Back then the decline in repayments by sub-prime mortgage borrowers led residential mortgage-backed securities (RMBS) to be branded as “toxic”. As the credit crunch set in, the toxic tag spread to commercial mortgage-backed securities (CMBS), while physical real estate – the hard stuff – devalued by around 35% and was labelled “distressed”.
Since then, not a lot has changed. Mortgage derivatives may be slightly less toxic – but the market is still stagnant as buyers are scarce. Government efforts to relieve banks of their bad mortgages should have encouraged so-called vulture funds to purchase these assets, but according to Philip Feder, a real estate lawyer at law firm Paul Hastings, high prices have deterred them.
“The problem is that the banks are unwilling to give major discounts. The government has shored up their capital but hasn't forced them to sell their under-performing loans. With their improved capital base, the banks have no incentive to sell off bad loans. The market remains at a virtual standstill,” he says.
Meanwhile, having already fallen off a precipice, the physical US real estate market, both residential and commercial, continues to be distressed. There has been a massive decline in home values since 2006, in some cases by 60%, while commercial real estate may still have another 15-20% to fall, according to some investors.
Nevertheless, it was recently reported that China Investment Corporation, the Chinese sovereign wealth fund, is preparing to invest in a range of US real estate assets, including those bad debts sitting motionless in the derivatives market.
European institutional money is significantly absent from US property, according to some American fund managers. There are exceptions, such as Dutch and German funds, but UK pension plans in particular are scarce.
Those institutions absent from the US real estate market may feel that their UK and European property investments correlate too closely with the US. After all, the underlying economies of the two continents move in sync and the fortunes of real estate are closely linked with economic activity.
Jay Davis, managing director of Principal Real Estate Investors, part of the Iowa-based Principal Financial Group which with $34.1bn (€23bn) of assets under management is the fourth largest US property investor, says: “UK institutions generally do not invest in US real estate because they see a high correlation between the US and UK real estate sectors.”
But he adds: “The US is much more deep than the real estate markets in the UK and Northern Europe, so you can in fact obtain a broad diversification through different regions and sectors.”
Similarly, London-based George Ochs, a managing director within the global real estate assets team at JP Morgan Asset Management, says: “Take for example industrial real estate. It is well diversified in the US with five macro markets centred around the major ports and distribution hubs, like New York, Los Angeles and Houston. Then there are smaller inland distribution centres beyond these as well.”
He adds: “The US and Europe are both in the Western world and there is a commonality in economic systems. But there are also some considerable differences. The US has a higher rate of population growth than Europe and certain pockets are higher still, particularly in the South and West.” He says diversification is found in the office sector too, between prime centres like New York City, and secondary sites like Miami.
Real estate managers say US portfolios are much more granular than similar portfolios in Europe. Whereas a UK commercial property portfolio offers exposure to a broad range of shops, warehouses and offices, in the US these sectors are dissected still further into sub-categories, such as national and local shopping malls, healthcare facilities and ports. Also, the breadth of the US landmass, the size of its population, and the different drivers of local economies, lead to diversification, they say.
“We believe the primary drivers for US commercial real estate are local,” says Steve Shigekawa, a co-manager of the US Real Estate Securities Fund at Neuberger Berman in New York City. “There are different drivers of US real estate depending on the region. For example, whether they are coastal or inland.”
The residential market
But one other, if now notorious, form of diversification for institutional investors in the US comes from the residential housing market.
Ochs, at JP Morgan, says: “There is exposure to housing in US commercial real estate funds, which you do not get so much in Germany, or at all in France and the UK.”
Residential property exposure is common in typical US commercial property portfolios. The sector can also be accessed by institutions through real estate investment trusts (Reits).
In the UK, pension schemes have no exposure to residential property. Regularly battered in the press, the last thing UK pension schemes want is to be caught evicting tenants and earning themselves a reputation of ‘Rachmanism’ after the notorious London landlord, Peter Rachman, in the 1950s.
Residential property is, of course, at the root of the current crisis and with hindsight pension schemes will be hardly disappointed at missing the residential property bubble of recent years. But just as the crisis started in this sector, it may also be the place where some of the first stirrings of recovery are to be found.
