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August 2015 Asset Management Documeent title on one or two Defensive investing in 24pt U.S. lines in Gustan Book commercial real estate What is defe...
Author: Mark Robbins
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August 2015

Asset Management

Documeent title on one or two Defensive investing in 24pt U.S. lines in Gustan Book commercial real estate What is defensive commercial real estate investing? TIAA-CREF Global Real Estate Strategy & Research Martha Peyton, Ph.D. Managing Director Edward F. Pierzak, Ph.D. Managing Director

Defensive commercial real estate investing involves tactical efforts to target property types, markets and property characteristics that are expected to outperform benchmarks during cycle downturns. As the commercial real estate cycle matures, investors commonly become more interested in allocating capital to defensive tactics as a hedge against an eventual cycle downturn. Such tactics are undertaken with the understanding that they can provide benefit only relative to benchmarks. Since defensive strategies cannot be expected to eliminate the entire downside risk of commercial real estate, some investors turn to a tactical market-timing strategy. Market timers might cash out of their real estate portfolios when a peaking in value is suspected. Abrupt cash-outs are not defensive because the risk of mistiming an exit is material, the risk of holding cash versus a return-producing asset is material and the difficulty in rebuilding an attractive property portfolio for the next cycle is material as well.

How do defensive investments provide outperformance versus benchmarks? Outperformance relative to benchmarks can arise from (1) stronger and steadier NOI versus benchmarks, (2) stronger and steadier occupancy versus benchmarks, (3) steadier liquidity versus benchmarks, (4) more moderate cap rate spread widening versus benchmarks. Stronger and steadier NOI and occupancy during periods of stress is associated with properties that have high occupancy and long-term leases with high-quality tenants as the cycle matures. Higher-quality properties have an added advantage in that vacancies can be more easily marketed to new tenants without the need for capital improvements beyond the usual leasing commissions and TI. Additionally, property segments that are least affected by structural transitions are more bulletproof during periods of stress. Structural transitions are now most prominent in the office sector, which is coping with obsolescent suburban office, and in the retail sector, which is coping with excess space in localities lacking sufficient consumer spending depth. Properties with these favorable characteristics that happen to be located in metro markets that have good growth drivers, tight vacancy rates and modest pipelines of new space have the added advantage of sustainable liquidity during periods of stress. Sustained liquidity produces an uninterrupted flow of transactions, which in turn offers a steady foundation for tracking value even though it will make values appear to be volatile. Less liquid markets and property types will have few transactions during periods of distress which curtails information on value changes. In historical data, this can be misinterpreted as lower cap rate spread volatility, but it is rather an artifact of few transactions and illiquidity.

Defensive investing in U.S. commercial real estate

When is the timing right for defensive CRE investing? Investors should consider the evolving characteristics of the cycle, their plans to put funds into real estate over the near term, their plans to divest of real estate that has achieved its goals and their appetite for riding the cycle versus hedging against it. In mid-year 2015, the U.S. commercial real estate cycle is in its sixth consecutive year of recovery. The NCREIF-National Property Index has produced five straight years of double-digit total returns with a good start on a sixth double-digit year in 2015. As shown in the chart below, the current positive phase of the cycle is quite mature in an historical context. But, real estate cycles do not die from old age nor do they have an expiration date. Rather, cycles turn either due to macro-economic shocks or accumulating imbalances affecting the demand and/or supply drivers of real estate performance. Macro-economic shocks are always a looming risk. When shocks hit, volatility spikes in financial markets and imbalanced sectors suffer. Big shocks hitting hugely

imbalanced sectors can produce enormous suffering as in the Global Financial Crisis. Recent shock sources include weak Euro-zone growth and Grexit risk, China’s growth slowdown and unexpected devaluation, weak demand for raw materials and negative impact on emerging markets, Russia-Ukraine-Iran-Iraq-Syria. U.S. commercial real estate markets are well-balanced currently at the national level. Vacancy rates are at or below their long-term historical averages across the four major property types and construction is subdued except for apartments. Even with the construction boom, the apartment sector is absorbing new stock handily with vacancy rates holding below their long-term average. This balance means that a macro-economic shock would be well-tolerated were it to hit today’s U.S. real estate environment. The balance is reminiscent of the 2001-2002 recession period when NCREIF total return remained positive despite the recession.

