Dynamic dealmaking: PAG sharpens its underwriting for downside protection

The Hong Kong-based manager is assuming higher cap rates, higher construction costs and longer project delays as it evaluates real estate investments.

With the rapidly changing dynamics in the global macroeconomic environment, some real estate managers are undertaking more intensive underwriting to better ensure downside protection in their investments.

Hong Kong-headquartered investment manager PAG is one such firm. Broderick Storie, PAG’s co-head of real assets, believes managers can address inflation or hedging against interest rate risk at the portfolio level.

“We have always covered our downside and we are looking for resiliency in our investments, particularly if you are looking at the circumstances that have impacted anyone who has been investing,” he says. “Some of these are unpredictable, but some of them are not.”

Jon-Paul Toppino, co-founder, executive director and president at PAG, points out the importance of considering the impact of inflation on construction costs in development and large-scale refurbishment projects when underwriting investments. “It is not just what it is today versus a year ago. It’s what it is today versus where you think it’s going to be a year or two from now,” he remarks.

Toppino: stresses the importance of factoring in construction costs when underwriting investments

Since early 2021, when supply chain disruptions and inflation concerns began to emerge, PAG’s investment committees have been scrutinizing projections for every deal, according to Storie. The firm has doubled the cost contingencies for investments involving a value-add strategy or construction work.

Toppino explains the firm has always locked in maximum price contracts so that it will not face huge delays or overruns even if construction costs go up. Although the firm has not been affected by any significant delays with its development or refurbishment projects so far, it is assuming an approximately six-month delay on all such projects. “You have to make sure that, with a 10 to 20 percent buffer into what you think it is going to cost, that your deal still works,” he notes.

Storie: believes managers can address inflation or hedging against interest rate risk at the portfolio level

Additionally, the firm is factoring in higher exit cap rates on deals in most of the Asian markets, which have yet to rise significantly outside of Australia and New Zealand. “If you’re driving your returns by 80 to 85 percent or even 90 percent financing in a market where that is not available, that is going to change some of those underwriting dynamics and what some of those active assumptions look like,” Toppino says.

PAG’s intensive underwriting makes the firm more comfortable with deploying capital at this time because it has a better understanding of the potential risks that lie ahead. Closed in 2020, the firm’s $2.75 billion flagship opportunistic fund Secured Capital Real Estate Partners VII is understood to have been 50 percent deployed. PAG is expected to deploy up to 80 percent of the fund’s capital by the end of the year.

The firm’s highest-conviction sector themes are in office and digital real estate. Unlike in the West, there has been no structural change in office demand in Asia, while the latter sector is one where PAG sees long-term growth, Storie explains.