Deep Dive: When will the lights go back on for real estate dealmaking?

Investors are still in the dark over real estate values, but there are several reasons why the industry may be back in business before long.

‘If you’re going to buy tomorrow at the new price, you’re a winner.” Those were the resounding words from Howard Lutnick, chairman and chief executive officer at US financial services company Cantor Fitzgerald, discussing the current period of price discovery on a real estate-themed panel at the World Economic Forum Annual Meeting in Davos in January. “Entry point is always what matters,” he said.

As in any downturn, there is money to be made for those with the appropriate appetite for risk. But determining when today tips over into tomorrow in Lutnick’s assessment is, quite literally in this case, the billion-dollar question.

Without any stabilization in interest rates, underwriting cap rates remains an uncertain task, casting doubt over the value of institution-owned property. Add to that the shrinking availability of debt, the need for many investors to rebalance allocations due to the denominator effect, and the discrepancies between listed and unlisted real estate prices, and the bid-ask spread between buyers and sellers has had plenty of reasons to grow.

As a result, dealflow has fallen off a cliff. In the Americas, data from broker JLL shows direct real estate investment volume in Q4 2022 was down 61 percent year-on-year to $120 billion.

In Europe, where the fallout from Russia’s war with Ukraine and the energy supply crisis kickstarted an earlier pricing reset, the drop-off in investment was just as stark. JLL shows the total value of real estate deals declined in each quarter of last year, with the $52 billion transacted in Q4 the lowest fourth-quarter total for the region since 2011, when the world was reeling from the global financial crisis, and down 58 percent from Q4 2021.

The picture in Asia-Pacific is more varied, given the range of economic trajectories. But, overall, Q4 deal volume was down 40 percent year-on-year at $31 billion, JLL reports.

“It’s just very painful for a short period of time,” was how Lutnick put it. But how long a ‘short period’ might be is a question without a clear answer currently. To find a consensus, PERE spoke with a range of managers, investors and appraisers across the globe during the first quarter of 2023.

Seeing is believing

There are several key components to returning to a more normalized level of transaction activity. One is sentiment.

Valuers PERE spoke with were keen to emphasize a key difference in investor attitudes compared with the aftermath of the GFC. “I would say that there is more confidence around a recovery within a relatively short space of time that we didn’t have in the GFC,” says Mark Wynne-Smith, head of JLL’s global valuation advisory platform. Despite the denominator effect, investors are still talking about maintaining an allocation to real estate. “I don’t think you would have had the same conversation with an investor in 2010.”

That confidence in a quick recovery comes partly from the resilience of the US industrial and apartment sectors, where net operating income growth has remained strong, according to NCREIF data compiled by real estate finance services and technology provider SitusAMC. This is mitigating the impact of rising debt costs on cap rates and helping asset owners to accept pricing adjustments. The outlook for office, by contrast, is significantly more complex.

When plotting where prices may land, all eyes will be on markets falling the fastest. Contrary to previous downturns, however, whereby other geographies have generally looked to the US for clues, MSCI data shows the UK is ahead of other global markets in the pricing reset. In December 2022, the MSCI UK Quarterly Property Index slid to -11.9 percent, its lowest figure since 2008. Jonathan Kendrick, senior director of SitusAMC’s valuations business in Europe and Asia-Pacific, says UK values may be falling the fastest, but sentiment among asset owners is holding up well: “There is a real thought process of the quicker prices correct and we can get back to a normal operating market with a sufficient number of transactions occurring, the quicker that recovery can come.”

“Sellers need to realize and accept the new paradigm that we’re in”

Justin Curlow

Kendrick thinks this should translate fairly quickly into deal volumes recovering in some sectors: “I’m hearing appetite for the residential and industrial sectors is back again. Later in the year, we could start to see those transaction levels improve in the UK, but they might be a bit more delayed, by perhaps another quarter, in Europe.”

In its Europe Real Estate Strategic Outlook published in January, German asset manager DWS said it believes “the full extent of the price correction should be over by the middle of this year.” Based on a total expected capital value loss of 15 to 20 percent, DWS forecasts that approximately four-fifths of this loss has already occurred and predicts the market will begin to recover during the second half of the year.

In the US, however, values should take longer to bottom out. “The UK and Europe are a little ahead of the curve in terms of capturing some of the rate movement in their valuations versus some of the rate movement in the US,” says Brian Velky, managing director and head of real estate valuation services at SitusAMC. “That’s yet to be fully reflected in some of the valuations, and why you’re going to likely see additional declines throughout at least the first half of the year for assets in the US.”

The NFI-ODCE index recorded a total return of -4.97 percent in Q4 2022, down from 0.52 percent in the previous quarter and marking the largest decline since Q4 2008.

Swift response

Although values have further to fall, the pace of the repricing thus far is quicker than many anticipated. According to Wynne-Smith, the combination of high inflation and a rapid increase in base rates has been hard to ignore. “I think what has surprised a number of institutional investors is the speed with which valuers have really taken on board the changing market conditions because, historically, there’s been a sort of slow and steady decline,” he says.

