Tuesday, February 16, 2016

How Capital Flows Affect Commercial Real Estate

New York Buildings
(New York buildings)

In previous posts I've discussed what drives demand at the property level (location, amenities, etc...). Particularly this post. Property level demand refers to why tenants and investors would want be attracted to a certain property versus another. This is an important concept, but perhaps even more important is the concept of capital flows and how they affect commercial real estate pricing.

Capital flows refer to how institutional money is being allocated between broad asset classes. For example, if an institutional fund, like CalPers, has 25% of their portfolio in stocks, 25% in bonds, 25% in commercial real estate, and 25% invested with private equity groups, but then changes their 25% bond allocation to commercial real estate then capital is said to have flowed from bonds to commercial real estate. So why would allocations / strategies change at the institutional level? Well, they have a team of investment managers who analyze different asset classes and will allocate money based on where they see the best opportunities. If these managers believe one asset class will outperform another, they'll increase the outperforming asset's allocation and ding one of the under-performing assets.

Overall, capital flows have a massive impact on commercial real estate valuations. Think of it this way: commercial real estate, as a whole, will produce a return / net cash flow of "x." This return / net cash flow of "x" is made up of all the return / net cash flow of all the individual properties within the commercial real estate asset class. Now, assume there is a given number of dollars "y" chasing this yield of "x." In fact, if the number of dollars chasing the returns is completely invested, then the yield "z" for commercial real estate is equal to "x" / "y." Now let's assume pension funds throughout the U.S. decide the yield of "z" is very attractive given the alternatives currently available. Money starts pouring into commercial real estate. The number of dollars chasing the returns will increase. If "y" increases, then the yield for commercial real estate "z" actually decreases (as y increases, x / y gets smaller).

What's happened in the above example is investors are willing to pay more dollars for the same yield as before. Another way to look at it is investors are willing to tolerate a smaller yield for the same amount of dollars. If you're a property owner, your property has a given yield. Even though the yield hasn't changed, investors are willing to pay more for your property's yield than before, so the value of your property has increased.

Capital flows seem especially relevant in today's turbulent markets. With the stock market experiencing extreme volatility, the bond market experiencing even more volatility and uncertainty due to potential Fed rate hikes, commodities struggling, and emerging markets in a seemingly endless downward spiral, it must be a difficult time to be a money manager. It'll be interesting to see how this volatility and uncertainty affects commercial real estate. Perhaps not coincidentally, two relevant articles popped up on Bloomberg:

Even though commercial real estate fundamentals might take a hit, lower valuations could be offset by capital viewing it as a safe haven of sorts and flowing into the asset class. Interest rates will help offset deterioration in the fundamentals as well by keeping financing cheap and abundant. Note that AIG and the UM endowment are not small players either; these are major pools of capital choosing to increase their exposure to commercial RE. Definitely a good sign for the asset class--at lease on the valuation side of things.

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