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U.S. Real Estate: More Reward in Core?

2019 December - 2 min read

As investors in the market continue to chase yield, the risk premium—or the reward for taking that risk—appears to be diminishing. In this environment, we’re seeing some of the best opportunities in the highest-quality assets.

This post is part of our 2020: The Road Ahead series⁠—read, watch or listen to the full conversation here.
 

Biggest Risk

In our view, one of the biggest risks for U.S. real estate markets is the cumulative effect of the election cycle, almost irrespective of the outcome. Elections, by nature, generate uncertainty, and uncertainty often results in inaction when it comes to real estate—transaction volumes slow, and investors’ willingness to take risk diminishes. That’s expected, and can even be healthy if it’s temporary. The bigger concern in our view is whether, once the election is over, market participants will be willing to wade back into the high water of where we stand today, where everything is priced to perfection, credit is inexpensive and growth seems, if not automatic, then highly likely.

The risk is that the election has a sobering effect on markets—like bright lights going on in a crowded bar right before closing time—and that decisions that seemed perfectly reasonable just moments before no longer seem like such a good idea. If the market experiences a post-election surge in risk-off sentiment, will today’s elevated valuation levels still look attractive, or will there be a prolonged period of reflection? Just like the end of a long night, reflection periods in the real estate market tend to bring about sounder reasoning, and perhaps a more risk-averse orientation, that could have a slowing effect on the market.
 

Biggest Opportunity

Looking across the real estate markets, we see some of the best opportunities in the highest-quality assets—certainly on a relative basis, but also, in some cases, on an absolute basis. For us that means core real estate assets that are well occupied, stable and best-in-class. As investors in the market continue to chase yield, the risk premium—or the reward for taking that risk—is diminishing. In other words, it’s not clear that investors are being adequately compensated for the risk they’re taking in pursing the extra yield. While it appears that all-in returns have declined to some extent across the board, yields on the very best assets have come down to a lesser degree, based on our observations, and still look fairly attractive on a relative basis.

In our experience, the best assets in the market are determined by their competitive advantages, such as their location and amenities. For an industrial asset like a warehouse, that could mean proximity to major interchanges or distribution channels. For a multifamily asset, it could mean walkability, or the quality of its city score—where the city is in terms of its population growth and household formation, for instance. As we look at the markets today, we think these assets are providing the most attractive value.

“While it appears that all-in returns have declined to some extent across the board, yields on the very best assets have come down to a lesser degree, based on our observations, and still look fairly attractive on a relative basis.”


Bold Prediction

One prediction for the next three to five years is that core real estate assets could outperform value-add and opportunistic assets on an absolute and relative basis. In other words, the higher-risk/higher-reward assets that seem on track to produce outsized returns, do not. This isn’t necessarily our base case scenario, but given the spread compression in the market today, coupled with the return expectations for value add versus core assets, we think it’s within the realm of possibility.

This commentary is provided for informational purposes only and should not be construed as investment advice. The opinions or forecasts contained herein reflect the subjective judgments and assumptions of the investment professional and do not necessarily reflect the views of Barings, LLC, or any portfolio manager. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.

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