New Era of Recalibration

There's plenty to be worried about in this market. The still-stagnant US economy, lack of job growth, European financial markets crisis and the stalled capital markets environment—including the anticlimactic would-be return of the CMBS market—are all putting a damper on the outlook for investors.

But just because one doesn't have a bullish take on the market doesn't mean there aren't opportunities to be found. Institutional players have come to terms with the realities of the current environment—that is, things aren't going to get much better anytime soon, and established investment strategies and practices are being redefined—to move ahead with transactions. It's all a matter of putting discipline to work and cherry-picking deals, be it "safe" transactions (core product in top-tier markets) or opportunities along the risk spectrum.

Deciding how, when and where to place capital was among the topics discussed by decision-makers from some of the nation's top institutions who gathered at New York City's Waldorf-Astoria hotel last month for the seventh annual Transwestern/Real Eestate Forum Capital Markets Symposium. In a candid session, these senior-level executives shared their views on the market and the global economy, their firms' 2012 investment strategies and expectations for the coming few years. An edited version of that discussion follows.

STEVEN PUMPER: We got off to a good start the first half of this year, but then things got worse in the second half. Still, a fair amount of transactions got done later in the year. How was the year for you and what's your 2012 strategy?

BRIAN WATKINS: We've been very active and are on course for about $1.8 billion by the end of the year. In terms of volume, we're up from the past few years, but historically, it's been more like $4.5 to $6 billion on average in acquisitions. We're very happy with the volume of transactions that we've done this year. We've done a couple of large transactions, but by and large, most of the investments were in the $30-to $75-million range. On the disposition side, we took advantage of the environment at the beginning of the year and completed the majority of our dispositions, but then sales activity tapered off a bit in the latter part of the year. We're looking at 2012 cautiously and we will be very selective about our investments.

PAUL BONEHAM: 2011 was a record year for us in the US, with $1.5 billion committed to a mix of core investment and development activities. We started 2011 with a strategic plan, but as the market fluctuated, we changed direction a bit. For instance, office investment wasn't in the strategic plan, and we made two very key investments that made up a big piece of the production this year. We felt that the story in each case was compelling to buy deeply discounted, very strategic assets in urban locations. On the dispo front, we'll be at about $600 million for the year.

ROBERT J. PLUMB: We've had a good year. We're clearly not at 2007 levels, which is fine, and I'm proud of the type of investments we've done. Not only do we invest in the four core property types, but we also do other types of assets, such as seniors housing. We got a lot of money in that space. We've also taken full advantage of the need for capital in the market and have gone up and down the capital stack with different types of transactions. One minute, we're buying a core office building, and the next, we're doing a structured mezzanine debt deal for a large operator. We really take advantage of the need for equity.

On the dispo sideat least in managing institutional client capital—there's a lot of change going on, not only on the operating level, but also on the pension funds. We've been moving assets for them and trying to high-grade their portfolios and bring them back into newer-vintage holdings.

CHARLES B. LEITNER: RREEF has been more active this year than the prior couple of years. When you look at where the capital is coming from, at least in terms of our client base, we're seeing a fair amount of demand from Europe and other offshore sources for core US product. We don't see as much demand for that from the domestic side. We're doing some tactical selling and some opportunistic buying, too—when we think the pricing is right—but a lot of people are looking for the same thing.

Yields are hard to reconcile, and there's still a lot of risk out there. So from an underwriting standpoint, we're still trying to be very careful on the buy side. If we have a client or a fund that's looking for some liquidity, we've been a seller in certain cases. But there's definitely been a big difference between the first half of this year and the second half. It's been really difficult to be aggressive, and I'm not sure if 2012 is going to be that different.

GERALD CASIMIR: This year has been a very robust year for us. We closed about $4 billion in acquisitions, predominantly all equity. If you look at the past three or four years, 2011 was sort of a banner year on a relative basis, but if you look at our average book of business over a longer period, 2011was probably more of a normal year.

For the past four or five years, we've acquired assets based on a target market strategy, which essentially focuses on bi-coastal gateway markets. In 2011 we had a tactical overweight to apartments because we saw good long-term value. The slowdown in for-sale housing due to the economy and concerns over sustainable employment has benefited the for-rent apartment market. Our philosophy is to buy positions in good quality, well located assets in highbarrier-to-entry markets.

In 2012, we will continue with that philosophy. Will it be more difficult? We believe so, but nonetheless, we have to have discipline, and we will adhere to our disciplined approach to investing. We are predominantly core, and we buy value-add on the margin.

MICHAEL G. DESIATO: CMBS issuance was predicted to hit $30 or $35 billion in 2011. We were starting to head in the right direction, but then the spigot shut off. What's your perspective on the CMBS and debt markets in general?

TODD T. LIKER: It's interesting, between the second half of 2010 and mid-2011, a lot of the aggressive lending associated with CMBS 1.0 started to rear its ugly head again in CMBS 2.0. Lending standards loosened and the banks that were in the CMBS business decided to start aggressively bidding for those loans. Profit spreads came in dramatically, and there was a general sentiment in the market that the worst was behind us.

