Office property values in 'superstar' cities boosted by foreign investors

THE driving force behind rising commercial real estate prices in gateway markets could be coming from foreign buyers and large private equity (PE) funds, rather than low interest rates.

In particular, foreigners are the least price-sensitive compared to other investor types, and chase trophy assets located in "superstar" or gateway cities like Manhattan.

That is according to a new approach in valuing commercial properties, proposed by Stijn Van Nieuwerburgh, professor of real estate at Columbia University's Graduate School of Business. His suggested model emphasises the role of capital flows and investor types.

To explain the compression of capitalisation rates, a popular theory is that when benchmark interest rates decline, future cash flows can be discounted by a lower rate, which results in higher valuations. That remained the conventional wisdom as cap rates continued to narrow in the Covid-19 pandemic amid ultra-low rates.

But an analysis of US property deals and US-listed real estate investment trusts' (Reits) expected returns showed that higher risk premiums were actually offsetting most of the decline in interest rates, preventing the cost of capital from falling, Prof Van Nieuwerburgh said.

The change in investor composition - and the different asset characteristics each investor type finds most valuable - may explain these higher risk premiums and, in turn, the strength in valuation ratios over the last two decades.

Speaking at Mapletree Investments' annual lecture at the Singapore Management University, Prof Van Nieuwerburgh highlighted the spike in cross-border investments in commercial real estate across the globe, including in the US and Asia, since 2001. The ecosystem of commercial real estate investing has also become "much more diverse", following an influx of institutional investors such as sovereign wealth funds, pension funds and university endowments.

Based on his estimations of price elasticity of demand for US commercial real estate, foreigners came in at the bottom, followed by real estate PE funds, and then institutional investors. That essentially means these investor types are the least worried about overpaying for office assets.

On the other hand, demand from individual investors was the most price-elastic, followed by local and national developers, owners and operators, as well as Reits. Being the most price-sensitive, they tend to walk away easily from assets that are too expensive.

Geographically, gateway markets are the most sought-after by foreign investors, followed by individuals, institutional players and PE funds.

Given these characteristics, Prof Van Nieuwerburgh's analysis found that foreigners had the largest positive price effects on gateway markets in the US, such as Manhattan, Washington DC, Boston, Los Angeles, Miami-Dade County, Seattle, San Francisco and Houston.

Using Manhattan as an example, the analysis showed that prices of offices there would have been 8 per cent lower if foreigners had not snapped up the 30 million square feet of assets they have purchased since 2005, and if other investors had absorbed that space instead.

Second-tier and third-tier cities, meanwhile, saw the largest negative price effects from foreigners due to a reduction in foreign demand for office space relative to the supply. These markets included Indianapolis, Jacksonville, Tampa, Orlando and Atlanta.

That being said, the Covid-19 shock hit gateway office markets harder than lower-tier cities and the work-from-home trend is likely to cause permanent changes, although the extent of the actual impact remains to be seen, Prof Van Nieuwerburgh noted. How strongly foreign demand rebounds will also be key to commercial real estate's future price path.

DBS Group Research wrote last month that the regional office segment appeared to be more resilient throughout the coronavirus pandemic, while the gateway office segment saw some hollowing out of space and an increase in sub-leasing.

In Singapore, there was a particularly large reduction in capital flows from Hong Kong and mainland China in the first three quarters of 2020, Prof Van Nieuwerburgh said, citing Real Capital Analytics data. He pointed out that foreign demand can be "very important" for the city-state.

If the findings on foreign buyers' low price sensitivity are also applicable to Singapore, the decline in capital flows would imply that Singapore commercial real estate valuations were under pressure, he said in response to queries from The Business Times.

Several properties held by the three Singapore-listed US office Reits are located in gateway markets. Manulife US Reit has assets in Los Angeles and Washington DC, and Keppel Pacific Oak US Reit holds properties in Seattle and Houston, for instance. Atlanta, a less-popular office market with foreign investors, features in the portfolios of Prime US Reit, Manulife US Reit and Keppel Pacific Oak US Reit.

To calculate the expected return on US Reits, Prof Van Nieuwerburgh's proposed model included commercial real estate's risk exposures to the overall stock market, bonds, small stocks and value stocks, and allowed these betas to be time-varying.

The increase in these risk premiums also points to investors' frothy expectations about future income growth of commercial real estate, he said.

Since 2000, US Reits' stocks have been trading at high multiples of about 25-30 times of annual dividends. In contrast, the Reits' annual real dividend growth was "strongly negative" at about -16.5 per cent in 2020, indicating that their actual realised cash flows were deteriorating.

This "stark dichotomy" between robust valuations and low cash-flow growth realisations could mean investors' expectations are "unreasonably optimistic" and that the US Reit market and perhaps the broader commercial real estate market are due for a correction, Prof Van Nieuwerburgh said.

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