In the late 1990s, Donald Sull, now senior lecturer at the MIT Sloan School of Management, set out to research why successful companies often fail to respond effectively to significant changes in their environment.
Business leaders typically respond to a significant shift in their environment by trying to do more of what has worked previously. Sull called this tendency to follow established behavior patterns “active inertia.”
Understanding the risk of active inertia is critical for real estate investment managers today, given the dramatic change in the availability of liquidity over the past year.
The end of an era
From the global financial crisis until the start of this year, central bank policies were stimulative, inflationary fears were dormant and the economic outlook was positive.
High income returns were hard to find in a low interest rate environment. Many government bond yields were negative, and corporate bond yield spreads were modest.
To achieve return objectives, investors had to take on more risk. But most were more than willing to do so. Investor sentiment was optimistic, capital was plentiful, financing was readily available, and markets became conditioned to believe that central banks would maintain a favorable environment for higher-risk assets.
Asset allocators increased their exposure to private markets, holding more illiquid assets in return for higher returns. Consequently, capital flowed into every part of real estate, with investors willing to take exposure to operational and development risk, including in non-traditional sectors.
Shift towards relative capital scarcity
Since the start of 2022, the investment environment has changed fundamentally. Fighting a surge in inflation, central banks worldwide moved towards markedly tighter monetary policy.
With this change, investment markets entered a new era. Liquidity and optimism tend to dry up simultaneously, so a more cautious sentiment has taken hold.
Tighter financial conditions mean many of the tailwinds that have driven strong real estate performance have gone. So ongoing downward pressure on values will continue.
Entering 2023, the clients of real estate investment managers have new objectives and different attitudes. In part, this is due to broader changes in investment markets. But it also reflects that psychology changes once losses are incurred.
Clients’ changing risk appetites
With higher yields in fixed income, asset allocators are under less pressure to allocate to private markets. As investors become more wary of illiquidity in a downturn, many will hesitate to commit capital to real estate. So, raising capital will be a challenge, but one that can be met with adaptation to clients’ changing risk appetites.
In the latest paradigm shift among investors, clients will be more risk-averse and more focused on capital preservation. While the market may provide enticing entry points for opportunistic investors, others may look for more defensive products. Sectors less sensitive to economic growth and driven by secular trends, such as affordable housing, may meet new client needs well.
When liquidity was abundant and the asset class delivering solid returns, real estate investment managers had to demonstrate they had access to dealflow and could deploy rapidly at scale. Clients were willing to pay to gain real estate market exposure efficiently.
Now that capital is relatively scarce, clients will not be looking for market exposure, but rather at exposure to the most resilient assets.
Managers must demonstrate that they have expert strategic thinking and a robust investment process to filter out all but the very best opportunities consistently.
Fighting active inertia
In recent years, many real estate investment managers have delivered strong returns to clients and achieved significant growth. But as Sull says, “success breeds active inertia, and active inertia breeds failure.” It takes a lot of courage to give up winning strategies. But that is what leaders should do when there has been an environmental shift like we have seen in 2022.
Real estate investment managers must rethink how to serve clients best when they are more cautious, uncertain and risk-averse. And if their organization’s strengths do not meet these new client requirements, it is time to build new muscle.