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U.S. Real Estate: A Storm Is Brewing

John Murray
Managing Director
Portfolio Manager
Anthony Clarke
Vice President
Portfolio Manager

Storms form when moisture, unstable air and updrafts

interact. Similarly, a confluence of factors volatility
in public markets, tightened regulations, maturing
loans and uncertain foreign capital flows is creating
a blast of volatility for U.S. commercial real estate (CRE)
that we anticipate could lower overall private U.S CRE
prices by as much as 5% over the next 12 months.
For nimble investment platforms, however, these
swirling winds should create attractive opportunities
over the secular horizon.
After the financial crisis, which sent prices sharply lower, commercial real estate in the U.S. has
enjoyed growth with solid fundamentals. Rents have steadily increased and demand generally
continues to exceed supply. Improving fundamentals, though, have not been the primary driver
of higher CRE prices. Consider this: Since the fourth quarter of 2009, overall office prices have
doubled (as have general CRE prices), yet national office rents have risen only about 15%
(see Figure 1). The primary price driver for U.S. CRE assets instead has been capital flows.
FIGURE 1: CAPITAL FLOWS AND ROBUST TRANSACTION VOLUMES HAVE LIFTED U.S. CRE PRICES MORE THAN
RISING RENTS
180

250

160
140

200

120
150

100
80

100

60
40

50

20
0

09

10

11

12

13

14

CBRE, RCA national commercial real estate transaction volume ($ billion)

Moodys/RCA national office values
CBRE-EA national office rent index
Source: CBRE and Moodys/RCA Commercial Property Price Indices as of March 2016

15

Billions ($)

Index = 100

AUTHORS

Featured Solution June 2016

But capital flows have grown unstable over the past year due to fears over interest rate hikes
and, more recently, events such as political and economic uncertainty in China. While this
instability began in the public CRE markets, it has blown in to private CRE as well,
particularly in non-major markets.
CHANGING DIRECTIONS: REIT DEMAND HIT BY MARKET VOLATILITY

Real estate investment trusts (REITs) are generally registered with the SEC and publicly
traded on a stock exchange. But theyre classified and often move in tandem with financial
stocks, which have been buffeted recently by global financial market volatility. Much to the
dismay of REIT CEOs, daily returns of REITs have had a 71% correlation to the broader S&P
Index since the beginning of 2015. The result: Despite private CRE price indexes such as
Moodys/RCA Index increasing over 7% since 2014, REIT prices have been essentially flat,
and dropped as much as 10% on multiple occasions over the same period (see Figure 2). As a
result, REITs have generally traded below their net asset value (NAV) for the majority of the
past 18 months. As capital efficiency textbooks would dictate, this persistent discount to NAV
has turned many REITs from net buyers to net sellers of U.S. CRE, suppressing a major buyer
within the market.
FIGURE 2: REITS AND STOCKS HIGHLY CORRELATED
115

15

110

10
5

105

100

-5

95

-10

90

-15

85
80

Percent (%)

Index = 100

-20
Jan
15

Mar
15

May
15

Jul
15

Sep
15

Nov
15

Jan
16

Mar
16

May
16

-25

S&P 500 Index

Dow Jones REIT Index
Green Street Advisors major sectors premium/discount to NAV (simple average)
Source: Bloomberg as of 3 June 2016

To put this into perspective, REITs acquired about $54 billion annually of private CRE from
2012 to 2014 (some 15% of total transaction volume), according to Real Capital Analytics.
However, in the second half of 2015 acquisitions plunged to $17 billion (less than 8% of total
transaction volume) due to heightened volatility.
In August of 2016, REITs will be reclassified as their own sector within the Global Industry
Classification Standard, which could partly account for recent outperformance. While a more
specific benchmark should result in increased flows to REITs from index-conscious equity
funds, REITs could still be exposed to highly correlated and volatile global capital markets.

