It has been a top-of-mind question for many private real estate participants in this rising rate environment: How do you calculate an exit yield today?
Francesca Boucard, head of research and strategy at Swiss Life Asset Managers, the asset management arm of Swiss Life, was asked this question by an audience member during the opening panel of the Women in Real Estate Forum, part of PEI Group’s Women in Private Markets Summit in London, last week. She responded: “That is actually the biggest challenge we have at the moment.” For Swiss Life, whose real estate investments are focused on Europe, determining an exit yield requires looking at the historical spread for each country in the region.
A key question has been whether to include yields from the last two to three years in the analysis. “I tend to say no, because the impact that demand from investors had on the overall yields and exit yields as well, it was crazy,” Boucard said.
Although the expectation is for exit yields to be higher in the future, it is difficult to quantify that increase on an overall basis, she added. Instead, each transaction needs to be analyzed individually. “So, we don’t have an overall view on exit yields.”
It is also not possible to have a standardized approach in analyzing yields, given the variation by sector and market, Boucard added. “Look at the UK at the moment with the gilts where they are and where they used to be, and then also look at Germany being at a completely different stage when it comes to the economy,” she explained.
Meanwhile, the logistics sector has seen dramatic yield compression over the past two to three years, while retail has already largely repriced and therefore is not as badly impacted as the other sectors are in terms of current or future yield expansion, Boucard said.
‘Still open for debate’
The topic of predicting exit cap rates was also raised during the opening session at the PERE America Summit 2022, held last month in New York. Aaron Jodka, director of research for US capital markets at Toronto-based commercial real estate brokerage Colliers, also expected cap rates to move up, given they are currently below the yields for BBB bonds. “At what level is still open for debate, but somewhere in [the] 100-150 basis points range is what we’ve already seen happen,” he said. “The experience that we’re seeing on the ground is very different than the transactional data given that lags. And the assets that are trading tend to be better, keeping cap rates lower. So, we are seeing a big disconnect there.”
Also speaking at PERE America, Christopher Merrill, chairman and chief executive at Chicago-based manager Harrison Street, said it was prudent to consider whether an asset would benefit or be hurt by a rise in exit cap rates. “I think you have to go through these sensitivities and these scenarios, and say, ‘let’s play this out’”, he said. “If exit cap rates go up 100 basis points, what does that mean? That means that we’re still in an inflationary time period. If it doesn’t, we’ve come down. I think you have to look at your asset classes and think through, is this the right risk-adjusted return in an inflationary environment?”
He also found it “mind boggling” that the funds in the Open-End Diversified Core Equity index continue to hold exit cap rates: “It’s going to be pretty interesting to see what happens when they start to take some of their medicine in the valuation metrics.”
However, Richard Barkham, global chief economist at Dallas-based commercial real estate services firm CBRE, believed that even with upward pressure on exit cap rates, “there are some good reasons to hold those exit cap rates.” That largely has to do with where long-term interest rates – composed of both inflation expectations and the real interest rate – are expected to end up.
While the US Federal Reserve works to get inflation expectations down over the next two to three years, he does not believe the real estate interest rate will necessarily rise over the next five years. So “there’s no reason why bond rates are not going to go back as low as they were in the covid crisis,” Barkham said. “If you take the five years from 2016 through 2021, the average long term bond rate that you get over that period would be a relatively good benchmark in five years’ time with which to price your assets. You have to adjust the spread according to fundamentals, but we wouldn’t necessarily think there’s a real reason to panic about exit cap rates, given the long-term fundamentals.”