COMMENT: A call for caution

Attendees of PERE’s inaugural US Investors Council expressed concern over the late stage of the current real estate recovery and how to cope with all the capital pouring into the sector. 

Who says the private equity real estate industry doesn’t learn its lessons from the past? If the conclusions reached by the participants of PERE’s inaugural US Investors Council are any indication, they are not only aware of those lessons but actively thinking about how to ensure a different outcome this time around.

On Wednesday, some 40 men and women from a wide cross-section of fund managers and institutional investors met at a retreat in New York’s Hudson Valley to discuss the current state of the real estate market in the US as well as that around the globe. The consensus opinion from the meeting was that we are getting late into the recovery cycle in the US – and even much of Europe – and that the weight of capital chasing the sector, particularly that seeking higher returns, could be in for disappointment fairly soon. As one participant put it: “The winds that once were at our back are now blowing in our face.”

At the start of the meeting, participants were asked to express their concerns in a few words or less, and their responses were quite telling. Among the choice phrases: weight of capital, monetary policy, pricing and underwriting, misalignment of interest, style drift, unfunded liability, setting expectations and reverting to the mean. Indeed, these pointed to a clear understanding of the risks and challenges that lie ahead.

Of course, not all risks can be managed. Of those that can – namely, pricing and underwriting, style drift and setting expectations – the trick is to not chase the market. For example, if you have a certain return expectation from your investments, it does not pay to aggressively bid on a deal to the point that you will not be able to achieve that return. Moreover, don’t make matters worse by underwriting rent growth assumptions that are overly optimistic. Being conservative on both front may save you from a world of heartache in the not-so-distant future.

Accordingly, it is equally important to set expectations for investors. Don’t promise returns that are not achievable by the investment strategy you are pursuing. If participants of the Investor Council are any indication, institutional investors are much more realistic about the return expectations of their real estate portfolios today anyway. It is better to under-promise and over-deliver than vice versa.

Lastly, regarding style drift, there is a temptation to pursue higher-yielding strategies and markets when returns for investments within your primary focus area begin to compress. However, a maturing cycle is the wrong time to pursue unfamiliar strategies and markets as that is when mistakes tend to happen. In a maturing cycle, it is best to “sticking to your knitting,” which is precisely what a number of firms are advocating with their latest fundraising.

No one is quite sure when exactly the real estate markets will reach their tipping point and slide into decline, nor is anyone sure about how severe that decline may be this time around. What is certain is that the recovery cycle is getting mature in a number of markets around the global and there will be some sort of correction. The best advice offered by those at the Investor Council: know yourself and stay disciplined.