics/ Federal Reserve, as of March 2nd 212. Quarterly data. 2. Datastream / S&P, S&P 5 composite dividend yield 3. Federal Reserve Flow of Funds Accounts, as of March 5th 212. Latest available data point is 3Q Explaining the Dividend Yield in the United States, Charles F. Kramer, World Economy in Transition, IMF, December The search for income returns: An Investment universe of declining yields Declining income flows One primary source of income returns government bonds has seen yields decline consistently over the last few decades, from double-digit levels in the early-198s to all-time lows in recent years (as of 1Q 198, 1-Year Treasury yields were at 12%, while they had fallen to 2% as of the end of 211, 1 Figure 1). Very low interest rates pushed yield-hungry investors into equities and corporate bonds. The dot-com bubble of the mid- and late-199s drove stock values up sharply and dividend yields to all-time lows (1.1% as of 1Q 2 2 ). At that time, households holdings of corporate equities reached a peak of 36% of their total assets (and 51% of their financial assets). 3 While these figures fell back in the wake of the dot-com bust and the financial crisis, the combination of low interest rates and flat yield curves has kept dividend yields low 4 (Figure 2). The growing need for income The decline in income flows from investment assets has occurred at a time when the need for income continues to grow. A major factor driving the need for income is the changing pattern of demographics: 211 was the first year in which the Baby Boom generation started turning into the Golden Boom generation, retiring and beginning to receive their main income stream from savings instead of jobs. The baby boomers (those born between 1946 and 1964) will turn 65 in the period between 211 and 229; on average, each of those years will see an increase of 1.6 million people in the 65+ cohort and by 229 people older than 65 will represent 19% of the total U.S. population (Figure 3). In short, healthy income flows will be more important than ever but also likely increasingly difficult to find. 2 Commercial Real Estate and the Quest for Income For Financial Advisor use only. 212 Cole Capital Advisors, Inc. All rights reserved.

3 2 Figure 1: Federal FundS and 1-Year Treasury Rates ANNUAL RATE, % Fed Funds Rate 1 Year Treasury Rate Source: Moody s Analytics FIGURE 2: household holdings of equities and dividend yields 4 7 % OF TOTAL ASSETS DIVIDEND YIELD (% ANNUALLY) 1965Q1 1976Q3 1988Q1 1999Q3 211Q1 Household holdings of corporate equities S&P 5 Dividend Yield Sources: Federal Reserve, Datastream/S&P, Cole Real Estate, as of March 5, 211. Households include households and nonprofit organizations. For Financial Advisor use only. 212 Cole Capital Advisors, Inc. All rights reserved. Commercial Real Estate and the Quest for Income 3

4 GROWTH IN POPULATION > 165 (ABSOLUTE) SHARE OF POPULATION > 65 OVER TOTAL POPULATION Figure 3: Population over 65 forecast 2,, 1,8, 1,6, 1,4, 1,2, 1,, 8, 6, 4, 2, Net New Population > 65 % of Population > 65 2% 18% 16% 14% 12% 1% Sources: Moody s Analytics, Cole Real Estate Investments Accompanying the change in the demographic make-up of the U.S., pension funds hit by the investment losses of the financial crisis have begun to shift towards liability matching investment models, under which they seek assets with stable cash flows timed to offset expected liabilities rather than lower-yielding, more volatile assets with greater appreciation potential. 5 As a result, the need for stable, consistent cash flows has assumed an even greater importance in recent years. 5. Global Pension Risk Survey 211, US Findings. AONHewitt 6. Sources: Cole Real Estate, NCREIF. Long term ( ) all property income return (7.6%, ) over total return (8.9%). 7. Written algebraically, the equation would be: Income Return= Net Operating Income / (Asset market value at the beginning of the quarter + ½ Capital Improvements ½ Partial sales 1/3 Net operating Income) NCREIF NPI definition for income returns. 8. This measures the probability of an expected result falling within a given number of deviations from the mean. 9. Income Return and capital appreciation figures come from NCREIF NPI All Property, The Potential for real estate Income Returns: a stable component of TOTAL returns Income returns from real estate have also declined since the 198s but at a more modest pace than comparable cash components of most major investment assets. Historically, real estate income returns as measured by the NCREIF Property Index have ranged between 5% and 9% annually and the long term average (7.6%) has represented 86% of total returns. 6 In other words commercial real estate returns have been dominated by income returns. Income returns are widely considered the stable part of total returns, since they are driven by the rent collected from the tenant (more specifically, they are computed by dividing the net operating income of a property by the average investment in the property). 7 Figure 4 shows the relative stability of property income returns over the past three decades. Historically, annual income returns have averaged 7.6% and the standard deviation, the most common measure of volatility/dispersion, 8 has been 1.1% for that period. Capital appreciation, on the other hand, has had a long-term average of 1.2% and has been much more volatile, with a standard deviation more than seven times that of income returns. 9 4 Commercial Real Estate and the Quest for Income For Financial Advisor use only. 212 Cole Capital Advisors, Inc. All rights reserved.

