NEW YORK CITY—Yesterday we looked at the idea that with interest rate increases on the horizon, the safest commercial real estate assets were value-add and opportunistic ones.
That, at least, was one conclusion of the Q2 2014 United Realty/Zogby Real Estate Confidence Index, in which 45% of respondents said they were anticipating a 50 basis-point increase, and 15% anticipating increases of more than 100 basis-points in the 10-Year Treasury.
And that conclusion is, as many respondents to our informal survey said, common sense. To recap, here is how Peter Muoio, chief economist at Auction.com explained it to GlobeSt.com.
Opportunistic/value add opportunities are likely to better weather rising interest rates because the going-in cap rates are generally less compressed, he says. “The NOI growth needed to counterbalance rising cap rates, to the extent increasing interest rates puts upward pressure on caps, is geometrically higher the lower the going-in cap rate,” he says,
“Additionally the property-specific turnaround potential provides investors with return potential beyond market-driven property segment valuation changes.”
That said, there is plenty of room for nuance, if not outright disagreement.
Jim Evans of Friedland Realty Advisors, for instance, agrees value add will work in this situation, but so will other select assets. “Other properties that would be able to withstand a higher interest rate environment would be those where the expenses are stopped, such as NNN type deals, and the leases have bumps in the rent that will protect the landlords exposure to increased debt service,” he tells GlobeSt.com.
Ross Yustein, chair of the real estate practice at Kleinberg Kaplan in New York City, also says that while opportunistic and value-add assets would work, so would other property types and activities.
“Many of my clients are taking on the risk of ground-up development projects for the better potential returns they can provide,” he tells GlobeSt.com. “These projects have come in a variety of sectors, including luxury hotels and high end condos in Manhattan, mid-level apartment rentals in growing smaller cities, and medical office and retail properties in a number of states. “
Also, he continues, some of his clients see medical office as a particularly good way to combine the value-add that construction brings with a sector that has unique factors working in its favor.
Scott Crowe, Global Portfolio Manager of the Resource Real Estate Diversified Income Fund in New York City, also says opportunistic and value-add properties could be “appealing” in a higher interest rate environment, but he is quick to add these investments should be made on a case by case basis.
Instead, the best opportunity to generate consistent returns with reliable yield and growth, he tells GlobeSt.com, will be a diversified approach to real estate investments, such as a diversified income fund whose portfolio is divvied up among three different types of CRE investments: traded equity, real estate credit and direct real estate.
Crowe, it must be noted, manages just such a fund, but he makes his case well.
Traded equity, or publicly traded REITs offer higher levels of growth, liquidity and access to a more global opportunity set, he explains. Real estate credit can offer higher security and income and direct real estate offers higher levels of capital stability and attractive income.
But this three-pronged approach is not necessarily simple, Crowe continues—the allocation has to be just right in order to balance the upside against the downside.
“Real estate credit is potentially one of the most sensitive to interest rates due to the often fixed interest rate of these investments,” he says. “Reducing this risk requires larger allocations to floating rate debt and shorter durations to decrease interest rate sensitivity. Private real estate requires reduced exposure to non-traded REITs due to their heavy net lease exposure, which are long duration leases with little to no rental increases.
Instead, he says, a smart play would be to increase allocation to private equity real estate, which has a track record of rising rents and capital value growth in addition to moderate yield.
Publicly traded REITs should be used to hedge interest rates by investing in real estate companies that will benefit the most from a rising interest rate environment, such as hotels, residential, international, CBD office and industrial, he says. However he also warns investors not to rely heavily on publicly traded REITs to deliver yield “as high yielding REITs can be very interest rate sensitive due to both yield surrogate nature and earnings growth link to cost of capital.”
Please come back tomorrow for part 3 of this article.