The release by the National Council of Real Estate Investment Fiduciaries (NCREIF) of third quarter 2012 results for its Open-end Diversified Core Equity Index (ODCE) this week revealed that returns from the index were higher than for second quarter of 2012, but lower than returns for third quarter 2011.
(The ODCE consists of 18 funds with 1880 real estate investments totaling $110.2 billion of gross real estate assets and $84.2 billion of net real estate assets.)
The difference between third quarter 2011 and third quarter 2012 ODCE results is not an indication that things are getting worse for the index, says Jeffrey Havsy, director of research at NCREIF in Chicago, even though third quarter 2011 ODCE gross returns were 3.52%, compared to 2.77% in third quarter 2012. (Second quarter 2012 results were 2.58%)
"As people expected a stronger recovery, returns got higher (mostly because of appreciation) as we were coming out of the downturn," says Havsy. From the middle of 2010 until mid 2011, the returns went up quickly, but now are getting back to sustainable levels, he says. "The (higher) returns, which were partially the result of inflated expectations, got ahead of fundamentals and only now are fundamentals starting to catch up," says Havsy.
Over the past four quarters (fourth quarter 2011 through third quarter 2012), gross returns from the ODCE were 11.61%. But gains in appreciation weren't necessarily supported by the underlying performance of the real estate, says Havsy. "You can charge higher rents or put more people in buildings and we didn't see either of these when we were coming out of the recession," he says. Still, people started to pay more for buildings, which was not sustainable until there were higher rents and occupancies," says Havsy.
Third quarter ODCE Index results compare favorably with NCREIF's NPI (NCREIF Property Index), whose gross returns were 2.34% in the third quarter. The better performance by ODCE was due to over-weighting in the West relative to the NPI, which was the best performing region, and underweighting in the East, which was the worst performing region. ODCE is also underweighted in the South relative to the NPI.
There was other good news for the ODCE in the third quarter NCREIF report, namely that leverage levels fell for the index for the 10th time in 11 quarters. They dropped to 22.7% from 23% in second quarter 2012. Other than a slight uptick in the fourth quarter 2011, leverage has fallen steadily since peaking at 33.5% in fourth quarter 2009. The drop in leverage for the ODCE puts it near pre-recession levels, which was 21.1% as of December 31, 2007. Leverage falls as a property's value appreciates or the owner is paying down the debt, says Havsy.
As leverage has dropped, occupancy has continued to rise for properties in the ODCE Index. Pre-recession occupancy levels were at 91.5% as of 12/31/07. In comparison, they stood at 90.3% at the end of third quarter 2012.
There are over 60 members contributing data to the NPI, but only 18 funds in the ODCE at moment, says Havsy. There are a couple more open-end funds that are close to joining the ODCE, which usually happens every couple of years, he says. At the same time, some funds have left the index or have merged with other funds, while others change investment strategies in a way that they no longer qualify.