The Principal Real Estate Investors 2011 Outlook


“Fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore.”
– Vincent Van Gogh

Sailors and investors have come to fear extremes; both violent storms and utter calms can be deadly. A storm at sea can sink even the finest ship, or dash it against the rocks of an unforgiving coast. When becalmed, the ship, robbed of wind for the sails, is literally dead in the water as food and hope fade away. For long-term investors, the turbulence of extremely volatile markets can similarly destroy even the most well-crafted portfolio and markets that are too calm can starve a portfolio of yields and returns.

The world’s financial markets have recently begun to emerge from what has been one of the worst financial tempests of the last 60 years. The flotsam and jetsam of the investment industry are scattered as far as the eye can see. Some financial firms have capsized, while others were able to weather the storm and emerge, if not unscathed, then unsettled.

Plotting a course for 2011 will be an exercise that balances caution and opportunity, because, as Van Gogh alludes, the search for greater rewards inevitably involves taking incremental risks. However, much like experienced sailors have learned to deal with the perils of the sea through managing the variables they can control and respecting those they cannot, a focus on effective risk management is equally critical in the investment industry. In real estate, that means carefully evaluating the shifting tides of macroeconomic variables that affect the industry and examining the outlook for the four quadrants of U.S. commercial real estate.


Despite policy uncertainty, a soft patch in the U.S. economy, and continued peril in the broader investment environment (with intermittent bouts of risk taking and risk aversion), we feel there are several reasons for optimism in 2011 and beyond. While unlikely to be accompanied by powerful economic tailwinds, we believe the following factors should collectively help provide further leeway for continued steady economic growth that gradually reduces unemployment rates and avoids a double-dip recession.

  • Political rebalancing following the 2010 U.S. elections should result in reduced risk of unwelcome legislative initiatives and reduced corporate perceptions of an anti-business political climate.
  • Stabilizing commercial real estate values should help unclog bank balance sheets through improved resolution of problem loans, freeing up lending capacity and improved credit formation for small businesses.
  • Continued progress with household deleveraging and higher personal savings rates should lead to a more stable consumer base that is less likely to reverse course to a retrenchment mode.
  • Corporate earnings in 2011 should continue their favorable tack in 2011.
  • Asset reflation-friendly actions by the U.S. Federal Reserve (Fed) which, while clearly generating longer term risks of inflationary pressures, will likely buoy up asset values over the near-to-intermediate term and help the wealth effect.
  • Markets should continue to see progress in a relatively orderly deleveraging of the commercial real estate market.

By and large, the cumulative impact of the above dynamics should prove helpful to both real estate space and capital markets in 2011 and 2012. The outlying years of 2013 and beyond do face the risk that a reversal of ultra-accommodative monetary policy and removal of quantitative easing could produce a material upward movement in Treasury rates, which would be generally unfavorable for cap rates, discount rates, and borrowing rates. The 2010 course correction in real estate pricing has been partially attributable to the macro forces of monetary policy. The asset reflation dynamics resulting from market anticipation of further Fed easing have contributed to the current round of cap rate compression in commercial real estate. While that has been positive for borrowing costs and real estate prices, Fed policy now potentially represents a form of future event risk that could halt or reverse cap rate compression as the economy improves. The Fed’s future actions imply that, while there will likely be material improvement in space markets before monetary policy is reversed, the subsequent trajectory of incremental property appreciation could be interrupted by rising Treasury rates. And the anticipatory nature of
the public bond markets means that those eventual forces could well blow ashore before improving space markets allow for a complete restoration of landlord pricing power. Indeed, because the recovery in space markets has thus far trailed the recovery in capital markets (especially for core real estate), it will be critical that space markets gain traction in 2011 and 2012 to catch up with the capital market recovery.

This is not to put a damper on a well-justified improvement in investor sentiment toward the U.S. real estate asset class. The two public quadrants have already provided investors with tremendous returns in just the few quarters since the recession ended. Sustained improvement in price recovery in the private equity quadrant appears to be in the offing and provides investors an opportunity for dollar-cost averaging by returning to the market at or near the bottom. A weak U.S. dollar will provide a further boost in real estate buying power for foreign buyers. We believe that attractive investment opportunities include not only highly sought after core strategies, but also selective value-add and opportunistic strategies. The latter two strategies entail less competitive bidding and in addition could perform well even in just a moderate economic recovery scenario if investors are sufficiently well capitalized and have strong leasing capabilities, providing a strong competitive advantage that facilitates taking tenant market share away from weaker, overleveraged competitors. Indeed, in some ways, while 2010 has seen the majority of capital pursuing core strategies in primary markets, we believe it is likely that 2011 will increasingly see that capital set its sights on selective non-core strategies and secondary markets.

The Four Quadrants of U.S. Commercial Real Estate

Publicly Traded REITs

Most real estate investment trusts (REITs) have made the transition from their defensive positions of early-to-mid 2009 and are now relatively well positioned to go on the offensive. REITs have been able to take advantage of very favorable credit markets to access debt capital through unsecured corporate bonds issuance and, in select situations, through the Commercial Mortgage-Backed Securities (CMBS) issuance market. Several REITs have also used secondary equity issuance to deleverage. As a result, the upcoming 2011 and 2012 loan maturities that confront the broader real estate market does not look all that threatening to U.S. REITs.