When Europe started to pull back, it forced a lot of CMBS investors to pull back and ask themselves what type of yields they really felt were warranted for this type of paper. That's what caused the CMBS markets to pull back more than anything else. There was some concern from bond investors that lending standards may have gotten a little too aggressive too quickly, but it was primarily a sentiment shift with respect to the type of yield that was appropriate for this type of risk. This was true across the fixedincome markets, not just in CMBS.

PLUMB: No one's going to do a loan when you don't even know what your rate will be until the day you close. CMBS isn't coming back any time soon, not at 6% borrowing rates. No one is going to borrow that money; they'll just give the property back. So what you're saying is there's going to be more properties going back.

There's a tremendous amount of debt that needs to be refinanced. That's the headlines for the next two years. People think we've been in this thing for a long time, but we're just starting. CMBS, the pig in the python, comes through here over the next three years. It's going to be awful.

LIKER: In primary markets, cap rates have come in meaningfully from the depths of the downturn, which means that further value recovery becomes a question of cash flow. The problem is that, in many cases, cash flow will struggle to recover meaningfully any time soon. So if a lender restructures a loan in the hope of future value recovery, the cap rate component has already played itself out. If you're waiting for cash flow to come back, you might be waiting for a while because the cash flow picture could look pretty much the same 12 to 24 months from now. So I agree, Bob. I'm not sure that market dynamics support large amounts of new debt issuance driven by refinancings, which would play an important role in driving new CMBS issuance.

PLUMB: And no one is going to step in because life insurance companies don't want it, and banks won't touch it, either. Most borrowers can't afford to borrow a loan from the bank. So it's just going to be a train wreck. The issue is about debt, and equity is going to have to become debt.

WATKINS: It does open up an opportunity for other types of capital, such as mezzanine debt and preferred equity. There's approximately $1.2 trillion of debt coming due between 2012 and 2015. That's going to put more distressed product in front of the equity. From an equity standpoint, that's a good thing, and such potential opportunities will include asset recapitalizations and mezzanine financings as well as preferred equity plays.

DESIATO: With all the negative things that are out there, is there anything that could potentially be good for real estate for 2012 or 2013?

WATKINS: On a risk-adjusted basis, industrial is still fairly strong relative to other yields. We like West Coast industrial, given that energy costs are going to spike and shipping companies will have to lower the speed of their ships to save fuel, which will mean that they're going to look to decrease ship transportation time. They're going to come into the West Coast ports more often.

One of the big things we're bullish on is the energy sector. We made a couple of big investments in Houston this year in office and multifamily because we believe in the long-term energy sector that is a dominant part of Houston's economy. Again, it's about being very selective about which markets and product types you invest in.

PLUMB: If you look at the portfolios of any of us on this panel, office has particularly struggled. But for the most part, any office product that had technology as a driver has done pretty well over the past couple of years, and probably will continue to do so because there hasn't been a whole lot of development. We've done really well in markets like San Jose and Cambridge, MA. And one of the biggest things this country exports is education, and we've got some good educational institutions in Boston. We also have great hospitals and other healthcare operations.

But it's true—there isn't a whole lot to be excited about. The boom in the energy industry is great for some, but what about the other 90% of us who are going to be paying $6 a gallon for gas? It's going to croak the economy.

LEITNER: Just because you're not bullish doesn't mean there isn't opportunity. It's very hard to be bullish about anything. There's not a lot of fundamental activity that gets you excited, but that doesn't mean there's no opportunity in the real estate asset class. It's just going to require a lot of selectivity and discipline. It also means volume isn't really going to be part of the story.

This debt situation has to be factored in. It's difficult to underwrite right now because there's a recalibration happening. We could say we don't care what's happening in Europe, but can't because it has too much to do with everything that's going on. Whether we like it or not, we're still in the middle—optimistically speaking—of a massive repositioning of everybody's balance sheet, be it corporate, consumer or government. But for an opportunistic player, Id be getting pretty excited about the markets.

DESIATO: Has the definition of opportunistic and value-add changed?

LEITNER: It should have changed by now. RREEF has a different definition of value-add than it used to have. A lot of it is about risk adjustment relative to the kind of return you're willing to accept. But I'd like to be an opportunistic guy with money going into 2012 and 2013. I wouldn't mind being the guy who's buying distressed debt in 2012 and 2013 because if you think about what's going on in Europe, these guys hold a lot of paper. They're sitting on the assets that we want to buy in this market. So just because the outlook is bearish doesn't mean there's not an opportunity to play.

CASIMIR: I agree—it's about selectivity. We are less cap rate focused because we believe rental rates have come in so much that it's not a cap rate game per se. It's more of a basis play. Cap rates are what they are; the question is how much growth do you see in rents? There will be growth, albeit slower than originally predicted at the start of 2011. You can't price in the level of inflation spikes that you did before. There will be opportunities, but not as many. And cash will be king because debt will be very difficult to obtain for value-add and opportunistic plays. If you're operating in the value-add or opportunistic space, and can afford to pay all cash, you should. Those who have the ability to fund equity across the entire capital stack are going to be in a great position in the upcoming years.

