Early in 2023, the private real estate industry is bracing itself for a wave of write-downs. Over the past year, listed real estate investment trusts traded downwards amid rapid central bank rate increases and rising bond yields. Private funds, on the other hand, have largely remained defiant on their valuations, widening the bid-ask spread. But with cap rates beginning to expand and sustained rate pressure looking likely through 2024, industry practitioners widely expect Q4 2022 appraisals to be the straw that breaks the camel’s back.
On December 1, in a valuations discussion hosted by US commercial real estate data provider NCREIF, the panelists charted a landscape of era-defining rate pressure. Indeed, data compiled by real estate solutions provider SitusAMC showed cap rates for US core real estate funds, as measured by NCREIF’s Open End Diversified Core Equity Index, inverting to the 10-year Treasury in Q3 2022 for the first time since 1992.
According to research and advisory firm Green Street, its Commercial Property Price Index declined by 13 percent in 2022. Property values are expected to fall during periods of high economic uncertainty, as they did during the global financial crisis and at the height of the covid pandemic. But it is the speed at which values have appreciated since Q3 2020 when rates were low, exacerbated by the speed at which the rate environment has inverted, that has positioned them for a potentially dramatic fall.
PERE spoke with Brian Velky – who moderated the webinar and is managing director and head of real estate valuation services at SitusAMC, and a member of NCREIF’s Valuation Committee – to understand how the valuations environment has evolved in the weeks since.
“I think there were certainly more value declines post-webinar than we were seeing take place in the quarter leading up to that webinar, with valuation firms recognizing what was happening in the current market environment,” he said.
From a total returns perspective, Velky has seen cap rates expand by at least 25 basis points over the fourth quarter, driving values down by 4-6 percent on average for core real estate funds. In the most recent data released by NCREIF, net total returns for the NFI-Daily Priced Index were down 2.96 percent in December.
“The write-downs will not be consistent across all asset classes”
Cushman & Wakefield
“We saw pretty substantial changes between a draft and final process because of the things that were taking place throughout the quarter,” said Velky. “For an appraisal that might have been received in November, oftentimes it ended up typically worse – and in some cases materially worse – than that draft when it actually finalized for the quarter.”
Alongside upward pressure on required returns, the increase in interest rates and pressure from rising 10-year Treasury yields and spread expansions, Velky said the cost of debt is “certainly factoring into these valuations as well.”
Furthest to fall
While the consensus is that values have begun to turn, the range and severity of write-downs will vary across sectors. During NCREIF’s webinar, respondents were polled on the change in value they expected to see in Q4 2022. More than half said they expected to see a decline between 3 and 6 percent in the ODCE index for the industrial and residential sectors. For office, most respondents were split evenly between an expected decline of 3-6 percent and 6-9 percent.
“Residential and industrial still have strong fundamentals, but it doesn’t mean that they are not going to have substantial rate pressure on them from a rate of return perspective,” said Velky. “And then you have office, which is really challenged from both sides with the rate of returns, as well as the fundamentals.”
Paula Thoreen, executive managing director of brokerage and advisory firm Cushman & Wakefield, and chair of NCREIF’s Valuation Committee, also expects office to be among the most affected asset types. “The write-downs will not be consistent across all asset classes,” she told PERE.
“While we think write-downs will be widespread, they will vary by asset type and location. For example, although retail in general may decline, necessity-type retail, such as grocery/drugstore anchored, may be far less affected.”
Beginning to thaw?
For managers sitting on significant dry powder, the incoming write-downs will be encouraging. But they may have to wait a little longer to get back to the business of putting capital to work.
Velky said in an environment of price discovery and rate pressures, an investor would be more willing to serve in a lending capacity to earn a near equal return to the equity, based on current values. On that basis, he predicts transaction activity will remain limited until clarity on return expectations is sorted through. “I think that, by mid-2023, we will begin to see the price discovery sort itself out, and will begin to see transaction activity in a more normalized type of environment,” he said.
According to Thoreen: “The turning point will be when the bid-ask spread narrows to the point investors have conviction.
“Transaction activity will pick up when this happens. No one wants to catch a falling knife.”