U.S. economic and commercial real estate cycles 8% 6 4 2 0 -2 -4 -6 -8

1Q80 to 3Q80

3Q82 to 4Q82

3Q90 to 1Q91

1Q01 to 4Q01

4Q7 to 2Q09

-10 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 Recession

NPI Quarterly Returns

Source: NCREIF, as of June 30, 2015

Defensive investing in U.S. commercial real estate  2

Defensive investing in U.S. commercial real estate

Safe haven: Completions and vacancy rates by property type (1Q00-2Q15) Vacancy rates are near long-term averages and new supply has generally been constrained New construction is starting to percolate in the apartment sector.

Completions (% of Stock; LHS)

Vacancy (RHS)

20-yr Completion Avg (% of Stock; LHS)

20-yr Vacancy Ag (RHS)

Completions (% of Stock; LHS)

Multi-Family

Vacancy (RHS)

20-yr Completion Avg (% of Stock; LHS)

1Q 15

1Q 14

1Q 13

1Q 12

1Q 11

0

1Q 10

0.0

1Q 09

0

1Q 08

2

0.0

1Q 07

0.2 1Q 06

2

1Q 05

4

0.2

1Q 04

0.4

1Q 03

4

1Q 02

6

0.4

1Q 01

0.6

1Q 00

6

Completions

8

0.6

1Q 15

0.8

1Q 14

8

1Q 13

10

0.8

1Q 12

1.0

1Q 11

10

1Q 10

12

1.0

1Q 09

1.2

1Q 08

12

1Q 07

14

1.2

1Q 06

1.4

1Q 05

14

1Q 04

16

1.4

1Q 03

1.6

1Q 02

16

1Q 01

18%

1.6

1Q 00

20%

1.8%

Completions

Industrial 2.0%

18%

Vacancy

20%

1.8%

Vacancy

2.0% Office

20-yr Vacancy Ag (RHS)

Completions (% of Stock; LHS)

Vacancy (RHS)

20-yr Completion Avg (% of Stock; LHS)

20-yr Vacancy Ag (RHS)

Completions (% of Stock; LHS)

Vacancy (RHS)

20-yr Completion Avg (% of Stock; LHS)

1Q 15

1Q 14

1Q 13

1Q 12

1Q 11

1Q 10

0

1Q 09

0.0

1Q 08

0

1Q 07

2

0.0

1Q 06

0.2 1Q 05

2

1Q 04

4

0.2

1Q 03

0.4

1Q 02

4

1Q 01

6

0.4

1Q 00

0.6

Completions

6

1Q 15

8

0.6

1Q 14

0.8

1Q 13

8

1Q 12

10

0.8

1Q 11

1.0

1Q 10

10

1Q 09

12

1.0

1Q 08

1.2

1Q 07

12

1Q 06

14

1.2

1Q 05

1.4

1Q 04

14

1Q 03

16

1.4

1Q 02

1.6

1Q 01

16

1Q 00

18%

1.6

Completions

1.8%

Vacancy

20%

18%

Vacancy

2.0% Retail

1.8%

20-yr Vacancy Ag (RHS)

Source: CBRE-EA, as of 2Q15

But, the balance will not hold indefinitely. As vacancy rates continue to tighten, an increasing number of metro markets are approaching rents that justify new construction. That new supply will increase the potential for imbalance in the medium term, 2017 and beyond. Macro-economic shocks hitting then could have a more severe impact than a shock hitting sooner. This scenario justifies consideration of defensive investing.

Considering defensive investing Property type sectors do differ in their relative opportunity for defensive investing. The history of NOI growth rates is a good indicator of strength and steadiness. As shown in the table on the next page, the least volatile NOI growth rates came from regional malls and strip retail over the last twenty years, while the strongest growth rates came from apartments and regional malls.

Defensive investing in U.S. commercial real estate  3

Defensive investing in U.S. commercial real estate

Historic same-store net operating income (NOI) growth by property sector Apartment