A confluence of low cost-of-debt capital, stabilizing credit ratings, the likelihood that acquisitions will be accretive to debt-capital costs, and the relationship of dividend yields to risk-free rates are additional positives. However, a lackluster economic recovery does bring into question whether REIT investors may be overly optimistic about the strength of rent recovery. Indeed, from a number of perspectives, REITs appear to be close to fully valued. A key question is how much additional pricing support a low Treasury-rate environment will give to REITs, especially since share prices continue to trade well above net asset value. Of course, part of this premium is an expectation that REITs will be able to grow earnings through accretive acquisitions, helped by access to the credit markets at low cost financing and indeed REITs have generated a considerable share of property acquisitions year to date.

Consequently, it is reasonable to expect REIT prices to remain somewhat range-bound pending additional clarity regarding the longer-term economic outlook. A sell-off also looks unlikely, given that REITs remain attractive because of high dividend yields, which play well amidst a growing investor desire for current income.

Commercial Mortgage Backed Securities

CMBS prices have rallied strongly across the risk spectrum in 2010, despite rising delinquency rates. Although seemingly counterintuitive, that is a function of the previous severity in decline of commercial real estate prices that was impounded into CMBS prices, and the degree to which that expected severity has since been favorably reevaluated.

Still, a high degree of watchfulness will be needed going into 2011. That is particularly true for junior AAA (AJ) tranches that continue to see a wide variation in pricing depending upon vintage and specific mortgage composition. Selectivity will also be important given how the amount of underlying mortgages in the CMBS universe that are below a breakeven debt-service coverage ratio.

Financial regulatory reform could still take the wind out of the sails of the burgeoning CMBS recovery, particularly when considering the uncertainty regarding what the final risk-retention provisions will look like, especially for banks that issue CMBS. The degree to which this will slow momentum of the issuance market is unknown, but banks have been one of the most active players to return to the CMBS issuance market in 2010.

On the margin, the strong rally in CMBS pricing has reduced its relative value compared to a year ago. The search for yield amidst the broader bond market rally has resulted in certain higher-rated CMBS bonds trading at prices well in excess of par–a major reversal for a quadrant that has consistently traded at a discount since the beginning of the credit crisis. Still, attractive buying opportunities remain, particularly for selective AAA mezzanine (AM) and AJ bonds, which offer attractive current spreads-to-swap rates with limited downside risks given generally sufficient subordination levels to absorb credit losses.

Private Debt

A sharp increase in lender appetite for commercial real estate mortgages has led to significant competition, especially among life companies and better-capitalized banks, to originate conservative loans on well-leased, high quality properties. While core mortgages remain attractive relative to corporate bonds, from a total-return outlook conservative mortgage loans perhaps offer the least relative value of any quadrant at this time, with investors most likely to utilize such investments as part of asset liability management strategies. Very low yields on senior mortgages are why most institutional investors in the private debt quadrant are seeking mezzanine or subordinate debt structures or higher loan-to-value (>70%) loans in search of yields that are more competitive with CMBS or core unleveraged equity. This subsector of the private debt quadrant reflects a gap in the mortgage market that could offer attractive risk-adjusted returns, especially if some meaningful amortization or substantial structure can be achieved in order to effectively navigate downside risks.

Given that the preponderance of private debt capital is seeking conservative, core loans, there is much less availability and higher cost-of-debt capital for lower quality properties, value-add properties, properties in secondary and tertiary markets, and vertical development/land acquisition activities. To some degree this simply reflects improved risk discipline and more appropriate pricing, but at the same time also provides an opportunity for investors to help fill a financing gap by selectively moving up the risk spectrum in search of higher returns.

Private Equity

As the markets traverse the fourth quarter of 2010, most pricing indicators for institutional quality, core real estate are signaling that, barring a double-dip recession or some other disruption, price corrections in U.S. commercial real estate have ended. Despite a longer and more severe recession in 2008 than was the case in the 1990s, core property value declines have not exceeded the severity of the 1990s.

Most investors are focused on core properties, especially high-quality assets in primary markets. However, despite (or possibly because of) reduced debt and equity capital availability, higher-quality, value-add properties in primary markets may offer somewhat better relative value opportunities within the private equity quadrant. This is especially true for well-capitalized investors that can buy properties on an all cash basis, have strong leasing capabilities and plenty of capital readiness for tenant procurement costs due to an opportunity to take leasing market share away from overleveraged competitors. In addition, green or sustainable buildings (especially in the office sector) will be increasingly important in order to maximize tenant bandwidth. The ability to acquire quality value-add assets at relatively steep discounts to reproduction costs can make select value add opportunities appealing, particularly in sub-markets with a multitude of undercapitalized competitors from which to potentially lure away tenants.

The information in this document has been derived from sources believed to be accurate as of December 2010. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however we do not independently verify or guarantee its accuracy or validity.

The information in this document contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The general information it contains does not take account of any investor’s investment objectives, particular needs or financial situation. Nor should it be relied upon in any way as forecast or guarantee of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.

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All figures shown in this document are in U.S. dollars unless otherwise noted.

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