Shawn Lese
Real estate managers were hit with rising interest rates, falling valuations and declining fundraising in the year ended June 30, resulting in their worldwide assets under management dropping by 2.9% to $1.9 trillion, Pensions & Investments’ annual real estate money manager survey shows.
Assets managed for U.S. institutional tax-exempt investors fared slightly better, with a 0.7% increase to $736 billion during the 12-month period.
Real estate managers say they spent a lot of time visiting with investors, tending to their portfolios and searching for deals that usually appear in times of dislocation.
The past year has been particularly challenging for real estate, said Peter Rogers, director, investments-Americas and head of real assets research at Willis Towers Watson.
“Rapidly rising interest rates, higher financing costs, limited debt availability and constrained liquidity have led to declining values and reduced investor demand for real estate over the past year,” Rogers said.
At the same time, property owners have faced moderating fundamentals, he said. Fundamentals that investors look at include slower rent growth, higher vacancy rates and more supply.
Valuations are expected to keep falling, real estate industry executives said.
“It’s hard to know exactly when the marks are going to settle out,” said Christy Fields, managing principal and head of real estate portfolio solutions at Meketa Investment Group, at the Sept. 18 meeting of CalPERS’ investment committee.
“You’ve taken several quarters of write-downs, some greater in certain sectors like office, and some less,” Fields said. “In fact, this past quarter that we have data for, office was down ... 7.3%; multifamily was down 1.2%; and you had industrial at a positive 0.2%.”
Transaction volume is down and “without significant transactions, pricing and knowing where the real estate market is today is more challenging than it is when transactions are … at a higher volume,” said Stephen P. McCourt, managing principal and co-CEO at Meketa, at the same CalPERS meeting.
The $457.9 billion California Public Employees’ Retirement System, Sacramento, has $55.4 billion in real estate.
Overall, real estate returns were hit hard in the year ended June 30, with the NCREIF Fund Index – Open-end Diversified Core Equity at a net -10.7% for the period. Real estate investors expect returns to end up in negative territory in 2023 at a -7.3% return, but regain ground in 2024 with 3% return, according to the Pension Real Estate Association’s third-quarter consensus forecast survey.
Shawn Lese, chief investment officer and head of funds management, Americas, for Nuveen’s real estate business, said that valuations are still falling, with the better-performing properties such as industrial, multifamily and open-air retail “bouncing across the bottom … and getting to where valuations are going to be.”
If inflation and interest rates continue to rise, there will be more declines in values, Lese said.
Nuveen was at the top of this year’s listings of managers with the most worldwide assets under management and the most assets managed for U.S. tax-exempt institutions, with $140.3 billion and $101.4 billion, respectively.
However, Nuveen was not immune from the industry trends, with the firm’s worldwide real estate assets down 2.2% and its U.S. institutional tax-exempt assets down 4.3% in the year ended June 30.
While Nuveen raised capital, valuation declines overcame those asset gains, Lese said. Focusing on the real estate sectors, he sees a lot of similarities between the decline in office and the earlier fall of the other major property type, retail, years earlier.
Until four or five years ago, office was a predominant asset for investors in commercial real estate, he said. Now, there’s a bifurcation between the haves and have-nots in terms of office properties that perform or underperform much like there was in 2017 “when the retail apocalypse first emerged,” Lese said.
Today, the best malls are doing very well, and the lower-quality malls are no longer operating as malls, he said. The same evolution is occurring in the office sector. Offices that are new — built no later than in 2015 — or office properties that have been extensively renovated “can lease for surprisingly high rents,” Lese said.
Indeed, this year’s survey results show office sector’s percentage of the total U.S. institutional tax-exempt AUM is down to 18.9% from 22% the year before.
Lese said that office has been fading as a major property type since before the pandemic due to the higher cost of operating the properties in the form of lease concessions and improvements that need to be made to retain and attract tenants.
By June 30, 2021, the office sector was already declining, down 3 percentage points to 26.2% from the year before, a larger decline in that period than malls, which were down a percentage point to 12.2%, P&I data shows.
Office’s place among real estate property types is being taken over by industrial and multifamily, with both sectors rising in the 12 months ended June 30, P&I’s survey results show. Industrial is now the largest sector, accounting for 28.4% of U.S. institutional tax-exempt AUM, inching up from 28% the year before, and a 7-percentage-point increase from 21.1% as of June 30, 2021. Multifamily is up close to 2 percentage points at 24.8%.
Toward the end of the 12-month period ended June 30 and extending into the third and fourth quarters of 2023, PGIM Real Estate executives will be concentrating on selling certain types of assets, said Cathy Marcus, co-CEO and global chief operating officer of PGIM Real Estate.
