With the recent publication of my book, The Advisor’s Guide to Commercial Real Estate Investing (Summit Media 2014), I am reminded in vivid detail how far commercial real estate has evolved as a major asset class. The book highlights in high relief the sophistication and depth of the commercial real estate asset class.
It’s amazing, looking back 20 years, how commercial real estate has evolved and become such a widely held investment class. Twenty years ago, the commercial real estate asset class had just emerged from a near-death experience with the Savings and Loan Crisis, which resulted in massive write-downs and a widespeard loss of confidence in the asset class. Many believed that the late ’80s and early ’90s marked the end of commercial real estate, but in fact, it was only the beginning of its emergence as a major investment asset class.
Major shifts have taken place in the commercial real estate industry, which is transforming from a highly localized, deal-driven business to an international market characterized by lower transactions costs, abundant information, lower risk premiums and increasing sophistication.
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Real estate has traditionally been a low-information, high-friction sector with high transactions costs. Most real estate firms have been locally based, rarely venturing out beyond their market areas. The cost of sourcing, investigating, bargaining, investing in and managing real estate outside of a particular investor’s market has been seen as prohibitive for many investors, both large and small. Nevertheless, an expanding array of information providers; an increasing number of professionals, media coverage and technology and the increasing popularity of the sector have all served to reduce transactions costs and to increase transparency, which, in turn, has brought more investment and increased information. The new public nature of commercial real estate thrives on information, which was once a scarce commodity, but is now an industry standard sustained by widespread information and a growing number of analysts. The transaction costs are decreasing as information becomes more widely available.
Changing perceptions, growing investor interest
Historical data has demonstrated how investment in real estate provides diversification, mitigates risk, as well as how it has been strengthened by proliferating investment vehicles. In addition to the evolution in vehicles and markets, an evolution of investor attitudes is also serving to shape the real estate investment landscape.
The hard tangibility and the comforting transparency of real estate may explain why many investors are drawn to it on a human, emotional level. However, real estate’s qualitative bricks-and-mortar appeal is also supported by its ability to reduce volatility and enhance returns through income and appreciation, which is derived from the diversification and stability that it offers. These attributes make real estate an especially appealing investment for those nearing retirement.
In terms of stability, real estate’s current income has been as good as or better than any major investment class over the last five years. The income derived from leasing and rental properties provides investors with a comparatively high yield level. The income component of real estate returns have not been negatively affected by the recent influx of investment capital, even though cap rates have declined.
Growing integration with capital markets
The perennial drawback to real estate has been its lack of liquidity. Real estate assets are large, “lumpy,” fixed in one location and characterized by local (imperfect) information. These negative attributes can be mitigated with securitized real estate investment products. Real estate is becoming much more integrated with financial markets and therefore more liquid.
Real estate securitization enables the investor to obtain ownership of securities with creditor’s rights instead of a direct object ownership. Through securities, the combination of real estate and the capital market changes the value of real estate from a fixed-capital state to tradable securities, thereby enlarging the processes of investment and participation and increasing the channels of capital collection for the industry. Securitization also has the effect of reducing the liquidity risk premium of real estate.
While not without its shortcomings—not the least of which was deteriorating underwriting quality and dubious credit ratings in the last run-up—CMBS bring a public financing aspect to what was a privately transacted area. These vehicles create supply and demand for funds that compete with traditional equity and fixed income. As well-defined and –analyzed asset classes, they provide liquidity and hence allow for more frequent decision-making and trading, therefore becoming amenable to inclusion in institutional portfolios. CMBS is back again and will likely exceed a $100B this year in new issuance.
New drivers: Demographics, emerging markets and urbanization
Demographics is a critical driver of real estate demand. Population is now increasing worldwide, having rapidly accelerated in the 20th century. While the growth may be leveling off in some industrialized countries, it is still robust in the majority of the world’s countries. Increased population requires more housing, shopping, places to work (both factories and office buildings) and hotels for travel and recreation. Sheer numbers are only one facet of the growing global population. As people become wealthier per capita consumption in all goods and services rises, which includes, and sometimes is especially reflected in, real estate.
By 2050, the world’s population is estimated to approach 9 billion to 10 billion people. It is not just the sheer numerical increase, but the distribution of the population—most people will be living in urban areas. The United States alone is expected to add 50 million people to its population over the next 20 years. Not only is the world’s population growing, but it is also aging in more developed countries. These shifts are changing the nature of demand for all types of real estate. Throughout the world, populations are aging because people are adopting healthier lifestyles and healthcare systems are rapidly improving. In Western societies—in particular, Japan—death rates are declining. These regions are producing fewer children and their populations are living longer.
With healthcare and increased life expectancy resulting in a broader retirement band, there will be fewer workers to support an increasingly large retirement population. By 2050, the retirement-age population will grow further to result in inverted pyramid in almost every industrialized country including the United States. Pensions and retirement investment become more critical in this scenario, and so will long-duration assets such as real estate.
Is part of the rising appeal in real estate attributable to the fact that an aging population, generally speaking, seeks less risky investments? An investor is said to be risk-averse if, when given the choice between a riskless investment with a given return and a risky investment with the same given return, that investor prefers the riskless investment. Because of the current income produced by stabilized, institutional real estate, real estate investment is generally considered stable compared to investing in stocks. The lifecycle risk-aversion hypothesis predicts that risk aversion will increase over the lifecycle. That means that the older a person is, the more risk averse they become. The underlying explanation for this lies in the relative importance of labor income and asset income over the lifecycle. It is believed that the further a person is from retirement the more risk they are willing to accept in their investments since the number of paychecks they expect to get is large and labor income can offset any adverse investment outcomes. Risky portfolio allocation is significantly lower for older households. The closer to retirement a person gets, the fewer paychecks that person has to cover any such adverse investment outcomes.
In the United States, baby boomers are retiring at a rate of 10,000 per day! Baby boomers are the wealthiest demographic segment in human history and there are about 75 million members of that generation in the United States, currently representing about 27 percent of the U.S. population. If we accept that baby boomers will increasingly shift to less risky investments and that real estate has is a low-risk, high-performing asset class, then the level of real estate investment will most likely continue to increase for the next two decades.
Accelerating urbanization
Populations are congregating in ever larger urban agglomerations. Known as “megalopoli,” these urban areas are spreading across major regions of the United States, pushing up land and building values and making real estate increasingly valuable.
People can and are increasingly able to migrate to regions, countries and cities where they can find better economic and lifestyle opportunities. Why the great movement to the cities? Cities have long been the place of opportunity as well as greater social and political freedom. In addition, as emerging market countries become less dependent on agriculture in their economies and become more automated, far fewer workers will be needed on the farm than today. People will increasingly go to the cities to find work. This is spurring growth, particularly in some of the globe’s larger cities—so-called “global gateway” cities such as London, New York and Hong Kong. The growth of Hong Kong is a testament to a massive amount of immigration from China in recent years. This has been one of the factors driving up the Hong Kong real estate market. With improvements in communications and transportation, people from rural areas are flocking to major cities around the world in search of a better life. This trend will continue well into the 21st century as long as the income of urban areas outpaces those of the rural hinterlands. The combination of population increase and rapid urbanization will quickly drive up the demand and value of real estate in many emerging market cities. Even with zero population growth, most emerging market cities would still experience rapid urban growth because of their high rates of urbanization as seen below.
In China alone, it is estimated that 300 million people will have migrated to the cities from the countryside by 2025. This explosive growth translates into hundreds of millions of new urban residents in major cities around the world. With greater numbers of people living in roughly the same urban areas, the value and economic returns of real estate will increase with its scarcity.
