Head of Private Real EstateMore by this author
Portfolio Manager, Private Real EstateMore by this author
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A 12-year investment cycle fueled by historically low rates is coming to an end as private real estate reprices
- Private real estate, facing a slowing economy and higher financing costs (due to higher rates intended to tame inflation), has reached a pivotal moment.
- Private real estate transaction volume has plummeted, and performance has lagged listed real estate for a second consecutive quarter. We expect significant repricing to create favorable entry points for investors – but these will demand judgement and selectivity.
- We expect valuations to decline in the area of 20% overall, but this will vary across property types. The weakest properties (older properties in gateway coastal markets) will be hit hardest and the strongest properties (newer, amenity laden real estate in sunbelt locations) will be the most resilient.
Three drivers of private real estate repricing
For the first time since the Great Financial Crisis, private commercial real estate (CRE) valuations are experiencing sustained quarterly losses; prices fell 5% in the fourth quarter of 2022, 3.2% in the first quarter of 2023 and 2.7% in the second quarter, as measured by the NCREIF ODCE Index (Exhibit 1). To put this in perspective, the 4Q22 decline is the fifth largest since 1978, and the 1Q23 decline is the eighth largest.
And without knowing exact timeframes, we are expecting a weighted average drop of around 20% in CRE prices peak to trough with the weakest assets and capital structures falling first and furthest.
This repricing warrants a certain amount of caution from investors as we wait to see what the depth of the challenges will be. However, we believe this regime shift may create a multi-year period of markdowns and entry points for the discerning investor.
There are three notable drivers of this repricing:
- The Federal Reserve’s aggressive rate hikes intended to tame inflation has led to both higher financing costs and slowing economic growth.
- Fundamental changes in how and where people live and work has had a profound impact on the usage patterns within the commercial real estate industry.
- Capital availability has shifted as 1) strong private real estate returns relative to other asset classes have created the so-called denominator effect in which investor portfolios appear overweight to private real estate, and, 2) capital that flowed into the financial markets in search of yield has been pulled out of the system toward more attractive fixed-income investments.
Private real estate returns beginning to echo 2022 listed performance
At June 30, 2023. Source: NCREIF, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.
Listed real estate, a leading indicator for private real estate, has foreshadowed these losses in the private space for several quarters, as listed tends to lead private in selloffs and recoveries due to its liquid and daily pricing.
As private values decline, transaction volume is likewise declining (Exhibit 2), as sellers are reluctant to transact at the new, lower levels where buyers are interested. According to consulting firm McKinsey, real estate transaction volumes fell off in the second half of last year, ultimately dropping 20% in 2022 after surging at a record pace in the first half of the year.
In fact, transaction volume declined in each consecutive quarter throughout 2022, according to the firm. Sectors experiencing falloffs included multi-family and industrial, areas which had previously benefited from shifts in lifestyle and shopping patterns, boosting growth. Performance has fallen as the rapid increase in rents and occupancy witnessed over the past two years tapered off.
Transaction volumes dry up
Transaction volume by sector ($M) Volume representative of verified transactions of $25M or more
At December 31, 2022. Source: Green Street.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. (1) YTD figures represent 01/01/2023 through 03/22/2023.
To that point, multi-family transactions fell 29% in 2022 after more than doubling the previous year, which accounts for nearly half of the decline in real estate deal activity, McKinsey states.
Buyers and sellers are at an impasse. Sellers would prefer not to sell into this down market, though some are being forced to transact. Buyers, for their part, are sifting their way through debt market conditions in which availability is uncertain. This standoff will persist until sellers’ hands are forced and they acknowledge the new reality of lower prices. We have already begun to see motivated sellers revealing themselves as prices have begun to fall.
High lending costs cause price declines
Rising interest rates have had a sizable impact on CRE asset prices, which reduces the amount of debt borrowers can afford. In short, the entire universe of commercial real estate is repricing as investors come to terms with the new cost of capital.
One important metric that lenders are using is the debt service coverage ratio (DSCR), which assesses the creditworthiness of borrowers and the overall risks associated with a particular property. A higher DSCR indicates the property can generate enough income to cover its debt payments, while a lower DSCR can lead to difficulties securing favorable financing terms as it shows the property is more vulnerable to default or distress.
