How to Deal with a Changing Market

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PGIM Real Estate completed more than $8 billion in acquisitions, dispositions and debt investments in the U.S. last year. NREI recently talked with PGIM Real Estate’s Alfonso Munk, Americas CIO and head of Latin America, to hear more about the firm’s strategy and views on commercial real estate market opportunities in 2018.

NREI: How does that $8 billion in transactions in 2017 compare to 2016?

Alfonso Munk: Overall, total transactions volume was flat compared to 2016. However, acquisitions were down around 15 percent, which is not inconsistent with what we have seen in total market volume for U.S. transactions in 2017, which saw a 16 to17 percent decline. We acquired about $3.7 billion and sold about $4.6 billion in assets. So overall, we were a net seller in 2017. In the prior year, we closed more acquisitions—closer to $4.4 billion with about $3.6 billion of dispositions.

NREI: Specific to acquisitions, the company has said that its focus is primarily on high-barrier markets, as well as higher-yielding secondary assets and markets. What’s driving that strategy?

Alfonso Munk: When we talk about markets specifically, the gateway and primary markets over the last six or seven years have seen a run up in prices. When you look at our activity last year, as compared to the earlier part of the cycle post-financial crisis, acquisitions were concentrated more in secondary and non-gateway markets, high-barrier and high-growth markets, such as the Sun Belt and higher growth coastal areas. We did that because we saw better values. The spread of returns between the non-gateway markets and the gateway markets widened in 2017 and we took advantage of opportunities in those markets.

NREI: Can you provide some examples of markets that you like right now?

Alfonso Munk: We were active in the Sun Belt, starting from Georgia and the Carolinas to Florida and Texas. We were active in Northern and Southern California, but we were less active in gateway markets like San Francisco and Los Angeles. In the Northeast, we selectively looked at areas such as the Washington/Virginia, New Jersey and Boston suburbs. We were as active as we were before in those gateway cities in the Northeast, but we were looking more in the suburban markets. We think the yield premium is more attractive in those suburban markets, which are still strong.

NREI: Specific to dispositions, the company was a net seller of office assets with more than $2 billion in dispositions last year. Can you explain some of your strategy related to office specifically?

Alfonso Munk: We would never get out of the sector entirely, because office is the largest commercial asset sector in the U.S. But we felt that it was a good time to reduce our overall weighting in office, because the rents have had a run-up since the financial crisis, as well as cap rate compression over the last five to seven years. So it was a good time to look at selling some of the assets that we bought at the beginning of the cycle in 2013 and 2014, especially where we did value-add work to assets that produced gains in occupancy and rents.

It is not that we are underweight in office, but we are overweight in other sectors where we see more opportunity for growth. Those sectors include multifamily, particularly workforce housing apartments, as well as industrial and selective retail.

NREI: What are the asset types that PGIM Real Estate is more actively buying right now?

Alfonso Munk: At the beginning of the cycle, we were doing a lot of development of class-A multifamily properties that had an interesting demand increase and run-up in rents over the last six to seven years. Now we are in a later stage in the cycle and rents have increased substantially. Given where rent levels are and where supply is in some markets (for premium apartments), we are now buying existing apartments or portfolios of workforce or older vintage, class-B apartments that typically have lower rents per unit than what we had been developing.

We are using our ability to access capital for larger and more complex transactions to buy those apartment portfolios and improve them with our strong asset management culture and eventually improve those rents. We are also looking at workforce housing assets that have average rent per unit at or around $1,000 per month as compared to a premium apartment that might see two to three times those numbers. We see a big, unmet demand for affordable apartments and we see that as an area where we want to increase our exposure.

Industrial has been growing significantly and has gone through a secular shift due to a variety of factors, most notably e-commerce. We have been increasing our exposure to industrial assets over the years. We also have taken positions on the development side with a few partners to develop industrial and logistics facilities across the U.S.

Lastly, retail. Even though it is in the headlines for what is happening in the overall retail sector, particularly in the malls, this is not the sector we are targeting. We are taking advantage of the shift in the demographics and also the shift in the overall fundamentals in the retail sector. This means we have been selectively buying more convenience-driven, lifestyle-entertainment retail centers, such as those anchored by a grocer coupled with a movie theater and food and beverage.

NREI: PGIM Real Estate also provided more than $100 million in debt financing last year. Are you more active in debt investments these days?

Alfonso Munk: We started investing with a new debt strategy last year, and we expect debt to take a more prominent role in our investment strategy in 2018. We think it is good timing because of the run-up in pricing that I mentioned earlier. We also are taking advantage of some of the regulatory changes and restrictions affecting the banks, and we think it is a good time in the cycle to invest in debt, because you have the equity cushion in front of you, as well as an attractive income profile.

NREI: Can you share a bit of your strategy related to debt? Do you do the whole spectrum, or are you focused more on higher yielding debt?

Alfonso Munk: We are working with our sister company, PGIM Real Estate Finance, to provide transitional short- and medium-term floating rate loans as opposed to PGIM Real Estate Finance’s typical strategy of providing longer, more fixed-rate finance and more traditional life insurance company loans. We have been doing more short-term, full-stack or first mortgage loans on assets that are going through some sort of transition.

NREI: Overall, do you expect investment activity to be about the same in 2018?

Alfonso Munk: Overall, we expect to have a little more investment activity in 2018 versus 2017, with the sell side likely to be flat or slightly less. On the acquisitions side, we always look closely at opportunities in the four main sectors of multifamily, office, retail and industrial. In 2018, we will be focused primarily on [multifamily], workforce housing, industrial and retail as I mentioned, and more selectively on office in non-gateway and suburban markets.

Last year, we also started increasing our investments in niche asset classes. The most notable one is manufactured housing. We continue to be very active in seniors housing, and we are actively looking at other niche asset classes, such as student housing or cold storage and logistics, where we think we can find interesting returns.

NREI: What do you see as some of the biggest challenges ahead for commercial real estate investment this year?

Alfonso Munk: On the acquisition side, prices have continually risen over the last almost eight years. We have reached a point where underwriting has been optimized to the maximum with occupancies and rent increases, and cap rates [are] at the lowest point since pre-financial crisis. So, the challenge on the acquisition side is finding good opportunities at values that we think make sense in pretty much any asset class.

The fact that we haven’t seen oversupply in this cycle because of low construction and we haven’t seen over-leverage makes it hard to find motivated sellers at attractive values. The lack of new supply and lack of excessive leverage has created an environment where sellers can afford not to sell and are holding onto assets. When good assets do come to the market, there is a lot of interest. There is a lot of liquidity in the market, and that liquidity is making it very difficult to find good investment opportunities.

On the development front, the challenge is not only finding attractive sites to develop, but we are also very concerned with development costs. Labor costs have increased substantially, and it is hard to find qualified labor. Secondly, the cost of construction materials has gone up significantly—more than we expected. This means that development is going to be harder to pencil out and make returns work, given where costs are today.

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