Finding CRE Alpha in Uncertain Times

Peter Muoio of SitusAMC Insights on how investors can beat the benchmark and find recession-proof opportunities in commercial real estate.
Peter Muoio

As the national and global economies start to emerge from the deadly pandemic amid historically low interest rates, investors are leaving no stone unturned in their quest for higher returns. The search for “alpha” is intensifying amid the surge of capital pumped into the markets by the Federal Reserve’s aggressive monetary policies and the government’s fiscal stimulus packages.

In general, alpha represents the performance of an active management strategy over and above the performance of the market as a whole, as measured by an index fund or other benchmark. Finding alpha means identifying the opportunities that will provide higher returns for the same amount of risk.

How do we find alpha in the real estate sector? It involves identifying the opportunities that others may not have considered. It’s about not thinking like everyone else. Alpha can be found as investors commit capital to a broadening array of value-add and opportunistic strategies that reflect an appetite for higher total returns than those expected from core, traditional properties.

In particular, finding alpha requires rethinking allocations and directing capital beyond the “four main food groups” to segments or specialized subsegments that have heretofore not been strongly considered by the private marketplace. Our data and research suggest these include data centers, single-family rentals, life sciences and cold storage facilities.

Data from RERC, a SitusAMC company, certainly suggests there are opportunities in alternative property types. Investment conditions in medical office and self-storage have piqued investor interest over the past year; our gauge of investment conditions shows these sectors are now on par with the “darlings” of the industry—multifamily and industrial. Medical office has historically been more recession-resilient compared to the broader office segment.

Self storage is also viewed as a recession-resilient segment and correlated with homeownership rates and home sales. Data center investment conditions are red-hot. Since the pandemic began, RERC’s investment conditions ratings for this niche property type have surpassed all four core property types, including the overall industrial sector. Demand for data centers will only increase as more of our activities become virtual.

The single-family rental market is a big area of opportunity, and institutional investors are getting into the game in a major way. Walker & Dunlop estimated that the single-family rental market at $3.4 trillion, with growth expected to outpace all major property types within the next few years. While price growth has moderated during the pandemic, it remained positive. Investments in different types of land have also shown pricing resilience in the wake of COVID-19.

What’s old can be new

Other alpha strategies can include redeveloping or repurposing existing buildings—something that the changed lifestyles and work styles resulting from the pandemic are forcing on many properties, leading to upgraded amenities or more efficient operational policies and procedures. We are seeing savvy investors scooping up distressed hotels at steep discounts and transforming them into in-demand apartments in a cost-effective way. Investors are trying myriad repurposing strategies on failed malls and other retail properties. In addition, the historically ultra-low interest rates are providing positive leverage opportunities.

Success in moving up the risk spectrum in search of real estate alpha will require even greater investor emphasis on careful risk assessment and navigation. Prior to the pandemic-induced recession, cap-rate compression often masked any underlying strategy execution missteps at the property level. This is why critical examination of property fundamentals, while rooting out the new opportunities, can allow us to find alpha.

Alpha often takes longer to reveal itself in the commercial estate market than the alternatives because property investing is typically a long-term investment strategy. Still, we find that commercial real estate returns are often more favorable on a risk-adjusted basis than the alternatives—no small feat in this era of global political and economic uncertainty amid rapidly changing technological, demographic and societal changes.

This past year has amplified the existing bifurcation in the commercial real estate market, with some property types thriving and others really struggling in this COVID-19 environment. As COVID-19 begins to dissipate, finding alpha will largely be identifying which property types or subtypes and markets present the greatest opportunities for investors, recognizing that some of the changes brought upon by COVID-19 may be here to stay.

Peter Muoio, Ph.D., is senior director at SitusAMC Insights.