5 3% Figure 4: Income Returns, Appreciation Returns and Total Returns for All Property (NPI) 2% YEAR-O N- YEAR RETURNS 1% % -1% -2% Income Returns Ca pital Growth Total Returns LTA ( ) -3% 4Q Q Q Q Q Q Q 214 Q 234 Q 254 Q 274 Q 294 Q 211 Source: NCREIF REAL ESTATE INCOME RETURNS COMPARED TO OTHER ASSET classes Commercial real estate has historically delivered attractive income returns relative to other asset classes. From 1978 to 211, income returns from commercial real estate averaged 7.6% annually, second only to corporate bonds (a more volatile asset that had a very strong decade in the 198s but slipped below real estate in the last decade, Figure 5). Figure 5: average income return/dividend yield by decade and asset type ANNUAL RATE O R YIELD 14% 12% 1% 8% 6% 4% 2% % 7.7% 12.8% 1.6% 8.1% 8.5% 6.7% 7.2% 7.1% 6.5% LTA ( ) 5.9% 7.6% 9.2% 7.% 4.2% 2.2% 4.5% 1.8% 3.% 1.6% 2.7% Private CRE Corporate Bonds 1-YR Treasuries Stocks Source: NCREIF, NAREIT, Standard and Poor s, Datastream, Federal Reserve Looking at relative risk, income returns from commercial real estate have also been the least volatile across the five asset classes observed, exhibiting a standard deviation of 1.1% from 4Q 1978 to 4Q 211. Stock dividends came in secondlowest, with a standard deviation.3% above that of commercial real estate. Commercial real estate income returns have had substantially lower volatility compared to corporate bonds (2.9%) and 1-year Treasuries (3.%). Positive returns combined with lower volatility produce a favorable reward-torisk ratio, which measures the gains in returns for each unit of risk assumed. This ratio is calculated by dividing the average annual income return by its standard deviation. On a risk-adjusted basis, commercial real estate has yielded an average income return equal to 7.3% per unit of risk (Figure 6). Bringing the analysis full circle, income returns from commercial real estate have historically provided better risk-adjusted income returns than typical portfolio safe havens such as corporate fixed-income and Treasuries. For Financial Advisor use only. 212 Cole Capital Advisors, Inc. All rights reserved. Commercial Real Estate and the Quest for Income 5

6 8 Figure 6: REward-to-risk ratio of income returns / dividend yields by investment asset ( ) 7 6 RETURN-RISK RATIO Private CRE Income Return C orporate Bond D atastream Yield 1-Year Treasury Yield Stocks D ividend Yield Source: NCREIF, NAREIT, Standard and Poor s, Datastream, Federal Reserve From an absolute income return perspective, industrial has been the most attractive property type followed by retail, office and apartments. Specific subtypes present differences, though, and single-tenant retail has shown the highest income returns (with the highest volatility as well), 1 even above industrial, while super regional retail showed income returns below those of apartments, with very low volatility. REAL ESTATE INCOME RETURNS AND INFLATION The capacity of commercial real estate to hedge inflation has been debated for decades, certainly since the nation s last major inflation epidemic in the 197s. Many studies confirm that real estate is a powerful hedge, albeit with two caveats: first, its effectiveness hinges on market conditions (i.e., high vacancies undermine landlords ability to hike rents amid rising prices). 11 And second, the hedge is mostly generated by the capital appreciation component; at the market level, the hedge does not come through the capacity to lock-in and index rents so much but through investors pricing higher future incomes into existing values. 12 Over the long run, however, it is noteworthy that income returns have outpaced inflation over time. Since 1978, income returns have yielded 7.6% annually, while inflation has averaged 3.9%. While inflation may occasionally overtake income returns (e.g., late-197s/early-198s), over the long run real estate income returns have more than covered inflation (Figure 7). 1. Cole Real Estate calculations with NCREIF data. Income returns for single-tenant retail for 1Q Q 211 (the longest period on record) are 9.%, above those for apartments, industrial, office, overall retail or superregional retail for that period or the longest period on record for each property type. 11. Wurtzebach, Charles H., Glenn R. Mueller, and Donna Machi. The Impact of Inflation and Vacancy on Real Estate Returns (1991). 12. Huang, Haibo, and Susan Hudson-Wilson. Private Commercial Real Estate Equity Returns and Inflation (27). 6 Commercial Real Estate and the Quest for Income For Financial Advisor use only. 212 Cole Capital Advisors, Inc. All rights reserved.