“We’re a very big believer that listed is a leading indicator for private valuations”

Rich Hill
Cohen & Steers

This sentiment is shared by Paula Thoreen, executive managing director of brokerage and advisory firm Cushman & Wakefield, and chair of NCREIF’s Valuation Committee.

“This downturn is very different because all of the assets and their locations really matter,” she says. “You can’t broad-brush that cap rates are up 50 basis points – you really have to look at every individual deal separately. Even the owners will tell you that; while there are some great Class A office assets selling without much of a discount, there are other office assets that are selling at a 30 percent discount. I think you’re seeing the valuation side react a little faster because our clients are reaching out to us and there is better dialogue about the changing market and where we are in price discovery.”

While the swift response from valuers may be helping some investors to accept the new reality, the lack of comparable transaction data is a sticking point for others. Justin Curlow, global head of research and strategy at asset manager AXA IM Alts, the alternative investment arm of the European insurer, argues the valuation community is pricing assets inconsistently as a result.

“Some valuers may be waiting for closed transaction evidence while others are taking into consideration active bidding interest,” he says. “Each individual valuer, or each individual organization, is taking a slightly different approach today, which I think is also accelerating the timing of the revaluation cycle given this more proactive approach versus previous cycles.”

As a consequence, Curlow believes pricing sentiment is still behind the curve: “Sellers need to realize and accept the new paradigm that we’re in, in order to permit a reopening of the transaction market and close the bid-ask spread. They’re still holding on to a year ago’s pricing, and are not willing to crystallize today’s offer pricing because they feel like it’s too heavy a discount.”

Bridging the gap

Through the secondary market, managers and investors can meet in the middle over value

Transactions on the direct real estate market may have dried up in the latter half of 2022, but it was a strong year for secondaries. According to Jamie Sunday, partner and co-head of real estate secondaries at Ares Secondaries Group, transaction volume should continue to grow on both the manager and investor side over the course of this year.

“I think with the capital markets freezing up, fund sponsors in real estate are really starting to embrace the secondary market more than they have been,” says Sunday.

For a manager, setting up a continuation vehicle offers a way to hold on to strong assets until there is more clarity on pricing. “There’s going to come a point where they might just decide to do a recap at that value to lock in the return for their investors, but still maintain some optionality and upside through the continuation vehicle,” he adds.

On the investor-led side, while some need liquidity, portfolios are trading at big discounts since net asset values are still inflated. Sunday thinks this will change as values adjust further: “Something that priced to a 40 percent discount last year might price to a 15 percent discount once you get out to Q2 this year, so that will bring groups to the market that really want liquidity but can’t sell at a 40 percent discount.”

Public vs private values

In a slow and opaque market, the pain of defining value is even more acute in the context of the lag between public and private real estate investments.

According to data compiled by analytics and advisory firm Altus Group, when the FTSE NAREIT All Equity Index posted a return of -14.7 percent for Q2 2022, and the NFI-ODCE index returned 4.8 percent, the gap between public and private real estate returns grew to 19.5 percent. This was the largest gap since Q1 2020 when the pandemic rocked equity markets.

Industry professionals PERE spoke to were quick to point out that public and private assets are valued and behave differently, and so comparisons should be treated with caution. That said, Rich Hill, head of real estate strategy and research at New York-headquartered Cohen & Steers, a manager that invests in both spheres of real estate, believes private markets can glean a directional head-start from public market returns.

“There’s a lot of capital on the sidelines ready to invest, which is very different to the experience we had in the last downturn”

Adam Woodward

“We’re a very big believer that listed is a leading indicator for private valuations,” he says. “That has been the case since at least the early 1990s. Listed declines prior to private valuations declining, and it rebounds prior to private valuations rebounding. What happened in 2022 was really no different than what we’ve historically seen.”

Data from Nareit shows US equity REITs returned a total of 4.1 percent in fourth quarter 2022, closing the gap with private markets to 9.1 percent and outperforming private real estate for the first time in a year. According to Hill, “the REIT market is sending a signal to the private market that valuations do have to reset lower, but there’s a light at the end of the tunnel here, once the market figures out where NOI growth is going and gets comfortable with the new normal of where financing costs are.”

Credit where due

Financing is another pain point that buyers and sellers need to work through before dealmaking will return in earnest. The cost of debt remains in limbo with a lack of clarity on the direction of rates. Asset owners with upcoming maturities could be forced to sell if debt costs remain prohibitive when they must refinance.

According to global risk advisory and solutions firm Chatham Financial, at least $220 billion in US commercial real estate loans represented in Chatham’s database is due to mature this year. Of these loans, 54 percent have an extension option. Similarly, Paris-based manager AEW forecasts a financing gap in the UK, France and Germany of up to €51 billion through 2025.

For potential buyers, the lack of rate stability means many are waiting for prices to fall further before potential investments become financially viable. This is where non-bank lenders can step in to fill the void left by banks and help to spur more transaction activity.

