Creating value amid disruption in real estate

Many commercial real estate investors endured a wretched 2023. Inflation and spiking interest rates saw rapid shifts in borrowing and build costs, valuations and asking rents.

Value-add dealmaking, the lifeblood of many funds, dried up as investors halted new commitments and managers grappled with the difficulty of underwriting transactions amid the rapidly unfolding situation. The headwinds buffeted the sector to such an extent that the global volume of transactions recorded by MSCI plummeted 48 percent from $1.18 trillion in 2022 to just $615 billion last year, marking the lowest level since 2012.

Rapid interest rate increases around the world marked a violent break from the smoothly rising market of the previous decade. These combined with underlying property sector trends that had been accelerating the transformation of real estate markets since the pandemic to create a whirlwind of disruption.

Now, as interest rates stabilize, investors and managers are surveying a radically altered market landscape for pockets of opportunity where they can create value amid the turmoil.

Incredibly volatile

Since 2020, real estate fundamentals and capital markets have been upended, observes Paul White, senior managing director at Hines and manager of its Hines European Real Estate Partners series of value-add funds. “Everything on both sides of the calculus has changed dramatically. That is scary, and it has left casualties on the battlefield. But as a value-add investor, it also generates opportunities to redirect real estate toward emerging patterns of demand.”

Ben Brady, a partner at Boston-headquartered manager Bain Capital, notes that the economic outlook is currently “incredibly volatile” with indicators pointing to a soft landing one day and the risk of a recession the next.

“There is a wide fan of outcomes, so alpha creation is at a premium,” Brady argues. “One of the biggest risks a manager could take right now is to assume that in a recovery vintage fund, merely acquiring assets at a low basis will allow you to generate value-add type returns. A lot of the assets that are cheap are cheap for a reason.”

While interest rates appear to have peaked, debt finance will remain comparatively expensive and scarce for years to come, says Julie Ingersoll, chief investment officer for Americas direct real estate strategies at CBRE Investment Management. As assets come up for refinancing and owners struggle to access equity capital to top up the shortfall that a withdrawal of lenders has left within the capital stack, that will generate opportunities for value-add buyers to step in, she argues. Meanwhile, sellers are pricing assets more realistically.

“An attractive strategy right now is to find opportunities to buy well-designed and located buildings from sellers that absolutely have to trade in this environment”

Matt Brodnik
EQT Exeter

“Since the last adjustment in Q4 2023, the book value of assets mirrors the level that the market is willing to trade at,” explains Ingersoll.

In the absence of cheap money and cap rate compression, successful managers will be those that can grow their net operating income. “This is the moment when a lot of your return is truly going to come from adding value to your assets. The big opportunity today is to buy in at a higher yield than we have historically seen, and really grow that yield the old-fashioned way, via leasing and repositioning.”

Sector specifics

In today’s market, there is no rising tide that can be relied upon to raise all boats, so selecting sectors and markets with growth potential is critical.

Brady says that understanding trends such as ageing populations, e-commerce, work-from-home, biotechnology innovation and housing growth in the US Sun Belt constitutes the “table stakes” before an investor can even begin seeking opportunities. “We are focused on what customers want and need from real estate today and into the future. That represents a narrowing of the opportunity set,” he says.

“The big opportunity today is to buy in at a higher yield than we have  historically seen, and really grow that yield the old-fashioned way, via leasing and repositioning”

Julie Ingersoll
CBRE IM

White adds: “In the context of a dramatic and comprehensive shift in occupier fundamental demand, being very clear minded about where you see sustainable demand that is growing and exceeding the pace that supply can meet is more important than it has ever been.” He explains that fulfilment logistics is an example of an asset class that meets those criteria.

Matt Brodnik, chief investment officer for EQT Exeter’s North American industrial real estate investment platform, says the sector remains near the top of many value-add investors’ wish-lists. Buyers of core logistics are less active, which has removed the impetus behind the rapid cap rate compression that characterized the market’s zenith.

“In 2020 to 2021, there was a lot more development, and there was less vacancy being bought, because vacant buildings were trading at virtually the same price as leased buildings,” notes Brodnik. “That has changed dramatically. Vacancy can be bought below replacement cost in a lot of places. An attractive strategy right now is to find opportunities to buy well-designed and located buildings from sellers that absolutely have to trade in this environment because of things like loan maturities or impatient equity partners.”

Because development has ground to a halt, land is also cheaper, he adds, allowing industrial platforms to prepare for the next cycle of development at a lower cost basis. Brodnik predicts that the buying opportunity will not last, however. “We hear about folks raising funds to invest in this environment. My perspective is they are almost too late.”

Such is the enduring popularity of the sector, that yields are already beginning to compress for the most sought-after assets, says Ingersoll. Warehouses with leases that will expire within the next three or four years are in demand because of the potential to re-let them imminently at much higher rents. But with most potential buyers looking at the same opportunities, pricing can be much more attractive for buildings that do not fit precisely that profile, for example those with slightly longer unexpired terms.

