The Game Is Changing: How Integration with the Capital Markets Is Altering How We Should Think about Real Estate
MacKinnon, Greg, Journal of Real Estate Portfolio Management
Over the last two decades, commercial real estate has become increasingly integrated with the broader capital markets. The rising importance of REITs since the beginning of the "Modern REIT era" in 1993 has created a direct link between the property and equity markets. REITs now provide an important avenue for equity capital to enter (or exit) the property markets. The existence of the CMBS market means that real estate debt capital now comes from global investors, not simply domestic banks or insurance companies. Further, many real estate professionals have long yearned for real estate to be accepted as a legitimate asset class by institutional investors. As this has in large part come to pass, real estate has become more exposed to fluctuations in other capital markets. For instance, during the recent downturn there was much discussion of the "denominator effect" in which investors wished to decrease their exposure to real estate due to the falling value of their positions in stocks; falling equity markets exerted downward pressure on real estate values.
Real estate no longer exists in a vacuum - what happens in other markets can have great effects. Certainly, the most recent cycle was a capital markets phenomenon. Prices spiked higher in 20052006 based on a "wall of capital" moving into real estate, and the fall in values began with the collapse of that wall. In discussions about a hoped for recovery, investors spend almost as much time talking about a possible revival in the CMBS market as they do about vacancy rates or rent growth.
The main point here is that integration of real estate with the broader markets has changed the nature of the real estate market in some important ways. Investors unaware of the fundamental changes that are occurring in the market risk being side-swiped by unexpected events. Industry research departments received blame from many after the recent collapse in property values for not having "seen it coming." One of the reasons that few warned of the impending crash was that this cycle was so much different than ones of the past. Based on their past experiences, real estate investors and industry researchers are highly attuned to changes in fundamentals: vacancy trends, rent growth, absorption, construction starts, and the like. Unlike previous cycles however, which were often associated with overbuilding, the origins of this cycle were in capital flows. Even before fundamentals turned down, valuations had crashed due to the disappearance of capital. Who knew that troubles at U.S. money market funds and German banks could have such an effect on real estate values?
Below, I outline four changes in the nature of the real estate market that that I believe have resulted from increased integration with the capital markets. This is not an all inclusive list, but simply items I believe to be of particular importance to the changing nature of real estate as an asset class. The effects of these changes may not yet have been fully felt; it is simply too early to tell whether the integration story has fully unfolded yet. Further, what follows is, in large part, speculation. We simply do not have a long enough time series to determine with any precision how the market has changed. Perhaps the conjectured changes will reverse themselves, fade over time, or be found in the future to never really have occurred at all. Nevertheless, investors should at least consider these potential changes when developing strategies for real estate portfolios.
Change 1: The Real Estate Market is More Efficient- And More Volatile?
As REITs and CMBS provide an avenue for deployment of capital into real estate, might some of the informational efficiency of the broader capital markets rub off on real estate? Capital flows into (out of) the real estate debt and equity sectors in anticipation of an upswing (downswing) in values can make the change in values occur more quickly - the essence of an informationally efficient market. …