According to PERE data, debt strategies accounted for 22 percent of capital raised in 2022 for real estate funds globally, their largest share since 2017. AXA IM Alts, for example, secured approximately €3.5 billion from its affiliates and third parties for real estate debt investments last year. While there is currently more opportunity to deploy this into refinancings given the slowdown in transaction activity, Curlow says the firm would also consider lending for new deals, “taking into account factors including pipeline size, underlying collateral quality and sponsor.”

As debt markets open up, more capital is expected to be made available to get deals over the line, notes Adam Woodward, head of office capital markets, Australia at real estate services and investment management company Colliers. “There’s a lot of capital on the sidelines ready to invest, which is very different to the experience we had in the last downturn with GFC, where after one or two years of the freefall, there was no capital around and there was no debt available,” he told delegates at the PERE Asia Summit. “We’re in a very different scenario now in that there’s lots of capital waiting for certainty around where interest rates will land.”

Public opportunity

As investors wait for the iron to heat up in private markets, some say the time to strike in listed real estate is now

In February, Pennsylvania-based private fund manager Argosy Real Estate Partners launched Argosy-Lionbridge Management to invest exclusively in publicly traded real estate companies. Greg Morillo, who was appointed chief investment officer of the platform, says the decision was driven by the current dislocation between the values of public stocks and private assets.

“Independent of where the private market ultimately shakes out in terms of price discovery, we see very significant opportunities today in the public markets amidst this uncertainty,” he says.

“Part of the reason why there’s so much dislocation and such a wide discrepancy between where real estate is priced in the public markets and where similar assets trade privately is because most of the investors in the space tend to be generalists or non-specialists. So they tend to react more to headline risk concerns around inflation, interest rates and sort of ‘sell first, think later.’ And that really contributes to the mispricing.”

Similarly, New York-based activist investor Arkhouse is exploiting the “extreme undervaluation in some instances” in the public market by taking REITs private, managing partner Gavriel Kahane explains. The firm undertook its first campaign in 2020 as a response to the pandemic and its impact on REIT pricing. Since then, the firm has noticed a “pretty persistent problem where there’s been a secular trend of diminishing public investor demand for asset-heavy businesses.”

Kahane says the privatization of REITs can capture the true value of real estate at a time when it is being called into question: “Public market investors are setting a price to buy a fractional piece of equity in a company or in a portfolio indirectly. But they’re not really setting the value of real estate. That is determined by the private market. A trade of a hard asset, that’s value. But a trade of a share, that’s betting on value.”

Window of opportunity

But even as more debt becomes available, not everyone expects a rebound in transaction activity to be forthcoming. Stéphane Theuriau, partner and head real estate at London-based investment firm BC Partners, notes many investors do not expect to be active until the second half of this year, which, in turn, means a lack of pricing adjustment: “If investors say they are going to wait for six months for the market to reprice, well maybe that will delay the repricing of the market because no one does anything.”

Another reason investors are staying out of the market is the denominator effect, he adds: “I think it’s a combination of: we want to see the repricing before we come back, and we have issues to deal with in our own portfolio.”

What this means for a current buying window and, indeed, whether or not it has opened yet, is up for debate.

“There’ll be windows as each asset class comes in and out of vogue”

James Stevens
Aviva Investors

“We’re seeing it as a series of windows,” says James Stevens, head of investments for global real estate at Aviva Investors, the asset management business of the UK insurer, which has approximately £1.5 billion ($1.8 billon; €1.7 billion) of capital to deploy into loans or direct real estate this year. “There’s currently a window to buy mispriced assets, especially those offering longer income. But that might be very short lived. Then there’ll be windows as each asset class comes in and out of vogue.”

Stevens says the repricing of the UK market has stabilized somewhat since values first started to fall in the middle of 2022. The inclination of vendors to sell now is mixed: “If some people are still looking back to the market conditions as they were in November, then they can still be inclined to sell at discounted pricing. If investors are on top of the current market conditions, then they perhaps don’t have external pressure and are more keen to hold on.”

He thinks it is likely more assets will be marketed from the end of Q1, as investors re-engage with the structural trends driving values prior to the reset, certainly in sectors such as logistics and affordable housing.

For the market to return to a more normalized level of transaction activity, then, sellers also need to be more motivated to sell. Shortly before press, the collapse of US regional banks Silicon Valley and Signature, together with the announced buyout of struggling European bank Credit Suisse by rival UBS, created additional uncertainty in the financial markets. This is expected to keep some sellers on the sidelines for longer.

However, along with the refinancings coming due, further forced selling by open-end vehicles to tackle redemption queues and other anticipated forms of distress should spur momentum and help crystallize prices. “I think once you start to see those distress transactions coming through, that gives a little bit more transparency on where valuations are,” says Hill.

“Sometimes it takes anywhere from 12 to 24 months to get transparency on where transactions are actually playing out. I don’t think it’s going to take that long this time; I think it’s probably going to be a 2023 event.”