BONEHAM: In New Jersey and Chicago, we bought two office buildings totaling two million square feet on an all-cash basis. A great deal of our strategic comparing of opportunities is based on the basis and what a 10-year unleveraged IRR looks like, because when you start throwing the financing in, that's just financial engineering. It really distorts the picture. You might use the debt later, but it's not the primary basis for making the decision.

PUMPER: Where do you see deal flow for 2012 on distressed debt? Is it increasing with maturities coming due?

LIKER: Absolutely. One of the things I'm encouraged about is that I think this era of deal paralysis is essentially behind us. Lenders and borrowers have started to realize that they need to work through their problems. They're not going to sit around and wait for brighter days tomorrow. They're starting to move the notes. They're starting to accept where value is. They're starting to accept A-B structures. They're starting to take back assets and sell assets. People are now much more accepting about the reality of the economic environment than they were 12 to 18 months ago. Trying to pin down the volume is tough, though. This is not a 12-or 24-month phenomenon.

DESIATO: What do you think about pricing and asset quality in some markets?

LIKER: For the best assets in the best markets, there are aggressive buyers. But many of the assets that need to be worked out aren't the trophies in the primary markets. It's often assets that have a story around them. Currently, there are good assets that have been capital starved, and good assets that happen to sit in tough markets. It's hard to make a sweeping generalization on pricing and quality, because the story of each opportunity is different. I'm exaggerating a bit, but broadly speaking, there's no such thing as a bad building or a bad market, it's the pricing that can make them bad. As long as you're realistic about the macroenvironment, willing to be disciplined, and look at the world through the lens of the new normal, there are good deals to do.

PUMPER: At this point in time, what percentage of your investment strategy would you direct toward opportunistic or value-add space?

WATKINS: Right now, given perceived risk, capital has been generally looking for core transactions. It's off-market core, maybe coreplus, maybe a build-to-core program that is being pursued as a way of ultimately getting at core transactions to produce stable yields.

BONEHAM: At the beginning of 2011, our plan was 80% core, 20% value-add. By the end of the year, it's more like 65/35, based on what the market would give us and where we saw risk and reward. In 2012, I would expect that 60% of our capital would be deployed into core assets, from which we expect to produce 7.5% to 8% unleveraged IRR on a 10-year hold, and 40% would go to value-add.

PLUMB: We have opportunistic funds, value-add funds and core funds. My guess is that we'll have a little bit of a barbell, with opportunistic and core at the ends. I'm most interested in the number of transitional assets that are going to get put on the market in the next couple of years. I would put that in the value-add bucket. That's the belly of this beast, and I see that as a really attractive place to be in the next couple of years.

LEITNER: Investors are saying there's a place for core real estate in an investment portfolio and you need to determine how the market defines quality. That's the one end of the barbell. Then there's the other side, which I think also has to be redefined. Value-add has crowded out core and opportunistic for a long time.

Opportunistic needs to be redefined to cover a much broader swath of the market rather than value-add covering it, because that's such a murky risk-return analysis. I'm a big believer in the barbell evolution, and that's why I'm a bit cynical about value-add because I think that's more confusing. Opportunistic is the right way to look at "risk" and core is the right way to look at "safe."

CASIMIR: We will predominantly be core. We will do value-add or opportunistic on the margin. We're looking to buy really good positions that, in the long term, will pay huge dividends. We haven't seen opportunistic deals and value-add deals are even rarer, almost impossible to find in the gateway cities.

DESIATO: We're experiencing unprecedented government dysfunction right now. Regardless of what happens with the election, has the political system now become a risk factor for doing business?

WATKINS: It always has been, but there's certainly an additional focus on it as of late. Our biggest concerns are whether the policymakers actually make key decisions, and whether those decisions are clear, decisive and easily understood. If not, the uncertainty will continue, and that would obviously be bad for the economy.

BONEHAM: Isn't it interesting that companies have cleaned up their balance sheets, pulled together large amounts of cash and have decided the best thing they could do with that cash is buy back their stock instead of making capital investments and creating jobs? That says it all as far as I'm concerned.

LEITNER: It's the number one issue, but we've got to figure out how to live with it. We might look back in 20 years and say that dysfunction is exactly what saved us because it created the relatively soft landing as opposed to the crisis that we were looking at two years ago when the markets really were in trouble. So as frustrating as it is, we might actually look back and say it worked, but it sure doesn't feel like it's working. It's really difficult to make decisions. When you look at how the markets just aren't responding and how we're not getting any economic growth—that's got to be the number one issue.

CASIMIR: Washington is the number one issue, but local and state governments are also in serious trouble. Corporations have deleveraged and cleaned up their balance sheets, but state and local governments have not. When you look at the debt at the state and local levels, it's just unbelievable, and I don't know how you get out of that. That's going to affect local economies for some time. For local, state and federal governments, it's a question of deleveraging and cleaning up their financial houses. I don't know how or when that's going to happen or which party can make it happen.