“They have to be kind of perfect,” Marcus said. “We are trying to sell only things where we think that the pricing is going to be fair and where there is a market. … Office gets crossed off the list.”
Earlier in the survey period, PGIM Real Estate executives were “big picture doing what everyone else was doing,” she said.
“We were trying to figure out when this (downturn) is going to end,” Marcus said. “It feels certainly closer now than had been.”
PGIM Real Estate is fortunate because its executives had been preparing for a downturn for quite some time, she said. “Probably too long,” she said.
PGIM Real Estate ranks third in worldwide assets at $129.8 billion, down 2.4%, and is in the second slot for managers of U.S. institutional tax-exempt assets at $64.2 billion, a 3% decline from the prior survey.
Like everyone else, fundraising was also an issue, Marcus said.
“We are raising capital but not in the numbers we were in 2021,” she said. PGIM Real Estate started 2022 with a very high fundraising target, which the firm whittled down as the year progressed, Marcus said.
In 2022, PGIM Real Estate ended up raising far less than executives thought the firm would. Fundraising in 2023 is anticipated to meet firm expectations, she said. Marcus declined to provide specifics.
PGIM is not alone, industry experts say.
“The fundraising market has gotten much more challenging over the past year as interest rates have risen,” said Nancy Lashine, founder and managing partner of Park Madison Partners, a private real asset placement firm.
Real estate funds raised $66.8 billion in the first six months of 2023 and $159.5 billion in all of 2002, PitchBook Data’s latest real estate report shows. These totals are tracking downward from the $192.1 billion raised in 2021, PitchBook’s report shows.
With fewer transactions, many institutional investors are seeing less of their capital commitments being called, which reduces the need to make fresh commitments, Lashine said.
“On the bright side, we’ve seen anecdotal evidence to suggest that institutional investors have continued to steadily increase their target allocations to real estate, so we believe real estate will continue to be a favored asset class over the long term,” she said.
At the same time, Park Madison executives are starting to see increased interest in niche sectors for investors that are underallocated to smaller property types such as self-storage and senior housing, Lashine said.
“Investors face a challenge of needing to build a diversified portfolio, but two of the four major property types — office and retail — continue to experience headwinds,” she said.
While office is expected to be the worst-performing sector in 2023 at -15.4%, PREA’s latest forecast survey shows, industrial and multifamily property types are expected to underperform retail this calendar year. The apartments sector is projected to have the second-worst performance at -6.5%, followed by industrial at -5.6% and retail, -1.4% in 2023, the PREA forecast shows.
“Niche property types are an attractive alternative, providing diversification benefits and in some cases the potential for outsized returns,” Lashine said.
In the past, niche property types were too small for large institutional investors, but that may be changing, consultants said.
“There are other property types that heretofore were perhaps too small (for) CalPERS to access and those are becoming more appropriately sized classes for you to explore and probably to step into,” Meketa’s Fields said at the September investment committee meeting.
CalPERS is moving away from office and retail investments and toward such sectors as data centers and affordable housing, Fields said. “Some of the best supply and demand fundamentals” are in affordable housing because the country is deeply in need of more of it, she said.
Indeed, while several niche sectors are inching up, they are still are still only a minuscule part of real estate managers’ AUM, P&I’s survey results show. The largest of the niches, single-family housing for rent and senior housing, represented 1% each of U.S. institutional tax-exempt assets in the current survey. The single-family housing for rent sector is up from 0.5% as of June 30, 2022, while senior housing is flat compared with last year’s survey.
While the space is growing, it’s still difficult to accumulate large portfolios of most niche properties, managers said.
“Data centers are hard to buy but definitely a good buy if you can find them at the right price,” said Kim Hourihan, chief investment officer for CBRE Investment Management.
CBRE Investment Management is in the fourth spot on P&I’s list of largest managers by worldwide assets with $113.6 billion, a 6.1% decline from a year earlier. CBRE ranked 14th for U.S. institutional tax-exempt assets, with assets up 3.2% to $15.9 billion.
Single family for rent is interesting and CBRE Investment Management has been investing in it for a while, she said. The sector has gotten past early worries that a disparate collection of homes would be too difficult to efficiently manage by using advances in technology, she said.
Self-storage, student housing and senior housing are also interesting niche sectors, she said. For example, senior housing is benefiting from demographic changes, mainly the large and aging baby boomer generation.
“Now we have to find a way to make it cool” for a generation that promoted 50 as the new 30, Hourihan said. “A whole lot of them are getting older.”
While alone no niche sector can represent a significant portion of investors’ portfolios, lumped together they could represent about 20% or 25%, Hourihan said.