For example, a 1.0X DSCR indicates the loan can cover interest payments, while a 2.0X DSCR is indicative that it can cover two times the interest payments.
In a higher interest rate environment, CRE owners will likely see their DSCR’s negatively impacted. Property valuations are marked lower due to higher financing costs and lenders become cautious about extending loans to properties with higher risk profiles. This occurs as investor confidence may falter and potentially lead to selloffs.
Conversely, a healthier DSCR profile can instill greater confidence in investors as it reflects stable cash flow and a property’s capacity to meet debt obligations. A low DSCR places unstable properties at a distinct competitive disadvantage, intensifying the potential for a selloff due to lack of demand and inaccessible resources.
One potential outcome of these challenges is the need for borrowers to infuse more cash into newly refinanced loans. If a property has been discounted by 20%, the lender may want the investor to place 20% more equity into the loan to keep the loan-to-value (LTV) ratio constant, which is also called a cash-in-refi (refinancing).
It is clear the tightening of monetary policy by the Federal Reserve has begun to hit its intended target by reducing exuberant risk-taking capital from the market, which is generally a byproduct of lower rates.
Changing landscape causing (dis)stress
Repricing is just getting underway with the weakest assets and capital structures failing first. Coastal, gateway office properties, for one, are on the leading edge of distress. In fact, some of the largest CRE asset managers in the industry have defaulted on billions of dollars worth of offices in New York and Los Angeles, two of the weakest gateway cities.
The one-two punch of rates pushing higher combined with many office tenants moving out of formerly coveted, coastal cities, has been too much for some investors to bear. The valuations of these assets were based on high multiples of rental income streams, which were boosted by low-cost financing. With office demand having softened and rates being higher, some CRE investors have been unable – or have chosen to forego – refinancing maturing debt.
Indeed, 16% of CRE loans will mature in 2023, of which office is the largest at 26% of that figure, followed by multi-family. From there, another 15% is maturing in 2024. As a result, pockets of distress will appear in the coming months. We do not believe this presents a systemic risk and will certainly not reach the depths of the GFC as fundamentals are on stronger footing while lending standards are much more conservative.
In short, spaces with fewer amenities in less desirable locations are experiencing pronounced markdowns.
While office is no longer a dominant component of the overall real estate investment trust (REIT) universe, these thematic changes will have a lasting impact. Similar to how housing in the U.S. was built for the baby boomer generation – big houses on large land plots in the suburbs of gateway cities – so too was U.S. office stock. As the millennial generation displaces baby boomers as the largest demographic in the U.S., transportation, affordable housing and the office environment are all evolving to meet new standards – shifting concentrations to locations such as Atlanta, Dallas, and Austin, with higher quality finishes, accompanying green space, and proximity to amenities.
Paradigm shift in how people live creates opportunity
As this repricing occurs, it will create select opportunities for selective investors amid what we believe may be a multi-year period of markdowns and entry points. The largest change in how people use real estate since the advent of the U.S. highway system is now underway.
Cities and states that have long enjoyed power as centers of industry – such as New York City in finance or the San Francisco Bay Area in technology – have taken their monopoly status for granted for too long. Their value propositions have eroded due to high taxes, costly regulations, an increased concern about crime, aging transportation infrastructure and the inability to provide affordable and convenient housing.
In addition, as technology allows for increasing adoption of remote work across many industries, workers today have more power to change locations while retaining their jobs.
Offices in growth cities benefit from migration
At December 31, 2022. Source: Green Street.
The allure of temperate weather, shorter commute times, affordable housing, lower taxes, and an overall lower cost of living, has created tailwinds of economic growth across the Southeastern U.S., as well as the Sunbelt and Mountain West regions. The migration away from gateway cities underscores the structural change in how people live and has resulted in these markets outperforming gateway markets. To use one metric, office leasing activity in the Southeast is currently at 85% of pre- Covid levels, compared to just 60% in the gateway markets.
The reality is rent pricing is no longer the driving factor in the office leasing industry. Simply put, some buildings and locations will work in this new environment while many will not, regardless of how inexpensive the space is offered to tenants.
As companies and individuals continue to focus on cities such as Dallas, Austin, Atlanta, Raleigh and Nashville, among others, we see support for our thesis that medium- to high-density cities in the Southeast and Sunbelt regions will continue to outperform.