DR Horton, the Texas-based national homebuilder whose stock price jumped 70% between January and August, reported a Q3 net loss of $142.3m this year. But the net loss for the same quarter of 2008 was much higher at $399.3m.
DR Horton’s revenue from home building has declined while the company winds down inventory, but home closures are also down, totalling 4,240 closures in Q3 this year compared to 6,167 homes in the year-ago quarter.
The company’s fortunes provide a minor snapshot of the US economy. More broadly, a slow recovery is now observed in the country where the financial crisis began.
Davis, of Principle Real Estate Investors which invests money for US pension plans and European investors, says there is a sense of stability in the US economy and a feeling that the real estate market is close to its trough.
“The recovery is starting now. We do not see a high probability of a double-dip recession. However, recovery and job growth will be uneven across geographies and industries.”
Pressure is still on real estate owners to liquidate holdings. Writedowns are currently at 25-30%, and the buying opportunities created by these will extend into 2011 and even 2012, says Davis.
Asked when the physical real state market will level off, Davis says: “The short answer is real estate will reach the trough in the first half of 2010 and it will be 35-40% off its peak in the fourth quarter of 2007.
He adds: “Capital demand for real estate is slowly recovering as we see some investors starting to invest again – or at least think about it.”
Bob Law, vice president at Titanum Real Estate, says that the residential market – with a few exceptions like Miami, Las Vegas and parts of southern California – has flattened, but it would be premature to suggest that a sustainable upswing is imminent.
“More likely, the residential market will bounce around at or near its current levels until consumers and businesses can figure out the new economy in terms of employment and taxes.”
And as for commercial real estate, he says this will be more problematic in the next 12 to 18 months.
“This market began its decline later than the residential market, and while its decline has been significant to date, in our opinion there is more to come over the next four to six quarters – perhaps another 15-20%.”
This view is based on five factors, including CMBS delinquencies, which are expected to continue rising. Investors are uneasy about their complexity and lack of transparency, says Law.
Also consumers and companies are still adjusting to the last 12 months, making them unsure of future plans. Lower rents and higher surplus properties could result in the next few years if office and industrial leases are not continued.
The US market continues to be fraught. But signals suggest the bottom is near. But the same is said of real estate in the UK and Europe, which only adds to the argument for correlation.
However, even if European investors are not persuaded that diversification is to be found in the US, then they might consider other factors.
|Economic growth prospects in the United States|
|The housing market is less of a drag on the US economy as home sales lift and supply reduces. "We have been surprised at the recovery in the housing market and have pencilled in a 5% rise for next year,” says Tim Drayson, an economist at Legal & General Investment Management in London.
One benefit of stabilising house prices is that it will help banks see their debt position better.
But homebuilders are unlikely to construct more homes in any significant sense in the near future because too many homes are still up for sale, discouraging them from increasing their inventory.
The uptick in demand for homes appears to be at odds with US consumer behaviour, where – like elsewhere – there is still caution as people try to rebuild their savings. Weaker consumer demand for goods across the board means the US public is unlikely to lead economic recovery, Drayson says.
Salary decreases and rising energy prices hamper them.
“We are pessimistic about final demand in the US. Labour income is looking poor.” Drayson adds: “The economic recovery will not be led by consumption.”
The US corporate sector needs to lead the economic recovery. However, although the corporate cash position in the US is “quite good”, businesses are scarred by the crisis.
Drayson says that although US economic data continues to surprise – particularly over the last couple of months – the US could still produce disappointing figures next year.
“While the stage is set for a global economic comeback, there is scope for disappointment in 2010, particularly in the US,” Drayson says. He expects 4% GDP growth for this year, followed by disappointment next year. A relapse in economic growth could result once the initial effects of government stimulus wear off.
The US is big, very big. An institution looking for exposure to commercial property in, say, Italy could take a significant slice of the market with a single large allocation, or only obtain a small chunk through a closed-end fund. But the US can more than easily swallow large chunks of money, and many funds are open-ended.
Meanwhile, a pan-European portfolio has to face differences in legal systems and currencies between nations, while the US is more standardised.
Investors may follow China and take a close look at US real estate. The sector has its benefits. But even if allocations are not made, it’s worth looking at even if only as a barometer for recovery in the country where the financial crisis began.
©2009 funds europe