Featured Solution June 2016

REGULATION MORE CLOUDS AHEAD

CRE liquidity has declined in recent years, driven by post-financial crisis regulations such
as Dodd-Frank and the Federal Reserves Comprehensive Capital Analysis and Review
(CCAR). This has intensified volatility for the sector during periods of broader public
market sell-offs. In February, for instance, oil-induced fears in the broader high yield debt
markets led to redemptions that forced several hedge funds to unload positions, including
subordinate U.S. commercial mortgage-backed securities (CMBS).
Here again, the sell-off had little to do with actual CRE fundamentals. Instead, it
highlighted an increasingly important headwind to U.S. CRE finance broadly reduced
bank dealer inventories. As with other areas of fixed income, banks have traditionally
served as market makers in CMBS. However, in response to a variety of regulatory
pressures, banks have reduced their balance sheet inventory by nearly half in the last two
years (see Figure 3). The impact of this inventory reduction is clear hedge funds hold
about 40% of subordinate U.S. CMBS positions, and as they began selling to meet
redemptions in February banks were unable to provide liquidity (or make a market).
As a result, prices for these subordinate CMBS positions fell by as much as 20% in a matter
of weeks.
FIGURE 3: DEALER INVENTORIES OF CMBS HAVE FALLEN BY NEARLY HALF
Total CMBS Dealer Inventory
13

Billions ($)

12
11
10
9
8
7
6

Apr
13

Jul
13

Oct
13

Jan
14

Apr
14

Jul
14

Oct
14

Jan
15

Apr
15

Jul
15

Oct
15

Jan
16

Apr
16

Source: Federal Reserve Bank of New York as of 4 May 2016

CMBS loan origination platforms also have been crushed by the plunge in prices, as banks
and originators found their recently originated loans, intended for securitization, to be
underwater based on CMBS pricing. According to Bank of America, CMBS issuance in
the first quarter of 2016 tumbled by over 30%.

CMBS loan origination

platforms have been
crushed by the plunge
in prices, as banks and
originators found their
recently originated loans,
intended for securitization,
to be underwater based
on CMBS pricing.

Featured Solution June 2016

Not surprisingly, with CMBS representing over 20% of the debt origination market in 2015,
the February fallout in CMBS had a notable impact on private CRE as well. CMBS lenders
increased rates on their debt quotes by 50100 basis points and buyers reduced property bids
to maintain target returns. Indeed, broker transaction volume affirms this dynamic first
quarter transactions dropped 11% compared with the same period in 2015, according to
CBRE Group.
Hardest hit were non-major markets, where CMBS represents over 35% of the nonmultifamily debt origination volume. Many deals fell out of contract or re-priced down
by as much as 10% to 15%.
Regulation will remain a headwind for CMBS and CRE for the foreseeable future. Later this
year, another reform new risk retention rules will be implemented. These will require CMBS
originators (or a long-term holder) to retain at least 5% of a new securitization. In essence, bank
originators will have to go from a moving business model to a costlier storage business
model, which in turn means lower volumes and higher rates for CRE borrowers.
Finally, recent regulations are taking a toll on another significant sector of U.S. CRE nontraded REITs. Enacted by the Financial Industry Regulatory Authority with an
implementation grace period that ended in April 2016, the rules require non-traded REITS
to disclose asset-based valuations of their securities. This requirement has already revealed
significant impairments to the NAV of many of these platforms.
This has dramatically affected fundraising for U.S. non-traded REITs, which fell to $9 billion
in the year ending January 2016, a 30% decline from the 20132015 average according to HFF.
Furthermore, its likely the numbers will continue to trend down. Similar to CMBS lending,
the negative impact will likely fall disproportionately on non-major markets, as non-traded
REITs were relatively more aggressive in these markets.
THE WALL OF MATURITY ROLLING THUNDER

Interestingly, the confluence of these forces comes as the U.S. CRE market is set to experience
a surge in forced liquidations. As is well known, more than $200 billion of 10-year CMBS
loans will mature over the next three years. Also, over the same period more than $50 billion
of 10-year CRE debt and equity funds will wind down. In many cases, these legacy funds have
held on to sub-performing assets to retain fees; however, at the 10-12 year point, investors
typically have the right to force liquidation.
SWIRLING WINDS OF FOREIGN CAPITAL