7 SPREAD TO 1-YEAR TREASURY 5YEAR FORWARD ANNUALIZED RETURNS CPI AND INCOME RETURNS INDEX, 1977 Q4 = 1 SPREAD OF INCOME RETURNS OVER INFLATION, (ANNUAL RATES AT QUARTERLY BASIS) Figure 7: Annual Income Returns and Annual Inflation Rates, Index, 4Q-1977 = 1 1,4 1,2 1, 1,2 8 1, (2) (4) (6) CPI Income Returns Annual Spread of Income Returns vs. Inflation Sources: Moody s Analytics/Bureau of Labor Statistics, NCREIF, Cole Real Estate Investments REAL ESTATE INCOME RETURNS: PRICING, OUTLOOK AND STRATEGIC CONSIDERATIONS Although from a historical perspective real estate income returns were below average as of the end of 211 (6.1% vs. a long-term average of 7.6% 13 ), their spreads to 1-year Treasury yields are near all-time highs: as of 4Q 211 cap rates were 422 basis points above the 1-year Treasury yields, whereas the long-term average for stands at 244 basis points. 14 The spread of income returns to long-term government bonds is a key metric of relative pricing attractiveness. In theory, longterm government bonds can be considered the closest to a risk-free investment. The spread between the yield of a given investment asset and bond yields illustrates the risk premium that investors will be receiving for investing in that asset instead of government bonds. Those spreads vary with economic and financial conditions and investors risk appetite, but the long-term average can be considered an indication of the fair relative pricing between the assets. Thus, a spread considerably higher than the long-term average, as we have now, implies that from a historical perspective real estate is relatively undervalued compared to government bonds. High income returns boost returns directly and leave room for yield-compression, especially if spreads to government bonds are high, which can fuel capital appreciation. Wide spreads over Treasury yields have traditionally been a good predictor of total returns. Accordingly, today s spreads may augur well for future realestate performance (Figure 8). 5% 4% Figure 8: Income spreads and 5-Year forward returns 18% 16% 3% 14% 12% 2% 1% % -1% -2% -3% Spread Average 5-Year Forward Annualized Returns Source: NCREIF, Federal Reserve, Cole Real Estate Investments 1% 8% 6% 4% 2% % -2% 13. Cole Real Estate Investments with NCREIF data. Average of all property annual income returns at quarterly basis for 4Q 199-4Q NCREIF, Federal Reserve, Cole Real Estate Investments For Financial Advisor use only. 212 Cole Capital Advisors, Inc. All rights reserved. Commercial Real Estate and the Quest for Income 7

8 By property type, spreads are high across all sectors. As of 211, spreads were well above their historical averages and close to their all-time highs (Figure 9). Retail, and to a lesser extent industrial and office, seem to offer better value, since their spreads are much wider compared to their own long-term averages. 6 Figure 9: Income Return spreads by Property Type 5 SPREADS OVER 1-YEAR GOVERNMENT BOND YIELDS Office Retail Industrial All Property Apartment Spread range Average 4Q 211 Sources: NCREIF, Federal Reserve, Cole Real Estate Investments Conclusion Over the long term, commercial real estate income returns have been an attractive and relatively stable portion of the total returns stack. Historically, income returns from commercial real estate have compared favorably with those from other asset classes, including stocks, corporate bonds and government bonds, exhibiting superior risk-return characteristics. And while today s income return levels are below historical norms, their spreads to 1-year Treasuries are near all-time highs. This paper or any part thereof may not be reproduced, distributed or in any way represented without the express written consent of Cole Real Estate Investments. Cole Real Estate Investments is the sponsor of a number of real estate investment programs. Cole Real Estate Investments is a trade name used to refer to a group of affiliated entities that provide external management services to the Colesponsored real estate investment programs. This paper contains forward-looking statements based on Cole s current expectations, estimates, forecasts, and projections and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements. A number of important factors could cause actual results to differ materially from the forward-looking statements contained in the paper. Forward-looking statements in this document speak only as of the date on which such statements were made, and we undertake no obligation to update any such statements that may become untrue because of subsequent events. Cole Real Estate Investments 2325 East Camelback Road, Phoenix, AZ 8516 P: F: For Financial Advisor use only. 212 Cole Capital Advisors, Inc. All rights reserved. WP-QUEST FOR INCOME (5-12)