Valuations dropping
It’s been tough for real estate, said Raimondo Amabile, co-CEO and global chief investment officer at PGIM Real Estate.
The asset class saw valuation decreases anywhere between 20% and 25% since mid-2022, with office as the worst-performing asset class, Amabile said.
Valuation declines were mainly driven by the rise in interest rates, which PGIM executives call the “big market reset,” he said.
PGIM’s worldwide real estate AUM dipped by 1.2% to $128.2 billion as of June 30, ranking third overall behind $132.9 billion MetLife Investment Management, whose AUM dropped 1.6%, and $130.1 billion Nuveen, whose AUM fell by 7.3% during the 12-month period.
PGIM’s AUM managed for U.S. institutional tax-exempt clients was also down by 5.5% to $60.7 billion as of June 30, placing it in the second spot on P&I’s rankings. Nuveen is in the top position even though its AUM managed for U.S. tax-exempt institutions dropped by 6.8% to $94.5 billion.
“We believe we are at a turning point in the market,” Amabile said. For instance, people are moving back to city centers after leaving during the height of the COVID-19 pandemic, he said.
Real estate values have dropped significantly and now some investors see real estate “as a growth story because the market is turning,” he said. In the past 12 months, investors were more interested in real estate credit.
But the asset class isn’t completely in the clear yet.
Even before the Fed cut interest rates, some transactions started coming back in the second quarter, Amabile said.
“It’s still pretty depressed,” he said. “There was a 10% increase in transaction volume but there’s quite a lot to go.”
During the height of the pandemic, transaction volume fell 64% year over year in the second quarter alone, according to Real Capital Analytics.
U.S. commercial real estate transactions were up 13.9% to $40.1 billion transacted across major property types at the end of the second quarter from the prior quarter but down 9.4% from the year-earlier quarter, according to real estate data provider Altus Group.
In Europe, central banks started cutting rates before the Fed took action and the cost of capital is coming down, Amabile said. The Bank of England announced a 25-basis-point cut to U.K. interest rates on Aug. 1 and the European Central Bank trimmed interest rates by 25 basis points for the second time this year on Sept. 12.
The markets are already factoring interest rate cuts in, but market participants need a sign that things will change that will give them enough confidence to begin buying and selling properties, he said.
“When the transaction market gets reactivated, capital will flow again into the system,” Amabile said. Investors will get more money back, which will free up additional capital for new investments, Amabile said.
What will get in the way of a recovery in real estate is if current trends reverse and there are signs of stickier inflation that is greater than 2.5%, said Kelly D. Rush, CEO, public real assets and chief investment officer, real estate securities with Principal Real Estate Investors.
REITs rebounding
Even before the Fed took action at its September meeting, REIT stocks were outperforming “in a really strong fashion” as the market anticipated interest rate reduction, Rush said.
Real estate investment trusts was one of the few categories tracked by P&I that saw growth during the 12-month period ended June 30, with worldwide AUM up 6.5% to $483.1 billion.
Principal ranked fifth on this year’s list of the largest managers of real estate investment trust securities with U.S. institutional tax-exempt assets up 4.6% to $20.5 billion. The firm is seventh on this year's list of top managers by worldwide assets with $65.8 billion, down 3.5%.
“Real estate is a very capital-intensive business and so the cost of capital is very important to the sector,” Rush said.
Even so, this real estate cycle has differed from past cycles in ways that are specific to REITs and ways that are not, he said. Traditionally, REITs have not been as sensitive to interest rate changes as they have been this time around. The FTSE Nareit All Equity REIT index posted positive total returns in 82% of months with rising Treasury yields over the period from the first quarter of 1992 to the fourth quarter of 2022, a Nareit analysis shows.
“My best explanation is that we saw a period of extra low interest rates over the past decade,” Rush said. “In that environment we saw real estate ... bid up to very high levels.”
Investors were searching for yield and real estate was one of the few asset classes offering yield, he said. Real estate assets increased in value and real estate securities increased in value as well, all in a low-interest-rate environment, Rush said.
“That shifted and we were no longer in low-interest-rate world ... it created a tremendous amount of fear ... and hypersensitivity to interest rates,” he said.
Another difference this cycle is investors’ “extraordinary confidence and optimism” that there is not going to be a significant drawdown in the market and that risk assets including real estate will prevail, Rush said.
