Real Estate Premium to U.S. Bonds Signals Time to BuyHui-yong Yu
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.
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.
“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.
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.”
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