We mentioned in prior written communications that our approach to the TIAA Real Estate account was under consideration. We have concluded our analysis. What follows is a review of where we have been, where we are now, and where we are going. If you do not have exposure to TIAA investments, then this may still be of value if you have an interest in the commercial real estate market in general.
In January, PIM reduced exposure to TIAA Real Estate in all client accounts by 50%. In April, we reduced exposure to TIAA Real Estate by 50% of what remained. PIM clients’ TIAA Real Estate exposure is approximately 25% of what it was on January 1st. As of August 17th, the performance of TIAA Real Estate is -8.35% for the year.
As we reported in an earlier communication, TIAA is limiting the amount of TIAA Real Estate that may be owned by each client to $150,000. Clients who own $150,000 or greater in TIAA Real Estate may not add to their position. Those who already own greater than the limit may keep what they own. The effective date of this new limitation is September 17th. We have had meetings with leadership of both the TIAA Real Estate Account and TIAA product management. From these conversations, we understand that the new position size limitation is designed to shield the TIAA General Account (not the TIAA Real Estate Account), from the risks associated with significant outflows, as the TIAA General Account provides a liquidity guarantee to the Real Estate Account. The new policy limit applies to capital flows/ transfers within TIAA only. This means that larger position sizes could be established, but only by transferring capital out of TIAA, then bringing it back as a new deposit.
PIM has a duty of loyalty to our clients, exclusively. We will not make investment decisions for the convenience of a custodian/ product manufacturer. Therefore, based upon the analysis presented below, we will not be increasing allocations to TIAA Real Estate before the September 17th new policy effective date. We will only increase allocations when doing so is in the best interests of our clients.
Commercial real estate transactions are down 70% from the peak. This suggests that buyers and sellers are unable to agree upon the fair market value of commercial properties.
Overall demand for office space is changing as employees have become accustomed to hybrid and work from home arrangements. While the balance of influence appears to be shifting back to employers, no one really knows how much office space will be needed this year, next year and thereafter. National office space vacancy rates are at an elevated 19% according to recent data, strongly suggesting lower rental income for building owners. Office space is 26% of the TIAA portfolio.
The Cost of Capital
The more pressing issue for the commercial real estate sector is the cost of borrowing, as most properties are financed. Rates are higher and many traditional lenders, such as regional banks, are losing their appetite for making loans.
On average, commercial real estate is financed with seven-year loans; every seven years, building owners need to re-finance, making the entire sector more sensitive to interest rates than other areas of the economy. Here, we have charted the Fed funds effective rate (red) TIAA Real Estate (blue) and the commercial real estate sector index (yellow):
As illustrated, the cost of capital hasn’t been this high since just before the 2007-2009 financial crisis. Note that the red line shown is the cost of overnight funding for Fed member banks. Typically, borrowers pay that rate plus a spread to compensate the lender for the risk of the loan. Also note the way in which the TIAA Real Estate account and the entire commercial real estate sector have been uniformly, negatively impacted. There’s no escaping the impact of rising rates.
The real estate market is funded by a variety of sources, including banks, insurance companies, private lenders, and the bond market. Rates from these sources currently range from 5.5% to 14% depending on the quality of the property, the specific lender, and the timeframe of the loan. For context, the TIAA Real Estate account issued a bond in March at 5.5%. TIAA is considered a high-quality borrower with high quality assets and can receive low interest rate loans relative to the rest of the market. However, the new loan is replacing a 3.75% loan that matured. The cost of funds for the best and most creditworthy borrowers, such as TIAA, has increased by 45%.
Nobody knows how long rates will remain elevated. There are signs of cracks in the economy, but recent momentum suggests continued growth and no recession in the foreseeable future. Should this momentum continue, then inflation likely remains elevated, and rates remain higher for longer.
Then Why Hold Any TIAA Real Estate?
One advantage of the TIAA portfolio is that it holds a range of property types. Office space is 26% of the TIAA portfolio. The remaining property types are apartment (26%), industrial (29%), and retail (12%). Surprisingly, retail is the strongest performing sector this year, largely because the sector has been dealing with headwinds from on-line retailers for years. A lot of retail real estate has already been redeveloped, leaving only the strongest, best performing properties. Apartments are dealing with a surge in supply. Multi-family buildings are being constructed at the fastest rate in a generation, putting mild downward pressure on property values. The industrial space has performed the best of all, since the start of the pandemic, due to changing consumer habits and evolving domestic supply chains. Here’s a busy, long-term chart for reference, showing the various sectors of commercial real estate and the performance of the TIAA account. The point of showing this chart is to highlight the fact that diversification of property types helps the overall portfolio remain more stable over time. The TIAA fund is presented in bright blue.
While the multi-family, industrial, and retail sectors of the TIAA Real Estate account are under far less stress than office space (demand and vacancy rates), these sectors are still at risk of higher cost of capital. The TIAA Real Estate account earns most of its return from the value of the property portfolio and from rental income. If property values stabilize, management expects annual total returns of 3-4%. This rate of return is not as compelling as other available options in the short, and probably intermediate term. Yet, it would be reasonable.
The role of real estate in client portfolios is to provide stable long-term total return, but this is no longer the only asset class that can fill that important role. Over the past decade or more, when rates were at historic lows, the TIAA Real Estate account performed exactly as expected, outperforming the aggregate bond market by 4.39% per year on an annualized basis, with amazing stability. Moving forward it appears that bonds will outperform, for a while anyway. TIAA Traditional currently yields 5.2% and short-term investment grade bonds are yielding 6%.
As mentioned earlier, TIAA has left open one mechanism for investors to increase their TIAA Real Estate position above the $150k limit. Assets can be transferred out of TIAA and then back into the TIAA Real Estate account in any amount. If the TIAA Real Estate account again represents the most compelling value proposition, relative to the alternatives within and outside of TIAA, then we will consider engaging in this process.