Institutional capital flows into real estate gained momentum in H2 2021, and that should continue in 2022. Real estate is still gaining favor as an asset class in institutional portfolios. It provides diversification benefits and attractive returns relative to other private assets with comparable levels of risk. The sector continues to offer potential for inflation hedging, while providing current income at a premium over market interest rates. With those likely anchored in the low single digits, cap rates should remain low across major property types amid healthy capital flows.
Here are five reasons we believe capital flows will rise next year:
Strong performance and bullish sentiment: After a sluggish 2020, investment returns bounced back strongly in 2021, driven by a combination of recovering fundamentals, low borrowing costs and ample liquidity. As of Q3 2021, the NCREIF Property Index was eyeing an annualized unleveraged return of 12.1 percent. Multifamily and industrial sectors led the way, returning 13.4 percent and 32.4 percent respectively, as secular demand drivers continued to propel those sectors higher. With bullish attitudes continuing, we expect robust institutional capital flows into real estate throughout 2022.
Low correlations to other asset classes: Real estate’s diversification benefits are also driving renewed interest in the asset class. US core property exhibits low correlations of 0.0 to 0.3 to other alternatives such as hedge funds, venture capital, private equity, private debt and even other hard assets such as timber and infrastructure. Uniquely among alternatives, real estate is slightly negatively correlated to US equities, providing similar diversification advantages as bonds but without sacrificing upside potential. Consequently, including real estate within institutional portfolios has the potential to reduce volatility and overall risk.
High levels of current income in a low-interest-rate environment: Real estate’s low correlations are largely due to its current income component, which provides another advantage for institutional investors in a low-interest-rate environment. Real estate yields tend to exceed those offered by both public equities and bonds. Low interest rates also provide more opportunities to achieve positive leverage on stabilized assets. And real estate’s cashflows tend to grow over time as rents increase. With market interest rates likely to remain low for the foreseeable future, capital flows into real estate should remain healthy as investors hunt for yield.
Real estate as a potential inflation hedge: Inflation worries are another reason we believe capital flows into real estate will remain healthy in 2022. US headline CPI touched a 40-year high of 6.8 percent in November. Rents tend to rise with inflation, especially in property types with shorter-term leases such as multifamily. Inflation also tends to increase the values of the real estate itself, while slowly diminishing the burden of in-place debt. The ability to borrow at today’s low interest rates despite elevated inflation is, therefore, a rare window of opportunity for investors seeking an inflation hedge.
Capital market appetite for stabilized core assets: With more capital chasing real estate assets, cap rates have fallen to fresh lows, with stabilized properties in favored asset classes commanding cap rates as low as 3 to 4 percent. Cap rates at these levels present both challenges and opportunities for investors. Price convexity is steeper with cap rates in the low-to-mid single digits, resulting in more dramatic price swings if cap rates change. For example, assets priced at a 3 percent cap rate would decline in value by 33 percent if rates widened by just 100 basis points. But upside scenarios are similarly magnified, and value-add and development strategies are potentially more lucrative. With capital markets so hungry for core real estate, managers that can deliver stabilized assets at yield premiums to market cap rates should be well-rewarded.
Given real estate’s diversification benefits, stable income stream and strong return potential, we expect average institutional investor allocations will approach 11 percent in 2022. In addition to rising allocations, we expect other catalysts will push real estate capital flows higher over the next year. Slow capital deployment during the pandemic has left many investors and managers playing catch up: investment volumes touched a 16-year high in Q3 2021 according to CBRE. The ‘denominator effect’ is also providing a tailwind, as strong performance by public markets has caused many institutions to be under-allocated to real estate versus target. As a result of all these factors, we expect real estate capital flows to reclaim pre-pandemic highs in 2022.