Real Estate Premium Near Record to U.S. Bonds Signals Time to Buy Property

September 2, 2010 7:12 pm

Bloomberg – Sep 1, 2010 10:15 AM ET

U.S. commercial real estate yields are near the highest level relative to
Treasury bonds on record, a signal to some investors it’s time to buy property.

Capitalization rates, a measure of real estate yields, averaged 7.22 percent in
the second quarter, based on an index calculated by the National Council of Real
Estate Investment Fiduciaries. That was 429 basis points, or 4.29 percentage
points, higher than the yield on 10-year government bonds as of June 30,
according to data compiled by Bloomberg. It’s about 475 basis points higher than
Treasury yields as of yesterday.

That spread is near the record 539 basis points in the first quarter of 2009,
when the U.S. was mired in the worst of the financial crisis and property prices
sank. Risk-averse investors are seeking the highest-quality office towers,
hotels and apartments as the gap widens, according to Nori Gerardo Lietz,
partner and chief strategist for private real estate at Partners Group AG in San
Francisco.

“The data indicate that real estate is poised for a rebound,” said Gerardo
Lietz, who advises pension funds on property investments.

Some buyers already are acquiring buildings at lower cap rates, which move
inversely to price. In June, a group of South Korean pension fund investors
bought the 33-story Wells Fargo Building in San Francisco for $333 million from
Principal Financial Group Inc. in one of the largest transactions in the second
quarter, according to Real Capital Analytics Inc., a property research firm. The
office tower sold at a cap rate of about 7 percent, said Goodwin Gaw, the
developer who helped broker on the deal.

New York Rates

In Manhattan, RXR Realty LLC bought a stake in 340 Madison Ave., a 22-story
office building, at a cap rate of 6 percent, according to New York-based Real
Capital. Cap rates are calculated by dividing net operating income by purchase
price, so the lower the rate, the higher the value of the property, and vice
versa.

The NCREIF index measures 6,066 U.S. properties with a market value of $234.5
billion. The spread over Treasury yields was calculated using transaction cap
rates, which are based on actual sales — 48 in the second quarter — and are
usually more reliable than appraised values, according to Chicago-based NCREIF.
The organization’s measure, which it began publishing in 1982, represents
current yield before any price appreciation.

Comparing Yields

Investors compare property yields with Treasuries to determine how much
potential profit real estate offers relative to an investment that’s considered
low-risk. The spread shrank to less than 80 basis points, the narrowest in 16
years, when commercial real estate prices peaked in 2007. Property values have
dropped more than 40 percent since the October 2007 top of the market, according
to Moody’s Investors Service.

The gap’s widening follows a plunge in bond yields after the global financial
crisis spurred a flight to safety and the Federal Reserve slashed interest rates
to a record low. Treasury bonds yesterday completed the biggest monthly rally
since the end of 2008 amid signs economic growth is faltering, with the
benchmark 10-year note yielding 2.47 percent.

“Property is attractively priced versus the fixed-income market,” said Ritson
Ferguson, chief investment officer of ING Clarion Real Estate Securities in
Radnor, Pennsylvania, which manages about $12 billion.

The wide spread carries a warning signal to some investors because the economy
remains weak, hurting commercial rents and occupancy.

Being ‘Picky’

“It’s questionable how much growth you’re going to get,” said James S. Corl,
managing director for distressed real estate investments at Siguler Guff & Co.,
a New York-based private- equity firm. “Yes, there is value in real estate but
you’ve got to be very picky. If you pay up for existing leases, it’s very hard
to manage your way out of that situation.”

For much of the past two decades, institutional real estate was valued at about
a 9 percent cap rate, according to Jeffrey D. Fisher, a consultant to NCREIF and
a real estate professor at Indiana University in Bloomington, Indiana. Cap rates
on some commercial deals fell to less than 4 percent during the peak.

The rate declined in the second quarter as transactions began to increase, he
said.

“What I’m seeing is a two-tiered market right now,” Fisher said. “For properties
that have high occupancy, that’s where you really have seen the price
appreciation and cap rates falling.” For buildings with low occupancy rates,
“there is very little interest,” he said.

Sales Rebound

U.S. sales of office, retail, industrial, apartment and hotel properties totaled
$20.7 billion in the second quarter, according to Real Capital. That was up 86
percent from $11.1 billion a year earlier.

The deals were still 85 percent below the peak of $135.7 billion in the second
quarter of 2007, Real Capital data show.

Corporate bond yields are a better comparison than Treasuries and also indicate
that properties are undervalued, said Michael Knott, managing director at Green
Street Advisors Inc., a Newport Beach, California-based company that specializes
in analyzing real estate investment trusts. Bonds rated Baa by Moody’s are
perceived as investments with moderate risk, similar to commercial real estate,
said Knott.

The spread between NCREIF real estate cap rates and Baa- rated corporate bonds
is more than 200 basis points, Knott said. The average during the past 25 years
is about 140 basis points.

“Underlying real estate looks cheap to us relative to where moderate-risk
corporate bond yields are priced,” Knott said in a telephone interview. The
exception is publicly traded REITs, which trade at a premium to asset values, he
said.

“Smart managers today are being very selective because they realize a lot more
property has to clear the market,” said Corl of Siguler Guff. “The volume of
deals is definitely going to go up.”