Industrial

Mall

Office

Strip retail

1995

5.8%

1.1%

3.0%

-0.2%

1.8%

1996

5.0%

3.7%

2.5%

1.5%

2.4%

1997

5.5%

4.7%

2.0%

5.1%

2.5%

1998

6.6%

5.1%

4.5%

5.7%

3.4%

1999

5.4%

4.6%

5.0%

6.0%

3.1%

2000

6.9%

6.0%

5.1%

7.1%

2.7%

2001

4.3%

3.3%

3.3%

6.7%

1.3%

2002

-4.9%

0.5%

2.7%

-0.6%

-0.3%

2003

-6.4%

-1.5%

3.5%

-3.6%

2.0%

2004

-0.8%

-0.1%

3.1%

-0.8%

2.9%

2005

4.3%

1.1%

3.8%

-0.3%

3.5%

2006

7.8%

3.0%

4.3%

4.1%

3.5%

2007

6.0%

4.9%

3.5%

4.9%

3.1%

2008

3.4%

2.1%

0.6%

3.2%

15%

2009

-4.6%

-4.7%

-2.1%

0.8%

-3.5%

2010

-1.7%

-3.6%

0.6%

-0.2%

1.1%

2011

6.9%

1.0%

2.9%

1.4%

1.1%

2012

7.1%

2.3%

4.3%

1.1%

3.4%

2013

5.3%

2.2%

4.7%

3.2%

3.9%

2014

5.2%

3.2%

4.1%

3.9%

3.3%

Average growth

3.3%

1.9%

3.1%

2.4%

2.1%

Standard deviation

4.5%

2.8%

1.7%

3.0%

1.7%

Source: Green St. Advisors Annualized Total Returns Super-regional malls

1 Year

3 Year

5 Year

7 Year

10 Year

15 Year

20 Year

30 Year

14.6%

15.6%

15.9%

9.7%

11.1%

12.3%

10.8%

10.2%

Apartment

11.6%

10.7%

13.3%

5.7%

7.8%

9.0%

9.8%

9.0%

Industrial

14.8%

12.7%

13.0%

5.3%

8.0%

8.9%

10.1%

8.4%

Office

12.9%

10.9%

11.7%

4.1%

8.0%

8.2%

9.7%

6.7%

Standard Deviation

Sharpe Ratios*

10 Year

15 Year

20 Year

30 Year

10 Year

15 Year

20 Year

30 Year

Super-regional malls

8.7%

8.6%

8.0%

8.0%

0.90

1.00

0.82

0.59

Apartment

12.0%

9.7%

8.4%

7.5%

0.38

0.55

0.66

0.47

Industrial

11.7%

9.5%

8.5%

8.2%

0.41

0.55

0.69

0.36

Office

12.6%

10.4%

9.6%

9.8%

0.38

0.43

0.57

0.12

Source: NCREIF, as of June 30, 2015

Defensive investing in U.S. commercial real estate  4

With regard to the strength of total return performance, the super-regional mall NCREIF category has outperformed other sectors for all time periods as shown in the table on page 4. Industrial and apartment properties have occupied second place for various time periods. While sector selection is a first step in constructing a defensive U.S. real estate program, it is not enough. Property selection is crucial to identify the characteristics of properties that offer superior total return and NOI growth within sectors. In TIAA’s own strategy, we have identified high-quality super-regional malls with superior prospects using a 16-point scoring matrix that examines the depth of trade area demand alongside the competitive characteristics of individual malls. For industrial space investments, our targeting of metro areas with deep-water ports and adjacent infill warehouse locations could also be deemed defensive. Defensive investing in apartment and office sectors is more difficult to achieve with the former dealing with a large supply pipeline, and the later coping with accumulating obsolete space.

How much protection can defensive investing offer? Defensive investing can constrain a portfolio’s exposure to sharply underperforming properties during a downturn. By clipping the extreme negative tail, market-weighted total return would be higher than it would in the absence of defensive tactics. The potential impact can be seen in the distribution of NPI total returns during the 2009 downturn. The bottom 5% of properties produced a -37.99% total return over the four quarters of 2009. Had these properties produced the NPI median return of -15.09%, the index total return would have been 1.15% stronger. Repositioning more than the lowest 5% would have created even more benefit. Defensive investing cannot eliminate cycle risk. Investors take cycle risk whether they hold portfolios over a long-term horizon or try to market-time hoping to “buy low and sell high.” Cycle risk has been estimated to account for up to half of the variation in NCREIF total returns on individual properties; it is our beta.

This material is prepared by and represents the views of Martha Peyton and Edward Pierzak and does not necessarily represent the views of TIAA-CREF, its affiliates, or other TIAA-CREF Asset Management staff. These views are presented for informational purposes only and may change in response to changing economic and market conditions. This material should not be regarded as financial advice, or as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance is not indicative of future results. Please note real estate investments are subject to various risks, including fluctuations in property values, higher expenses or lower income than expected, and potential environmental problems and liability. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, TIAA-CREF Alternatives Advisors, LLC and Teachers Insurance and Annuity Association® (TIAA®). TIAA-CREF Alternatives Advisors, LLC is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). ©2015 Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY 10017 C25763 1 6601-INV-Y-08/16 141010589