A Tectonic Shift Is Happening in the Real Estate WorldSep 2, 2016
As you may have heard by now, real estate is set to become a separate asset class on the Global Industry Classification Standard (GICS) and the S&P 500, separating it from the Financials Sector. Notably mortgage REIT’s will be left behind in the Financials Sector under a newly created sub-industry group called...you guessed it…Mortgage REIT’s.
What are the implications of this? I think they are dramatic and possibly one of the biggest changes to the real estate investment world since the internet popped up twenty some-odd years ago and made information freely available.
There are a bunch of articles already written on this subject, and almost all of them deal with the effect on REIT’s themselves; however, here I am going to give my thoughts on the effect of this transition on the non-REIT portion of the real estate world.
For background, please click here for some of the articles (that pertain to REIT’s). These articles make some possibly (obvious?) points as follows:
They predict that a lot more money will now flow into REIT’s. One of the articles points out that right now the total market cap of REIT’s is about $900B and that another $500B additional dollars will now flow into real estate due to increased real estate investment targets by major investors, such as Norway’s $890B Government Pension Fund. I suspect there is no real way to quantify this and the number is plucked from thin air, but it does seem like “a lot” more money will indeed flow into REIT’s.
They also predict that REIT’s will become a “have to own sector” for appropriately diversified investors and, logically, REIT stocks will go up. I will not touch that prediction.
And one of the articles states that it “will increase the visibility of real estate as a distinct asset class and encourage investors, their advisors and managers to more actively consider real estate – especially REIT’s – when developing investment policies and portfolios [and this will] likely lead to the creation of new investment products, such as active and passive mutual funds and exchange traded funds. Advisors and managers will have more real estate fund options to recommend to their clients, likely facilitating positive capital flows into listed real estate equities.”
Here are my thoughts on the effect of this transition on the non-REIT portion of the real estate world.
First – I hate to be obvious myself; however, I do think that overall this change means that a lot more money will flow into the non-REIT portion of the real estate world. Real estate will be considered its own asset class and investors of many different kinds will take it more seriously. Investment professionals will steer their clients into these investments to a greater degree.
Second – I think this will to some extent move real estate closer to a place where, for more parties, real estate assets are thought of by many like “widgets” that happen to be in the general category of “real estate”. This is because many, new, investors will want some vague concept of “real estate” in their portfolios, without knowing (or even likely caring much) what the underlying real estate really is. In other words, much real estate will be invested in by parties that have no idea exactly what they are investing in. I will call these parties, who are buying real estate for diversification of investment reasons, “Diversification Purchasers”. To be clear here, I do not think Diversification Purchasers are necessarily “dumb money”; instead, they are potentially very intelligent parties who may recognize that they have no real ability to analyze real estate assets and, accordingly, will want a diversified portfolio that includes real estate in it without specificity as to the exact nature of the of the assets themselves.
Third – I suspect that this latest development will “never, ever” change. Things like this (i.e. real estate now being a separate asset class) never, ever reverse course, so my sense is that this change is here to stay forever…
Fourth – my suspicion is that a lot of money will slosh towards the (perceived) safest part of the capital stack where the theme is (perceived) safety in yields, as this will be the easiest to sell to the Diversification Purchasers. Returns for core and other income-producing real estate will likely fall if this is the case. And, since “core” often consists of assets priced for perfection, there is a good shot that Diversification Purchasers will lose money from time to time, even when they think they are buying the safest alternatives.
Fifth – I suspect that this change in asset class for real estate is brought on by interest rates staying so low for so long that real estate, with higher yields, looks better and better by comparison. Sometimes changes like these are made at exactly the “wrong” time in the market, so I wonder whether this is the bell ringing that interest rates are finally about to go up? But I don’t dare predict this. Many people much smarter than me have predicted that interest rates will go up (for sure) over the past eight years and they may be smart, but so far they have been wrong in that prediction.
Sixth – since there will likely be an increase in the number of parties buying real estate without really knowing what they are buying (i.e., the Diversification Purchasers) – and possibly inadvertently paying top dollar for it for diversification – it will make a lot of sense for “players” in the real estate industry to buy or develop real estate and package it for sales to these Diversification Purchasers. I suspect that this is a good real estate strategy that will become better and better over time. Sort of an enhancement on “Build to Core,” it will essentially be “Build to Diversification Purchasers”.
Seventh – it will be plain old dumb to compete with Diversification Purchasers. They simply will have a different motivation to purchase than a sophisticated investor in the real estate world. Accordingly, if you have a fund that is buying core assets – or assets close-to-core – it will get harder and harder to acquire assets of this nature at prices that are within logical and traditional underwriting, since there will be more and more Diversification Purchasers competing for it. So, I suggest – don’t compete with the Diversification Purchasers – sell to them or manage their money in a public or private vehicle. I wonder here whether possibly public non-traded REIT’s will come into greater vogue.
Eighth – it will be more and more important to be “the guy who creates value”, as I pointed out in my earlier articles in The Real Estate Philosopher. If you can create value, then the products you create will be in more demand than ever from Diversification Purchasers. However – I think, a bit sadly – the pressure will be on you to “create” real estate assets that fit into the “checked boxes” of the Diversification Purchasers, so innovation may become harder to justify.
Ninth – the companies which are advising the Diversification Purchasers will do better and better. Diversification Purchasers will logically gravitate toward the biggest and most well-regarded advisors and, in turn, those advisors will be able to increase their market share. If you are starting a career, this will likely be a good place to get a job.
Tenth – I suspect there will be more and more deals that are huge in size, as more money-manager-type “elephants” that are really financial services providers wade into the real estate area. They will need to have very large portfolios to provide necessary diversification to their investors. They will probably not want to acquire these portfolios piece-by-piece, but instead will want to gain control of them in one fell swoop.
Eleventh – I suspect that the regulatory changes sweeping the real estate world will increase significantly. Over time, as real estate looks more and more like a part of the financial services sector, it will become more and more regulated like the financial services sector. This will be a good thing for lawyers, compliance officers and other parties who work in this part of the industry.
Twelfth – “average performance” will become the goal for most real estate money managers catering to Diversification Purchasers. Since the Diversification Purchasers are not (almost by definition) looking to outperform, they will want a diversified portfolio that includes an “average-performing” class of real estate.
These are my thoughts. Of course, I likely will be right in some of them and wrong in others; however, one thing is for sure, and that is that as real estate becomes a separate asset class there will be a significant impact on the real estate world (both the REIT and non-REIT portions). All of us – lawyers, as well businesspersons – would be well advised to be perceptive about how this will affect our businesses so that we will benefit from the changes afoot, rather than the converse.
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Featured Article: As we have mentioned in prior issues of The Real Estate Philosopher, our China Real Estate Law Practice is growing fast, largely with cross-border joint ventures. Last week I wrote an article that was published in Bisnow entitled Rebuttal: China Investors in U.S. Real Estate Aren't Crazy At All. Among other things, the article gives my thoughts about how Chinese investors should logically proceed in making U.S. real estate investments. Click here to view the article.
Specialty Practice at Duval & Stachenfeld – Fund Formation: This week I highlight our Fund Formation, Investment Management & Compliance Practice Group, headed by partner Heather Wyckoff. The Fund Formation Group at Duval & Stachenfeld fits neatly within our Pure Play in Real Estate Law. The group advises investment managers on the formation, regulatory compliance and other ongoing operations of domestic and offshore private investment funds (including real estate, private equity, venture and hedge) and their management entities. The group also advises investors in private funds with respect to investments in fund interests on the secondary market, seed and incubation deals and due diligence matters. Read more