COVER STORY, FEBRUARY 2012

CASHING IN
Institutions generate healthy returns on Texas real estate investments.
John Nelson

Plaza of the Americas, a 1.2 million-square-foot office and retail complex in Dallas’ Central Business District, has fallen on hard times recently, reaching an approximate 25 percent vacancy in December. A joint venture between an institutional investor client of Dallas-based Invesco Real Estate and M-M Properties, a real estate investment firm, decided to seize on the opportunity and purchase the property, which was built in 1980.

“We were able to buy a high-quality asset with a great location within downtown Dallas with substantial vacancy,” says Max Swango, managing director and founding partner of Invesco. “But we were able to buy it at a cap rate on the existing income that’s very attractive.”

The joint venture plans to renovate and re-tenant the property in order to maximize the profits from income.

The acquisition is an example of what some institutional investors are doing in Texas’ commercial real estate market. Life insurance companies, pension funds and endowments have long invested capital in commercial real estate, seeking returns on their investments.

“It’s important to have real estate in your portfolio,” says Jeff Havsy, director of research at the National Council of Real Estate Investment Fiduciaries (NCREIF). “The fact that you have some dividends coming back is extremely important. At the same time, you have the upside that the value of the real estate can be improved over time.”

Real estate has generated relatively generous returns for investors, whether it’s from property appreciation or income growth. Total returns for the NCREIF Property Index averaged 16.1 percent for a 12-month span, ending on Sept. 30, 2011. The returns are impressive considering it was substantially higher than other indices, including Barclays Capital Government Bond Index (5.58 percent), Consumer Price Index (3.87 percent), Standard & Poor’s 500 Index (1.14 percent), NAREIT Equity REIT Index (0.93 percent) and the 3-Month Treasury Bill Index (0.11 percent), according to NCREIF.

“Large funds are concerned about the volatility that we’ve had in the stock market in the past 3 to 4 years, so they’re looking more at alternative investments as a result, such as hedge funds, real estate, private equity, things that don’t fluctuate day-to-day,” says Norman Nabhan, managing director of Morgan Stanley-Smith Barney, and member of Graystone Consulting Division, the consulting division of the firm. “Real estate helps anchor the portfolios from the swings of the stock market and bond market.”

Exactly how much an institution should weight its total portfolio toward real estate will vary for a number of reasons, based on the preferences of the institution. Institutions that need to remain liquid likely won’t invest much in real estate because they need immediate access to capital.

“We’ll work with a fund to figure out what their asset allocation should be, and then once we identify those asset classes we’ll help find something to fill that space,” says Nabhan. “There are a lot of opportunities in the marketplace, so our clients are making allocations to real estate for the growth in cash flow. There are still a lot of distressed properties and distressed mortgages that can be bought at discount prices, held for 5 to 10 years and turned around.”

Nabhan says that there is no magic percentage for institutions to aim for, but there are plenty of opportunities to expand their real estate allocation in their portfolio, especially in Texas. Investors have zeroed in on Texas’ commercial real estate market to take advantage of the relative growth of the state’s economy.

“Texas is attractive because of the job growth and economic growth the state has shown in the last 18 months,” says Mark Seedorff, principal of Prudential Real Estate Investors.

The state has several drivers that have helped spur the economy, including high-tech companies in Austin, the Eagle Ford Shale in south Texas, the trade routes and diversified economy in Dallas and the energy companies in Houston. Houston has had what Michael Burrichter, principal of CBRE Strategic Partners, refers to as a “historic” year in 2011 in respect to office sales.

“Houston’s office market has come back with a storm, and frankly it’s on the verge of becoming a gateway market,” says Burrichter. “I’m hearing that more and more from national investors.”

Institutions have been keen on the investment opportunities in Houston and other markets in Texas, whether it’s for core properties, value-add or opportunistic investments.

RISK/RETURN

Core properties are on the lower end of the risk/return spectrum. Since they are historically well-operated and well-located properties, they will come at a higher price, and therefore the returns will be limited. The good thing about core properties, though, is that they are low-risk ventures because they have historically performed well.

“Bouncing off the lows of 2008, core real estate has performed extremely well. We had double-digit returns the past couple of years from core,” says Swango. “We don’t expect that to continue, we’d expect returns on core to be in the mid- to high-single digits going forward for the next 3 to 5 years.”

