Yet the commercial real estate sector already is strong. During the last three years, real estate investment trusts, the most liquid way to invest in commercial real estate, have been on fire. According to Morningstar, real estate has been the top-performing fund category in that time period. The average fund in the group returned 35% for the three years that ended April 5, 2012, versus 20.9% for the S&P 500.
Those aren't the results you'd expect from a sector that was wounded so recently. But Steve Shigekawa and Brian Jones, co-managers of the $495 million Neuberger Berman Real Estate fund, aren't surprised. After the FTSE NAREIT All Equity REIT index dropped 37.3% in 2008, much of the recent performance has been making up that lost ground.
These days, the real estate market is stronger and there are solid reasons at play. With relatively slow new development of offices and apartments, pent-up demand is driving firms to put shovels in the ground, increasing profits.
Jones and Shigekawa are well suited to understand the ins and outs of this particular real estate cycle. They took the reins of Neuberger Berman Real Estate in October 2008, just as the sector was beginning its swan dive. As analysts on the fund before that, the two still make macro economic calls as a way to determine what direction to take the portfolio.
Over the last three years ending April 5, Neuberger Berman Real Estate returned an average 36.6% a year annualized, placing it in the top 21% of funds in the real estate category. During the five-year period, a time in which Shigekawa was also a co-manager, Neuberger Berman Real Estate was up 2.3% a year annualized, in the category's top 6%.
Some of the recovery can be credited to investors' hunger for yield. To get favorable tax treatment, REITs pass on at least 90% of their taxable income to shareholders. REITs' average dividend yield is now 4.3%, according to the National Association of Real Estate Investment Trusts. Though lower than it's been in years, it's almost twice as high as the 10-year Treasury note's 2.2% yield.
Real estate cycles tend to last five to 10 years, and Jones and Shigekawa believe the current surge is just the beginning of the new real estate cycle. To take advantage of it, the duo emphasizes companies that are in the most economically sensitive sectors. "We think we're in the early part of the third year of the recovery," Jones says. "Typically, you have a number of additional years in which occupancy rates are improving and rental rates are moving higher."
The National Association of Realtors, a trade group, forecasts that over the next year vacancy rates will drop 0.9% in the retail rental market and 0.2% in offices.
BETTING ON TECH
Another factor pushing REITs forward, Jones and Shigekawa say, are their reasonable valuations. Valuations are usually assessed by looking at share price to net asset value of the underlying real estate portfolios.
Share prices are now at a slight premium, the managers say. But in strong REIT markets, premiums typically climb into the double digits, as they did in 1993 when they were at 15% and 37% during the 1996 to 1998 stretch.
Investors are willing to pay for REITs because the firms are worth more than the individual properties. Liquidity, transparency and professional management are also accounted for in REIT share prices. "Considering that we're early in a recovery, we find the modest premium to NAV an attractive valuation," Jones says.
While Shigekawa and Jones always have exposure to the different sectors of real estate benchmarks, they assign overweight or underweight designations to particular sectors depending on their economic views. With an improving economy, they are especially fond of technology. "That's one of the sectors that's seeing good job growth and that points us to thinking about markets like Northern California, where we can take advantage of those trends," Shigekawa says.
One name that allows them to do that is Digital Realty Trust, which owns and operates data centers worldwide. "When you think about tech and social media, these data centers are the backbone of that," Shigekawa says.
When clients sign on with Digital Realty, they bear much of the cost of adding technical improvements to the facilities. Tenants often are willing to sign long-term leases of a decade or longer, with rental increases built in. Digital Realty is up 12% in 2012 through April 5.