A Close Up View of the End of the Cycle

On a mid-August morning, the yield curve inverted—that is, yields on two-year Treasury bonds were higher than those on the 10-year bonds, for a short period of time. As brief as the inversion was, the stock market shook and rolled as economists warned that recessions typically follow 18 to 24 months after this type of yield curve inversion.

Of course, the yield curve has been steadily declining since January 2014 and other portions of it have inverted in recent months, such as the 10-year/three-month yield curve. However, these developments did not set off widespread alarm bells like the inversion of the psychologically significant 10-year/two-month piece. In truth, this event was just one more reminder that we are at the end of both a real estate and larger economic cycle. And after that? A recession will likely follow.

We even know what that recession will probably look like: mild and short-lived, based on current projections.

What many of us may not know is how to handle the waiting period between then and now. What investments and developments are safe for the duration? This was among the topics discussed at the recent 23rd Annual Transwestern Real Estate Forum Institutional Insurance Investors Symposium. There, a roundtable of seven panelists gathered to discuss industry trends and perhaps more importantly, what they are investing in and developing right now.

The panelists included Carrie DeWees, portfolio manager at Allstate Insurance Co., Jim Halliwell, managing director of Principal Global Investors, Rob Mason, executive director of PGIM Real Estate, Paul Hanson, a managing director of Northwestern Mutual Real Estate, Brandi Radovitskiy, a senior asset manager at Travelers in the real estate investment group, Pritesh Patel, head of US Real Estate Investments at Manulife / John Hancock and Scott Cote, executive vice president and co-head of Real Assets at Aegon Real Assets US. Though we do not have a crystal ball to tell us what path to take during these end days, the aggregated knowledge of this group gets us pretty close.

Following is an excerpt from that conversation. It has been edited for clarity.

Equity Increases for Apartments, Industrial

Panelists are approaching this piece of the cycle cautiously, while still on the lookout for new opportunities.

This year, for example, Northwestern Mutual Real Estate is increasing its amount of equity placements, especially in the apartment and industrial sectors.

Lately, the company has shifted towards acquisitions—Hanson said that this year, half of the company’s equity production may well be in acquisitions—after being primarily a development shop for years. The company decided to prune its portfolio after a good look at the environment, Hanson said. “It’s a good opportunity to take some gains and harvest those and bring new properties into the portfolio. So we’ve been looking to maintain the size of our accounts at least or potentially grow them.”

Real estate still looks relatively dry, so Northwestern Mutual continues to invest in it, Hanson said, “despite how I might feel sometimes—being in the market.” Regardless of the occasional qualms about time, real estate offers strong returns, whether it is for acquisitions or for development, for land or for deal structures with developers, he added. “We’ve looked for opportunities where we think we can find something that has replacement costs or close to it, and/or in markets where we can necessarily develop,” he said.

An Industrial Empire in the US Sunbelt

For years, PGIM Real Estate has primarily been focused on joint venture multifamily development. The company stays competitive by being “extremely picky on submarkets,” Mason says. Industrial is also a big focus, he adds. “We want to grow the industrial portfolio, so our focus has been on building an empire in the Sunbelt for the most part.”

The team is on track to meet its goal for the year, however, he added that the environment for deals is getting more difficult to navigate and it takes more calls to get a transaction done. “You’re having to have 20 balls in the air to have two kinds of hits,” he said.

Repurposing Land for Multifamily Development

Patel of Manulife / John Hancock noted that over the last few years the company rebalanced its portfolio, reducing its book of nonstrategic assets in the office area. “We’re looking to increase our multifamily and our industrial exposure,” he said.

The company is also repurposing land where it has assets and developing multifamily product on it. “We’ve got [residential] developments going on in Midtown Atlanta, Washington, DC, Boston, San Francisco and San Diego,” he said. Doing so provides a competitive advantage for cost basis because the land base is close to zero, he said.

Multifamily development, however, is not without its risks, and Patel points to rising construction costs in particular. “We’re looking at our San Francisco tower. We’ve entitled it—we don’t know if we’re going to build it yet.”

When the Office Asset Class Makes Sense

Radovitskiy said that for Travelers, the office asset class makes a lot of sense. “We definitely avoid more capital-intensive asset classes, so we’re not looking at hotels. We’re more core plus, I would say.” Travelers’ portfolio is predominantly wholly-owned, peppered with a handful of joint venture projects. Like everyone else, she added, the company is also looking at industrial. “It’s definitely, though, a very tough time in terms of acquisitions.”

Like Manulife / John Hancock, Travelers is taking advantage of its previously owned/acquired lands for joint bite-size developments across the country, she added.  The company is moving forward on developments in Houston, Los Angeles’ Florence submarket and Tampa, FL. “So that’s our way of trying to be innovative and continue to grow our portfolio,” Radovitskiy said.

Workforce Housing as a Defensive Play

Aegon Real Assets US’ Cote holds no illusions that a recession is coming—the only question is when. It could be anywhere in the next 19 to 24 months, or perhaps sooner as geopolitical risk creates more downsite. The company evaluated its private strategies and landed on multifamily—workforce housing in particular—as resilient to a downside scenario in the economy.

The company is partnering with local developers, usually though a JV equity structure, he said. It is staying away from new construction luxury because that property market is weaker right now and doesn’t have the demand drivers seen in the middle market.

All told, Aegon Real Assets US has picked 17 markets located in the “smile of the US,” he said. “New York’s a great market, but rent controls ruin it for investment and multifamily. But even down in Florida and in the Central US there is Denver, Salt Lake, Phoenix—we see a lot of opportunities there.”

“We’ve had this strategy in place for about a year and a half now.  And the good news is we’ve levered and we’ve delivered really solid results,” he concluded.

Still Room for Appreciation in Industrial

Over the last three years Principal Global Investors has been doing more in development than in acquisitions, Halliwell said. Between 60% to 65% of its equity placements have been in development, which have mainly focused on industrial and multifamily. “If you have a pretty good research department, pretty good partners, pick the right product, it’s been hard not to make money in a development deal,” Halliwell said.  Within industrial in particular, the industry wonders if there is any more room for appreciation, “but it appears there is,” he said.

“If you look at the dispersion of returns in all property types, industrial has the lowest,” he continued. Multifamily, by contrast, has a fairly wide variable of returns. “So that is what caused us to go to the Orlandos, go the Austins, go to the Charlottes for industrial development. Denver is now one of the best development markets. Ten years ago it was only a tertiary industrial market.”

The Benefits of Opportunity Zone Investing

Allstate has just finished its first structuring for an Opportunity Zone, setting up its first fund. It took a couple of months to establish, Dewees said, after following the market for quite a while.

“It’s frankly not that hard to structure.  It’s really a relatively easy structuring.” The hardest part, she said, is the developer and taxing entity piece “and making sure you’re balancing that managing member rights versus the rights that you need in order to qualify.”

To date, the company has invested in a single asset deal in Phoenix and plans on testing the Chicago market.

The deferral benefit is important and an investor can defer it from one day to 10 years, she said. “There’s a step-up in basis. And then you have to hold the investment, the investment property that’s in the Opportunity Zone, 10 years to get that benefit.”

One downside is that there has been some backlash about Opportunity Zone projects not being socially responsible. From Allstate’s perspective, it can be worrisome being invested in those types of projects, she said.

But that has not deterred other investors. “I know a number of high net worth real estate people who are selling off major portions of their low basis stock to generate gains to go because it’s so attractive in what’s there.”