Houston Municipal Employees Pension System (HMEPS), an institution with more than $1.91 billion in assets as of Sept. 30, 2011, has pension checks it must provide for members and participants in the plan. The low risk with core is attractive for institutions such as HMEPS because of the obligations they have to their members.

“Investors don’t deviate much from core because of the pressure to put out money,” says Havsy.

On the other hand, core properties tend to sell at high prices, which has deterred institutions that want to buy low and sell high.

“There are some investors who think core is overpriced,” says Swango.

For investors wanting to maximize their returns, opportunistic and value-add spaces provide the best way to buy low and sell high, as was the case with the Plaza of the Americas transaction. Investing opportunistically doesn’t inherently mean choosing bad properties or bad locations.

“Most of the time people start thinking value-add properties are lesser-quality properties,” says Burrichter. “We’re targeting high-quality properties that are under-performing,”

Steve Zaleski, managing director of the Multifamily Group for CBRE Global Investors, echoes Burrichter’s sentiments. “Sometimes we’re able to buy a core property at value-add returns because there maybe distressed ownership, a loan coming due, poor operations or it’s under-capitalized, and we’re able to come in and turn those operations around. What we end up with is essentially a core product.”

Value-add and opportunistic properties are at the high end of the risk/return spectrum because there is not as much certainty that the asset will deliver adequate returns. Some Texas property types like office space are struggling because of the high amount of vacancies and stagnant rents.

“Value-add at the office space is a very risky proposition,” says Havsy. “Investors are unsure about the pace of the recovery and how long it will take to backfill vacant space, reposition buildings and re-tenant space.”

A number of institutional investors have a mix of core assets and opportunistic properties in their portfolios in order to spread the risk around.

“Most of our clients have a diversified real estate portfolio,” says Swango. “Most of our clients are investing across the spectrum.”

INVESTING IN WHAT?

In a forecast survey of brokers conducted by Texas Real Estate Business, 67.5 percent of participants said they expect Texas multifamily properties to experience a high velocity of sales this year. Multifamily is experiencing great fundamentals and returns in Texas. In Austin, apartments posted a 20.05 percent return in a 12-month period ending Sept. 30, 2011, according to NCREIF. Dallas (22.51 percent), Fort Worth (20.72 percent) and Houston (17.98 percent) posted similar numbers in the same time frame.

“If you’re trying to play the low end of the spectrum, multifamily’s fundamentals are the best,” says Swango.

Additionally, 95.5 percent of lenders and fiduciary professionals in the Texas Real Estate Business lender survey indicated that multifamily was a solid investment. The asset type is a hot item right now because of where the economy is on a national and state level.

“Right now, apartments are attractive for a combination of factors, one of them being the demographic trends in housing,” says Seedorff. “Fewer people want or can afford to buy a house today. There’s a growing population between the ages of 20-34, the primary renter age. That trend and the growing general population creates a demand for more housing.”

As noted before, Texas’ job growth has also increased the demand in multifamily. The more jobs in a region, the more housing it will take to catch up to the influx of workers.

“Jobs, especially entry-level jobs, are a big driver for multifamily,” says Zaleski.

Apartments aren’t the only product type that institutional investors are interested in. A joint venture between Prudential Real Estate Investors and Lodging Capital Partners recently purchased the 291-room Austin Four Seasons, a luxury hotel property fronting Lady Bird Lake in downtown Austin. Prudential was acting on behalf of institutional investors in its core real estate fund.

Towers at Williams Square, like Plaza of the Americas, is an office complex in the Dallas area that was acquired on behalf of an institutional investor.

Additionally, The Brookdale Group, an Atlanta-based commercial real estate investment company, closed on its acquisition of the Towers at Williams Square, a 1.4 million-square-foot Class A office complex in the Las Colinas submarket of Dallas. The Brookdale Group typically invests on behalf of its institutional investment partners and principals.

These transactions show that it’s not just multifamily properties that are piquing the interest of investors, although it is the clear darling right now. What institutions are looking at is an area with the good returns on their investment. According to NCREIF, the Southwest division, which includes Texas, posted the second highest third-quarter total return of 3.35 percent and the 12-month average came out to be 15.69 percent.

Although it was outperformed by the Pacific region in the index, institutions are investing in Texas and will continue to as long as the state’s economy is humming. Job growth and the state’s reputation as a lower-cost market has been advantageous.

“There is general optimism about investing in Texas because of the job growth, says Burrichter. “Everyone notices it.”

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