“What this means is that risk assets can be bid up in value,” he said. “But if they come under pressure they won’t stand up to pressure very long.”
Over the past 12 months, concerns about the potential for significant distress in real estate caused investors to pause making increased investments in equity real estate and REITs, Rush said.
While investors' worst fears have faded, the real estate sector is quite mixed today, he said. Some areas have done very well but there are areas of weakness. Some of the sectors showing weakness are Sun Belt apartments where there is demand but too much supply; self-storage where there is oversupply and less demand because people are moving less often; and biotechnology due to reduced venture capital investment in the once hot sector, resulting in less demand for the large number of new biotech buildings that were built.
Even with weakness in some areas, Principal Real Estate executives are seeing an uptick of investment in REITs over the past six months, Rush said.
More investors are sensing that real estate is at a bottom, he said. “Real estate is being taken out of the penalty box,” Rush added.
The FTSE Nareit All Equity REIT index was -2.2% for the year ended June 30.
Managers point to a few areas that have been winners during this difficult time for the industry.
"We believe there are clear segments that have seen real growth over the past 12 months — especially credit and infrastructure including data centers, some of which are real estate," said Avi Shemesh, co-founder and principal at CIM Group. "CIM Group has been investing in data centers for about a decade, recognizing that the need for additional cloud capacity, along with cloud AI, is going to become necessary and valuable to daily life in urban communities."
During the survey period, CIM's worldwide and U.S. institutional tax-exempt assets fell by 5.8% to $8.3 billion.
'Inflection point'
That's the message CalSTRS' investment committee heard at its Sept. 25 meeting.
While it was a rough two years for investors with valuation declines leading to negative returns and underperformance over the long term, “we’re likely at an inflection point,” Ben Maslan, a managing director with RCLCO Fund Advisors, told the investment committee of the $346.5 billion California State Teachers' Retirement System, West Sacramento. RCLCO is CalSTRS’ real estate consultant.
That period of valuation declines with indexes down 17% or 18% in terms of values is probably at an end and could reverse as the Federal Reserve begins to cut interest rates, Maslan said.
Higher interest rates and the resulting “meaningfully lower valuations” also cooled real estate transaction volume due to valuation uncertainty, said Taylor Mammen, a senior managing director at RCLCO, at the same meeting.
CalSTRS' $47.3 billion real estate portfolio outperformed its benchmark in the one-, three-, five- and 10-year periods ended June 30. For example, the portfolio outperformed its benchmark return of 5.2% by about 220 basis points over the 10-year period, according to a RCLCO report to the investment committee.
There still are risks remaining in real estate. There is a risk that the Fed could be wrong and inflationary pressures cause further tightening, Mammen said. The economy could also go into a recession, which would impact demand, he added. But RCLCO’s base case is that the real estate market is at an inflection point that should cause asset values to start to turn around over the next few quarters, Mammen said.
Multiyear recovery
Nancy I. Lashine, founder and managing partner of Park Madison Partners, a private real assets placement firm, said that real estate is most likely in the second year of a three-year recovery.
“It usually takes three years for distress to work its way through the system,” said Lashine, adding that this is the fourth real estate cycle of her career.
Real estate is “along the bottom and we’re starting to see prices moderate and transaction volumes pick up,” Lashine said.
What is different this time is that the downturn was an interest rate-driven crisis. What is the same is that it will take time to work out, she said.
Public assets will take the shortest amount of time to work out, while open-end funds, whose valuations are based on appraisals rather than transactions, will take longer, Lashine said.
"Appraisals are still going down because transaction volumes are so low,” she said.
Open-end funds will probably lag another quarter or so, behind closed-end funds, Lashine said.
There’s a huge spread between appraisal and transaction-based pricing used by closed-end funds, she said.
“That’s why the ODCE (NCREIF Fund Index - Open End Diversified Core Equity) exit queues are at the highest level yet ... 18% of net assets, which is really high,” Lashine said.
Indeed, assets in core properties, much of which reside in open-end funds, dropped 6.8% to $445.3 billion among this year's respondents, while value-added was up 10.4% to $96.6 billion and opportunistic was up 5.7% to $59.3 billion in the 12 months ended June 30, P&I survey data shows.
Assets in open-end funds were down by 10% to $267.4 billion. Meanwhile, closed-end fund assets grew by 16.9% to $115.4 billion and separately managed account AUM dipped 2.3% to $257.5 billion, this year’s survey reveals.
