In 2018, direct investment into most income producing commercial real estate outperformed U.S. equity markets according to a December 17 release by the National Council of Real Estate And Investment Fiduciaries (NCREIF). The volatility of the U.S. equity markets was significantly higher than the volatility of private direct investment into income producing CRE. Even most publicly traded REITs underperformed most private direct investment into CRE.
“Will investing directly into income producing commercial real estate finally get more attention by individual investors in 2019?”
Most investors are aware of the increased volatility in the global equity markets, and it looks like volatility could continue in 2019. Thus, as many investors plan their investment strategies for 2019, many will be concerned about potential volatility and uncertainty of returns and dividends.
Individual investors, who are concerned about the volatility in traded markets, may want to look at how some large institutional investors mitigate their exposure to traded market volatility. The institutional investors who allocated capital at the end of 2017 and in 2018, to mainly Class A multitenant commercial office buildings (with high tenant occupancies), experienced stable cash flow derived from rental income, net of the operating costs of the assets. The dividends and distributions paid to investors were generally constant and met expectations because the relative stability of income from in-place leases spread over many different tenants.
The key variables to total return for investors in Class A office buildings (with high tenant occupancy) are:
- Income from rent collected less operating expenses
- Any change in valuation of the asset, or the sale or re-financing of the assets/buildings.
This is very different than investors buying publicly traded stocks which trade at a multiple to their cash flows and in most cases at a multiple to their book value. A stock market investor can perform all the analysis on a publicly traded company, and estimate what a company may be worth, and what the earnings might be, but there is no way for investors to determine what the multiple or premium will be for a specific stock at any given time. The multiple will be determined by other investors and market participants and their willingness to pay a premium for an actual set of cash flows.
This is different than income producing Class A commercial real estate assets where there is typically much less fluctuation in the actual NAV of the building in the short run, because there are few fundamental changes to a building and its cash flow in the short run, and since there is no traded premium attached to the asset, there is no risk of massive multiple contraction, as there can be in publicly traded stock valuations. In the traded equity markets, the fundamentals can be exactly the same for a specific company, but if investors suddenly decide that they will no-longer pay 25x earnings and will only pay 20x or 15x earnings, the stock price is going to decline significantly in the short run.
In 2018, total returns for a large cross-section of Class A office assets, in markets that KBS follows, ranged from 3% to 15%. The total return comprised of dividends and distributions ranging from 3% to 7%. Valuation gains on buildings and assets ranged from 1% to 9% for a large cross-section of Class A office assets.
So many of these investors in Class A commercial real estate achieved total returns in 2018 of 6% to 12% with minimal volatility in the return stream and valuation of the assets. This 6% to 12% total return in 2018 compares favorably to the negative return of -4.4% for the S&P 500 Index in 2018. In addition, there was minimal volatility with the total return of the CRE investments, whereas the U.S. equity markets were quite volatile, especially in Q4 2018. In December 2018, the U.S. equity markets experienced a significant decline, (S&P 500 Index -9%), as investors fled the markets. Fundamentals of the entire market did not change that much to warrant a decline of over 20% in Q4 for most averages.
Measuring Risk/reward and the certainty of distributions to investors
When most investors analyze the risk of an investment, they are concerned with:
- Return of capital
- Dividends and distributions
- Gains on the value of the asset
- Liquidity or sale of the asset
When analyzing these factors for Class A commercial office buildings, there is the ability to analyze each one of these factors with more certainty than the vast majority of publicly traded equities. The biggest difference being that investing in income producing Class A office buildings does not have the risk of paying a market multiple that can fluctuate or evaporate just because investors are selling at a moment in time.
In a diversified portfolio of several Class A office buildings consisting of several tenants in each building, an investor can better analyze the certainty of the cash flow and distributions compared to a portfolio of stocks. The value of the portfolio of Class A office buildings will typically not fluctuate very much as the asset is not liquid and might be valued 1-2 times a year. This can compare favorably to a portfolio of stocks that can fluctuate with significant volatility in the short term, depending on market conditions.
Instant Liquidity vs. Longer Term Hold
Liquidity is the biggest differentiating factor between direct investment into CRE and investing into equity markets. Direct investment into CRE is not for investors who will need their investment capital returned in two years or less. Direct investment into Class A commercial office buildings is usually made by institutional investors and some individual investors who are looking for some certainty of distributions from rental income, lower volatility of asset values and a more predictable approach to try and achieve a target total return objective.
2019 Investment Strategy Options: Class A CRE
If individual investors are setting their investment plans for 2019 and are concerned about experiencing a significant amount of volatility while trying to achieve high single digit returns, they may want to consider evaluating direct investment in to a diversified portfolio of Class A commercial office buildings where there is transparency provided by the owner with regard to financing of the building, tenant composition, lease terms/lengths and the sponsor’s view and evaluation of the local market. Finally, if an investor does review and analyze a vehicle to make direct investments into Class A CRE, the investor should try not to pay a commission to invest into the vehicle. There are options to invest directly into CRE without paying a commission to do so.