Somewhat counterintuitively, the global public market volatility that has hurt REITs and CMBS
has arguably had the opposite effect in the direct CRE investment space. Here, the combination
of negative interest rates in Europe and Japan, fears of currency devaluation in Latin America
and Asia and a continued thirst for safe yield has increasingly inspired long-term investments
in U.S. CRE. As such, foreign private investment volume ballooned from $22 billion in 2012
(8% of total volume) to $84 billion in 2015 (16% of total transaction volume), according to
Real Capital Analytics. Importantly, the impact has centered on major markets.

Featured Solution June 2016

Prospectively, continued volatility could support additional foreign investment, as

sovereign wealth funds remain underallocated to CRE, according to Preqin. In fact,
several sovereign wealth funds have recently announced significant increases in their
planned CRE investments. For example, Norways Government Pension Fund announced
plans to increase its global real estate allocation by some $17 billion; the China Investment
Corporation plans to double exposure by about $35 billion.
To put this in perspective, these plans alone equated to over 10% of the total transaction
volume in U.S. CRE in 2015. In addition, last December President Obama signed the
Protecting Americans From Tax Hikes (PATH) Act of 2015. The law reduces taxes on
U.S. CRE for many foreign pension funds and could prompt an additional $10 billion
to $30 billion of cross-border investment into U.S. CRE, according to the National
Association of Realtors.
That said, increasing dependence on foreign demand creates even more uncertainty for
U.S. CRE, as capital flows are far from guaranteed: China has hinted at increased controls
on capital outflows; lower oil prices could curtail investment from the Middle East and
Canada; and even certain U.S. presidential outcomes could influence foreign investors
confidence in U.S. CRE assets.

BIOGRAPHIES
John Murray
Mr. Murray is a managing director
and a portfolio manager in the
Newport Beach office, and is
co-head of U.S. commercial real
estate. Prior to joining PIMCO
in 2009, he structured real estate
transactions throughout the U.S. at
JER Partners. Before JER Partners,
Mr.Murray was in commercial real
estate development and
construction and also served as
a combat engineer officer with the
U.S. Army. He has 15 years of
investment experience and holds
an MBA from the Wharton School
of the University of Pennsylvania.
He also holds a masters degree in
civil engineering from MIT and
a bachelors degree from
Lehigh University.

WEATHERING THE STORM: UNCERTAINTY AND VOLATILITY CREATE OPPORTUNITY

The pressure from volatility, regulations, maturing loans and uncertainty over foreign
capital flows suggests prices could slump by as much as 5% over the next 12 months,
with a disproportionate impact on secondary and tertiary markets.
However, this dynamic could create opportunities across U.S. CRE debt and equity
markets, both public and private. In public CRE debt (CMBS), reduced dealer inventories
and the 10-year maturity wall will quickly alter underlying credit profiles in CMBS and
could create attractive entry points for nimble capital that understands CMBS structure
and the underlying CRE assets. Similarly, on the public equities side, broad sell-offs like
those in January and February will likely create opportunities to invest in CRE at
potentially cheaper levels than the underlying private assets, with potentially even better
liquidity. On the private side, regulatory pressures in CMBS should create financing gaps
that could be filled by non-bank capital through subordinate debt or preferred equity.
Finally, sustained periods of public market volatility, as well as disproportionate foreign
capital demand for core assets, could create attractive arbitrage opportunities for larger
platforms that can acquire mixed portfolios from forced sellers.
For flexible capital, this storm might be a welcome one indeed.

Anthony Clarke
Mr. Clarke is a vice president and
commercial real estate portfolio
manager in the Newport Beach
office. Prior to joining PIMCO
in 2014, he focused on real estate
acquisitions throughout the United
States at Walton Street Capital.
He has four years of investment
experience and holds graduate
and undergraduate degrees in
civil engineering from
Stanford University.

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