Shopping centers also stand to benefit from this migration trend and are increasingly adopting the role of last-mile warehouse, which are internet- resilient properties that have readily adapted to the growing ‘click and collect’ trend. This hybrid e-commerce model offers higher yield potential than the traditional warehouse in industrial areas.
And it’s not just offices and shopping centers benefiting from this new, supportive backdrop in the Southeast, but also residential markets.
Apartment rents and housing prices alike remain strong, which is a trend we expect to continue.
In our view, the residential sector is poised to benefit from the inadequate supply of homes for sale and affordability challenges, resulting in an increased demand for rental housing, particularly for single-family homes.
Office leasing activity in the Southeast is currently at 85% of pre-Covid levels, compared to just 60% in the gateway markets.
Capital availability leading to further pricing pressure
Further pricing pressure is being levied by a shift in capital as asset allocations are being shifted away from private real estate.
First, investors’ asset allocation decisions have continued to shift because fixed income yields have become more attractive. Capital that was previously investing in alternatives, including private real estate, as investors sought yield, is now being pulled toward fixed income, where yields have been pushed higher by rising rates.
Second, is the so-called denominator effect, which refers to how changes in the overall portfolio value can impact the relative allocation or weighting of different asset classes, potentially affecting diversification and risk levels.
Private real estate’s strong performance in 2022 relative to other asset classes is a prime example. The Bloomberg U.S. Aggregate Bond Index fell 13% in 2022. The S&P 500 dropped 19.4% for the year. Listed real estate fell 24.9% in 2022, as measured by the FTSE Nareit All Equity REITs index. Private real estate, by comparison, rose 7.5% over the same timeframe, as measured by the NCREIF ODCE Index.
Further pricing pressure is being levied by a shift in capital, as asset allocations are being shifted away from private real estate.
An example allocation for a moderate investor would be a target allocation of 51% U.S. equities, 36% bonds, 7.5% private real estate and 5.5% listed real estate. If an investor started 2022 with this asset mix, their allocation to private real estate would have climbed to 9.5% by the end of the year, as the overall value of the portfolio declined (the denominator) and performance of private estate climbed (Exhibit 4).
Even if the rebalancing away from private real estate doesn’t force investors to redeem their private real estate allocations, it means that investors are not making significant new private real estate investments, lessening demand and further lowering prices for opportunistic investors.
Overall, changes in interest rates, usage patterns of real estate, and capital availability are creating what we believe are highly favorable opportunities to invest in private real estate over the next two to three years, and investors are beginning to recognize this backdrop.
The denominator effect: Start vs end of 2022
At December 31, 2022. Source: Bloomberg, Cohen & Steers.
For illustrative purposes only. The information presented should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. (1) 2022 returns represented by equity: S&P 500 Index; fixed income: Bloomberg U.S. Aggregate Bond Index; private real estate: NCREIF ODCE Index; listed real estate: FTSE Nareit All Equity REITs Index.
An investor cannot invest directly in an index and index performance does not reflect the deduction of any fees, expenses or taxes. Index comparisons have limitations as volatility and other characteristics may differ from a particular investment.
Data quoted represents past performance, which is no guarantee of future results. The views and opinions presented in this document are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this document will be realized. This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. This material is not being provided in a fiduciary capacity and is not intended to recommend any investment policy or investment strategy or to account for the specific objectives or circumstances of any investor. We consider the information to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of appropriateness for investment. Cohen & Steers does not provide investment, tax or legal advice. Please consult with your investment, tax or legal professional regarding your individual circumstances prior to investing.
Risks of Investing in Private Real Estate. Private real estate investments are illiquid and susceptible to economic slowdowns or recessions and industry cycles, which could lead to financial losses and a decrease in revenues, net income and assets. Lack of liquidity in the private real estate market makes valuing underlying assets difficult. Appraisal values may vary substantially from a price at which an investment in real estate may actually be sold.
Risks of investing in real estate securities. The risks of investing in real estate securities are similar to those associated with direct investments in real estate, including falling property values due to increasing vacancies; declining rents resulting from economic, legal, political or technological developments; lack of liquidity; lack of availability of financing; limited diversification, sensitivity to certain economic factors such as interest rate changes and market recessions and changes in supply of or demand for similar properties in a given market. No representation or warranty is made as to the efficacy of any particular strategy or fund or the actual returns that may be achieved.
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