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Investors Going Back to Core in 2016, Keeping an Eye On Tech, Energy Sectors and Corporate Downsizing

Office Investment Dollars Will Move Away from Risk to Current Income
December 29, 2015
The shift of investor money away from easy price appreciation to current net operating income is already beginning to define the office market of 2016.

The change in investment strategy is particluarly evident among pension funds. Now that the days of interest-free federal money has come to an end with the Federal Reserve moving the borrowing rate up from 0% to 0.25% this month, several major investment funds have taken steps to reposition their real estate portfolios in an effort to improve their inflation-hedging potential by focusing on current income generation.

The $70 billion Oregon Public Employees Retirement Fund (OPERF) is the latest fund to shift money away from risk (value-add) to current yield. Currently valued at $7.93 billion, OPERF is looking to increase the real estate portfolio value to $8.85 billion.

To do so, the fund plans to move investment funds out of public REITs and opportunistic investments into private core investments, increasing its core investment target by 20% and reducing the other two categories by 10% each. Fund managers said they plan to reduce the fund's opportunistic real estate holdings by selling the majority of its existing opportunistic holdings over the next five to seven years.

OPERF is currently overweighted in apartment and industrial holdings, with office accounting for about 28% of its core diversification, compared to 38% weighting in its benchmark NCREIF core index.

The California State Teachers Retirement System, the country’s second-largest public pension fund with more than $25 billion in real estate investments, also approved a revised real estate investment policy to move more of its investment funds away from opportunistic investments to focus on core properties.

Managers of the fund said the primary reason for the shift was to reduce risk. Like OPERF, CalSTRS plans to rebalance its real estate investments largely by selling its holdings in older, vintage opportunistic properties.

While it may sound counter-intuitive for investors to shift money into higher-cost core properties, Paul Noland, director of acquisitions for L&B Realty Advisors LLP in Dallas, said, "We prefer to pursue ‘fortress’ core buildings in top tier markets. The assets L&B purchased near the end of the last cycle that performed the worst were when we chased yield to lesser quality markets."

"2016 vintage feels similar to 2006-2007 from a fundamental perspective," Noland added. "The economy is doing well, rents are at all-time highs, cap rates/debt are at historic lows and underwriting is aggressive. As with most advisors, our clients want to put capital to work, so sitting on the sidelines is not an option."

However, with the demand for core office real estate strong and the acquisition side becoming more competitive, Daniel Goldstein, co-founder and managing partner of Accesso Partners LLC in Hallandale Beach, FL, said investors can still find opportunities in the current market.

"We feel there are still great opportunities in the office sector,” Goldstein said. “Institutions still have record funds to deploy, and allocations to real estate continue to grow as the search for yield intensifies. Companies are just being slightly more selective in their deployment of equity at this time."

Foreign investors continue to see the U.S. as a safe haven for capital, said Goldstein, and their continued influence should be a net positive for the economy and for real estate specifically, he added.

As for his investment firm, Goldstein said he wouldn’t rule out value add.

“We will continue to be opportunistic in 2016 and remain receptive to acquiring well-situated stabilized and value-add Class A office properties."

The End (of the Cycle) Is Near

Several real estate players we contacted regarding the 2016 office outlook were beginning to issue warnings about market conditions.

"(Previously) there were 20-30 year cycles between busts and peaks," said Joseph M. Ryan, president of LaSalle Appraisal Group Inc. in Chicago. "I think we have shortened that cycle to eight years. The bubble inflated faster (banks did not learn the lesson of 2008-‘09) the MBA’s cranked back up their flawed discounted cash flows (DCF)’s and the 'Grave Dancer' is selling, so he has cash to buy but at the low end prices that are surely coming."

The grave dancer Ryan refers to is legendary investor Sam Zell, who said earlier this month in a Bloomberg Television interview that there is “a high probability” that U.S. economy could go into a recession in 2016.

With 'pricing currently available in the commercial real estate market, it is very hard not to be a seller," Zell said, and cited a number of reasons for his recession forecast: Multinational companies are laying off workers, global trade is slowing, there’s a possibility China’s economy will falter further, and the strong dollar is having a tremendous impact on U.S. production and U.S. businesses, he said.

Other investment brokers we spoke with also cited warnings that might play out in 2016.

"If you believe the commentary on the newest bubble, the tech start up industry is what will take us down next,” said Blake Puttkammer of Marcus & Millichap in San Diego. "This will most likely affect the fictitiously healthy home market, which is driven by the inflated tech salaries."

That could be both a blessing and a curse, Pluttkammer said. Money that flees from risky tech startups could find safety in the CRE market, which may offset or dampen the blow on the office and housing markets.

Meanwhile low energy prices will continue to dampen office markets dependent on energy.

"The Houston office market has been dramatically affected by the drop in oil prices and the projected decline in occupancy for 2016 will even be worse,” said Tom Costello of Marcus & Millichap in The Woodlands, TX. “Currently, there is more than 7 million square feet of sublease space on the market right now. As big oil continues to tighten their belts, vacancy is projected to expand due to weak demand and more space becomes available."

More is Less and Less is More

Corporate downsizing is another notable office trend to watch out for in 2016.

"The cost of new product is changing the expectations of company demands for space," said George Kurz, a principal of Kurz & Hebert Commercial Real Estate in Baton Rouge, LA. "Here in our market, tilt-up concrete and other budget-friendly construction methods are being adjusted to meet the demands for large corporate office space. They can be done far cheaper than conventional glass and steel boxes, completed more quickly, and provide a more flexible layout to meet today’s open office requirements."

Kurz expects any weakness in the office segment will come in the small-office rental market. “With rates low, it is cheaper to buy than to rent. And with increased technology, smaller companies have less demand for office space and more employees at those companies are using technology to keep office requirements low, with many employees working from home or the nearby coffee shop wireless."

Rising rents are also forcing companies to re-evaluate their space needs, noted L&B Realty Advisors’ Paul Noland. But that may not be such a bad thing from an investor's perspective.

“Office users are being more efficient with their space plans. While rents are above pre-recession levels, because employers are putting more people into less space, the costs per employee seems more palatable than just looking at rent per square foot,” Noland said.

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