While concerns have been voiced about oversupply in the US multifamily housing market, some living sector assets still offer attractive characteristics to value-add buyers.

Wes Fuller, chief investment officer at residential platform Greystar, highlights the European multifamily rental market, where supply remains constrained, as well as student housing and purpose-built, single-family rented residential.

He argues that while universities have seen rising enrolments both in the US and Europe, supply has failed to keep pace. Meanwhile, because of rising mortgage rates, home ownership has become more expensive in comparison with renting.

“As the current generation gets to their mid-thirties, we will see a dramatic increase in demand for larger format, single-family homes, and we believe a large percentage of those will be renters versus homeowners,” Fuller predicts.

“There is a wide fan of outcomes, so alpha creation is at a premium”

Ben Brady
Bain Capital

Creating value-add returns by buying and refurbishing older US multifamily assets is more challenging in current market conditions, however. Fuller says: “We are a bit more cautious today about investing capex to generate a rental premium. That investment costs more given the higher cost of leverage and inflation. And then we need to be judicious about whether our residents can afford those rent premiums, and that those assets don’t compete with some of the newly built supply.”

Separate strategies

Much has been written about the opportunity for pursuing brown-to-green strategies that refresh outdated office stock. But caution remains about the prospects for all but the very best assets, particularly in the US.

Ingersoll warns: “AI could be the second shoe to drop for office demand in the US. It could take over 25 percent of repetitive task office jobs. We like responsive office, life science, medical office, but the traditional commoditized office, that’s going to be a long, very tough slog. And we don’t know when liquidity will come back, even for the best of the best. So, for a value-add investor, the critical point is, what’s your exit?”

Hines’s White argues that the picture is different in Europe, where office attendance is higher and the environment in city centers has not deteriorated in the same way as in some urban areas of the US.

Meanwhile, the supply of sustainable, next-generation office buildings in European gateway cities is “extremely low.” Hines also remains a believer in “rifle-shot” investing in the best US office buildings, White adds.

There is also the prospect of a small-scale resurgence in value-add retail investing thanks to a combination of almost total lack of development, historic low pricing, rock-bottom rents and a tenant base that has been whittled down to the most resilient operators.

“We may have a fairly short window of time when we can take advantage of a generational handover of ownership of some of the best retail assets around Europe”

Paul White
Hines

“We may have a fairly short window of time when we can take advantage of a generational handover of ownership of some of the best retail assets around Europe,” says White.

“Last year we did our first two retail deals since 2016 in our value-add fund,” says Ingersoll. “The great thing about them is rents haven’t been marked to market in a decade.”

Investors of all kinds are, by their nature, optimistic, conditioned to sniff out opportunity even in the darkest times. But the turmoil of recent years has not been forgotten.

“The concern on the mind of every investor in their underwriting and capital allocations is still the potential for changes in the macro environment that are out of our control,” says Fuller. “Until there is certainty about monetary policy, we will still see a risk premium attached to every investment.”

Value-add fundraising could recover in 2024

Appetite to take advantage of market dislocation could lead to an improved outlook for capital formation, say managers.

For private real estate fundraising, 2023 was a bleak year. Capital formation for value-add funds was no exception, with $42.4 billion raised, compared with $57.87 billion the previous year and $71.69 billion in 2021. Through the first quarter of 2024, just $8.3 billion has been raised, according to PERE data.

“From our own experience, and what I have heard from our peers and competitors, fundraising is extremely hard,” says Hines’s Paul White.

While the latest edition of the manager’s Hines European Real Estate Partners series of funds exceeded its target of €1.5 billion by around €100 million when it closed in November 2023, the process involved a higher ratio of meetings with investors to commitments secured than previously, he notes.

“We spend a lot of time trying to persuade investors that their instincts may be wrong at these moments. If they don’t commit in the darkest hour, then they may, in retrospect, realize that they missed the period of greatest opportunity in the cycle. The paradox for a lot of institutional investors is that it is difficult to double down into a market where they may be feeling pain in their existing portfolio.”

However, following a “wait and see” year in 2023 that saw a dramatic decrease in both capital formation and transaction volume for almost all private real estate managers, 2024 holds out the promise of a material increase in commitments to the sector from institutional investors, says Greystar’s Wes Fuller.

Many of them will be keen to deploy through value-add strategies, he predicts. “Investors are very focused on taking advantage of stress or distress. A common theme is absolute return and how they are going to create that.”

Value-add investing targeted on accessing “generational” investment opportunities at the market’s low point is “front of mind” for investors, says CBRE IM’s Julie Ingersoll. But lack of liquidity is likely to limit how much capital they can deploy.

“The check sizes are a little smaller,” Ingersoll says. “What would have been a $200 million check is now $150 million. What would have been $100 million is now $75 million. That is because some investors are still struggling to either recycle their legacy value-add capital because disposals are taking a little bit longer, or they are finding it difficult to get capital out of their core strategies.”