Expectations Meet Reality in the Hunt for Yield. Finally

(Mark Your Calendars: RealShare REAL ESTATE 2012, March 22^nd in Los Angeles and RealShare Apartments East, February 15^th in Washington, DC).

Not that long ago—perhaps a year—a seller of a multifamily property, even a class B one, in suburban Washington, DC would have been outraged at the prospect of their property trading at a seven-and-a-quarter cap rate. Now, such trades routinely come in at this pricing and it is not because the market is heating up. Rather, says William S. Roohan, vice chairman of CBRE and Baltimore-based head of the company’s Multi-Housing Investment Properties team, sellers have finally come to grips with the realities of the market.

“It has just taken a bit longer than expected for bid-ask spreads to narrow,” he explains. Much of this has to do with the cost of capital, which for class A assets is usually pegged at 10-year Treasury bills, while for value-add, B deals it’s usually linked to LIBOR.

Then there is this: investors are more realistic about the yields that they can realize from commercial real estate investments these days. This tempered attitude has been helped along by those 10-year T-bill yields, which are hovering below 2%, giving investors little other choice but to accept yields that are sometimes only slightly above that.

“Investment decisions are always made based on what the yield is expected to be; that goes without saying,” says Dan E. Gorczycki, managing director of Savills in New York City. What is tricky is trying to pinpoint projected yields of any investment—and then balancing that against expected yields of competing investment vehicles, he says. Real estate, since the start of the liquidity crisis and recession, has consistently come out on top, even when investors are not happy about the specific yield.

In some cases, investors are just accepting the status quo, especially if they have stretched themselves as far as they are willing to go on the risk-return spectrum. Opportunistic investors, it seems, have decided to retreat from their long-held expectation of realizing returns in the mid-teens, according to Emerging Trends in Real Estate 2012, a report by PricewaterhouseCoopers and the Urban Land Institute. It noted that such investors are downgrading return expectations because they have concluded that there is too much supply in the equity market. Yields for core properties are at subterranean levels, in large part because there are too many investors chasing too few deals.

Other investors are willing to tweak their risk profiles to get better yield. Mortgage REITs, for example, are moving away from agency securities to non-agency RMBS. Last year, according to SNL Financial Services Daily, Deutsche Bank initiated coverage of AG Mortgage Investment Trust, citing discounted valuation and investment opportunities in the market.

SNL quoted analyst Stephen Laws: "We expect AG Mortgage to take advantage of attractive investment opportunities in non-agency RMBS caused by the recent market dislocations as well as to benefit from the low financing cost, slow prepayment, steep yield curve environment for the agency RMBS portfolio," Laws wrote. “Given our portfolio assumptions, we expect AG Mortgage to generate portfolio ROEs of 16-18% and net ROEs of 14%."

The same balancing act—more risk-better return—is playing out at the retail level. REITs are still a favored investment even with yields clocking in at 4% because, after all, where else can shareholders—especially retirees looking for a fixed income stream—go? Bond funds are only paying out in the 3% range and T-bills are barely, if at all, outstretching inflation.

Indeed, one of the reasons for REITs’ stellar performance in 2011 was the number of retail investors grabbing shares because of their dividends, according to Keven Lindemann, director of SNL Financial’s Real Estate Group. “It is difficult anywhere in the fixed-income world to find a really secured yield of 4% or greater,” Lindemann told NAREIT in a video interview posted on the organization’s website. Out of 126 equity REITs in the FTSE NAREIT All Equity REITs Index, 71 had a dividend of 4% or greater, he pointed out.

Some of these trends can be expected to continue this year. Mortgage REITs began to get interested in non-agency securities last year because of the low interest rate environment—being able to borrow at such low costs it may make their returns all the better. Now, with the Federal Reserve guaranteeing low interest rates for the foreseeable future, such transactions are bound to increase.

Some changes can be expected to mix things up, though. Savills’ Gorczycki thinks that this year special servicers will stop playing nice with investors and lenders and start clearing out the pipeline. “We have been thinking it will happen for a while, but it is really looking as though now we will finally start to see more distressed assets come to market.”