A sharp recovery from the economic impact of the covid pandemic has been derailed by inflation, rising interest rates and the conflict in Ukraine, causing many institutional real estate investors to proceed only with the utmost caution.
In some cases, falling equity prices – the S&P 500 was down 21 percent in the first half of 2022 – have given rise to the denominator effect, where an investor with a 10 percent allocation to real estate now finds itself overweight due to a fall in the value of its equity holdings.
Real estate transactions slowed in the second quarter of 2022. Data from MSCI Real Assets shows global volumes for Q2 were flat at $280 billion, but EMEA volumes were down 26 percent and European and Asia-Pacific volumes were down 19 percent; US volumes were up 26 percent.
Inflation is close to reaching double-digit territory in the US and EU, and already in it in the UK, while central banks in nations including South Korea, the UK and the US have introduced sharp interest rate hikes. The US Federal Reserve has raised the federal funds rate to a target range of 2.25-2.5 percent in a series of increases this year, and some commentators expect rates to hit 4 percent by year end.
Such macroeconomic conditions tend to drive market dislocation and mispricing in real estate, which may offer opportunities for real estate investors to acquire assets from distressed situations, or at more sustainable prices.
“Everyone now is in price discovery mode; it is very hard to know what is under- or over-priced”
Brett Robson, global head of real estate at Macquarie Asset Management, says the principal dislocation that is visible at the moment is when comparing private and public real estate markets. “Real estate investment trusts are trading at relatively high discounts to net asset value, even where we view NAV as reasonably supportable. That is the biggest thing we’re seeing, rather than portfolio-level dislocation.
“Clearly, we expect there to be public-to-private opportunities as a result, but that is really the domain of the more sophisticated and experienced investors, just because of the scale and complexity of those transactions.”
Doug Cain, head of unlisted property at Future Fund, Australia’s sovereign wealth fund, believes “the main dislocation opportunity is the public market versus private.” He adds: “In the private market space we haven’t actually seen material dislocation as of yet, but we think it’s coming, and rising interest rates should accentuate it.”
Some dislocation is expected in private real estate, agrees Jelte Bakker, global head of opportunistic real estate at Macquarie. “In real estate, dislocation is normally driven by a fall away in investor demand and debt financing.
On the equity side, as soon as there’s a level of uncertainty around the outlook, we generally see most institutional investors choosing to pause, to review their existing portfolio, and look at what is needed to make them comfortable in a changing environment.”
On the debt financing side, we are seeing a number of banks pull back as well. This has already opened a window to provide debt-style instruments as an attractive alternative to equity investment, as they offer downside protection and, generally, shorter hold periods. “Something investors are already quite actively pursuing is investing at a different point in the capital stack,” says Bakker. “We don’t expect a dislocation anywhere near the scale of the global financial crisis, when liquidity completely dried up. But, at the same time, we expect values will come back to a more sustainable level.”
Pricing the risks
At the time of writing, the global real estate markets are characterized by uncertainty more than anything else. “Everyone now is in price discovery mode; it is very hard to know what is under- or over-priced,” says Carole Guérin, managing director, head of Americas at PSP Investments, a Canadian pension fund with $31.1 billion of real estate assets under management.
“Macroeconomic volatility has brought challenges,” adds Guérin. “It is harder to finance real estate, especially in retail and office. Some lenders are pulling back and the CMBS market in the US is stalling. The expression ‘don’t try to catch a falling knife’ has never been so relevant.”
Prime assets tend to be a beneficiary of market uncertainty as their cashflows are considered more secure during a downturn of occupier demand. This could already be seen in global office markets as a reaction to the pandemic and is being intensified by current economic and political events. For example, MSCI Real Assets describes the UK market – especially large prime London offices – as a “bright spot” in Europe.
“As investors become more risk averse or price risks, prime often holds pretty well, but secondary yields move out quite quickly, as the cashflow risks attached to those sectors, assets or subsectors of real estate are higher,” says Robson. “That applies to locations as well as assets: as proven locations, gateway cities tend to be more resilient.”
These secondary assets may be another source of opportunity. This is especially true in the office segment, particularly where the investor can add value. “Adding value by making assets more sustainable, by adding the right kind of collaborative and wellness spaces and features, for example, enables a stranded office asset to become office space of choice for both investors and tenants,” adds Robson.
Development projects worldwide are also vulnerable to inflation, says Guérin: “Rental rate increases are not keeping pace with increasing construction costs, so I think we will see some projects cancelled or put on hold.”
Bakker agrees: “We expect development activity to pull back a little. If you look at some markets, say US logistics, where land values have in some cases almost doubled over the last few years on the back of very strong rental growth, we are seeing some pullback from quite a heated market, particularly from the more highly leveraged investors.”
Bakker suggests there will be opportunities, especially in more resilient sectors, as a result. “Despite rising construction costs, build-to-rent in Australia, for example, continues to stack up in our view, as rents are growing very strongly on the back of a shortage of housing supply and reducing house purchase affordability.”
Robson adds: “We continue to very selectively proceed with development activity, particularly in sectors that have good long-term structural demand drivers like logistics or rental housing. We do expect some attractive land acquisition opportunities to emerge over the coming period, as it is generally the first to reprice. It will be a good time for real estate investors to have available capital to deploy should such opportunities arise.”
Rising inflation is also affecting how investors think about long-term rental streams, which may not be as defensive as shorter leases that can better keep pace. “Certain assets that until recently were valued highly because of the locked-in rental income stream are becoming less attractive,” says Robson.
“Until four or five months ago, locking in a 20-year lease to Amazon in logistics would give you a premium for that asset, but that premium is gone and instead may be a discount depending on the lease rental escalation structure.”
Better to be prepared
Many real estate investors find themselves in a wait-and-see period. Guérin says: “There will be opportunities, but we are very cautious for the moment; it is a time for investors to be patient and to be very prudent in investment assumptions.
“Our portfolio’s convictions are primarily driven by long-term trends, but we continue to adjust the portfolio and sell assets, even in favored sectors, which have reached completion of their business plan. We also still have capacity and the agility to react to market opportunities as they arise.”
Future Fund’s Cain concurs: “I think now is a moment for positioning yourself to take advantage of those dislocation opportunities that should come about, which could mean forming relationships or partnerships that could take advantage of those opportunities in the near term.
“You need to be nimble to take these opportunities when they arise and that means being prepared. We’re in a position where we can wait for the right opportunity, so we’re being cautious at the moment given the current market volatility.”
Over the last decade, the main themes for opportunistic real estate investing have been cap-rate compression, some rental growth and high gearing at low interest rates. That opportunity is over for the moment, says Bakker. “We believe we are well positioned for this environment as our opportunistic investment strategy is very much bottom up, with real estate returns augmented by the return generated out of platform investments. In this environment we will see a greater focus on replacement cost and the prospect of fundamental value.”
Where will the opportunity to take advantage of mispricing be most present?
Jelte Bakker, Macquarie Asset Management:
“I think the US is probably the best market because of how liquid and deep the market is. With capital ready to deploy, our experience is that in the US you will find vendors willing to meet the market. We expect there to be opportunities in Europe as well, but it is harder to see the growth.”
Doug Cain, Future Fund:
“There are generally more opportunities in developed markets simply because those markets are larger; however, there might well be stronger dislocation-driven opportunities in developing markets, although they will be much harder work to exploit.”
Carole Guérin, PSP Investments:
“Developing markets offer opportunities, but also come with much higher risks stemming from a lack of liquidity, political and regulatory risk, and a lack of depth in the occupier market.”