Higher interest rates wreaking havoc on real estate managers

Higher-for-longer interest rates swamped all property types, causing most real estate managers’ assets under management to sink in 2023, the results of Pensions & Investments’ latest money manager survey shows.

The close to 18-months-long higher interest rate environment is making last year’s rallying cry of "Survive ‘til '25" in need of a rewrite to something more akin to "Don’t deep-six before ’26."

Real estate equity AUM managed for U.S. tax-exempt institutions dipped 1.9% to $509.7 billion between 2023 and 2022 and is up only 10.8% over the past five years, P&I data shows.

“There is downward pressure on AUM because real estate property values have dropped,” said Colin Hill, managing principal, real estate consultant at Meketa Investment Group.

The reason: there’s been a significant change in the risk-free rate, he said.

“Now that the 10-year Treasury is much higher than it was two to three years ago, investors require higher yields to earn an appropriate premium,” resulting in properties selling at lower valuations, Hill said.

Returns were not pretty last year. The NCREIF Property index lost 7.9% and the NCREIF Fund Index-Open End Diversified Core Equity index was down -12.7% net of fees in 2023.

Open-end funds

For big open-end funds, there are not only lower property values but many have also paid out some redemptions, Hill said.

“The combination of the two actions have resulted in a drop in fund NAV (net asset value) and firm AUM," he said. “I don’t know any real estate manager that has been immune over the last 12-18 months.”

Many core, open-end fund managers are offering incentives in the form of fee reductions if investors add new capital or if investors remove themselves from redemption/exit pools to help limit redemptions and encourage new investment, Hill said.

With the higher interest rate environment persisting, real estate owners are in no hurry to sell properties, Hill said.

“If you own a property and don’t have to sell it today and don’t need liquidity, you are likely crossing your fingers and hoping the Fed takes action sooner than later,” Hill said.

Closed-end funds

In closed-end funds, where the holding period was intended to be three or four years, many general partners are working with lenders to extend the maturities on their loans, with mixed success, he said.

“If the bank has pressure on its balance sheet, it will often want to preserve its liquidity for the best customers,” Hill said.

The best customers can often refinance their portfolio with lenders that may not always enforce the letter of the contract, he said.

The bank might require only a modest paydown and a slight bump-up in interest rate with a fee while “everyone hopes and waits for things to get better,” he said.

Some property owners are selling equity stakes in their properties to pay down a maturing loan, Hill said. That way, the property gets a capital infusion, the loan gets paid down and the property owner has more time until a new loan matures, he said.

“It’s a tough thing for business development teams trying to raise a new fund,” Hill said. “Any properties that you bought before the interest rate increases that you still own probably have a lesser value.”

Even for money managers that own high-quality property in sectors with better fundamentals like industrial and multifamily, “the risk-free rate applies to everybody,” he said.

Nuveen's assets grow

Despite AUM drops for most real estate firms, the manager with the most AUM for U.S. tax-exempt institutions, Nuveen, saw its assets grown by 19.5% to $71.3 billion in 2023.

“It was a challenging year as the market continued to grapple with the hiking cycle and the uncertainty that created,” said Carly Tripp, global chief investment officer and head of investments for Nuveen Real Estate.

With public equities and bonds down for a good part of 2022, investors were generally overallocated to real estate in 2022, Tripp said. Transactions were down because managers didn’t want to buy or sell because “nobody knew how to price” properties, she said.

Even so, armed with dry powder and balance sheet money, Nuveen was a net acquirer in 2023, Tripp said. Nuveen’s real estate business not only completed mergers and acquisitions but also some strategic transactions that executives had been working on last year, she said.

Nuveen’s funds have relatively low leverage and staggered debt maturities, so the firm was not forced to sell properties last year, Tripp said.

“Of course the legacy book experienced what the market experienced with some depreciation,” she said.

Among the deals were Nuveen’s acquisition of an affordable housing portfolio in May 2023 from Omni Holding Co., that increased its affordable housing AUM to $6.4 billion. Terms of the transaction were not disclosed. In February 2023, Nuveen made a further investment in self-storage real estate business MyPlace, a business it helped launch with Kurt O’Brien founder and former CEO of Simply Self Storage, Tripp said. Nuveen and MyPlace started acquiring self-storage assets in 2022 and had about $300 million of assets under management across both value-added and core-plus strategies. The partnership aims to increase its AUM to about $1 billion over two years.

Nuveen also increased its self-storage portfolio in Europe with a deal to take Scandinavian public self-storage company Self Storage Group private for 3.79 billion Norwegian kroner ($360 million).

The Self Storage deal was Nuveen’s third strategic acquisition in Europe, Tripp said.

Transactions down

Across the industry, fundraising fell in 2023 in the U.S. by an estimate of around 50% from 2022 levels, said Peter Rogers, director, investments-Americas and head of real assets research at Willis Towers Watson.

It varies by sector but generally transaction volume has been subdued, Rogers said. Using core, open-end funds as a proxy, real estate pricing declined, depending on the sector, on average by 20% to 25% last year, he said.

Transactions are expected to resume in earnest when long-term interest rates start settling down, Rogers said. “That will hopefully take uncertainty out of the market and allow more transactions to occur,” he said.

While it’s hard to generalize, many of the early transactions are where there is property level or capital market distress, meaning the manager or property owner has a loan coming due on a property, Rogers said.

“In certain sectors, there’s going to be difficulty, particularly office, “ he said.

But Rogers said he doesn’t expect a tsunami of debt maturity overtaking the real estate market.

“Every year everyone likes to say there’s going to be a wave of debt maturities,” Rogers said. “There’s always pockets of distress.”

But Willis Towers Watson executives don't think there’s going to be widespread distress in the real estate market, he said.

Sectors with more resilience, sustainable long-term demand drivers and the ability to increase rents faster than other sectors generally fared better such as data centers, single-family rentals and manufactured housing, Rogers said.

“But they weren’t immune to valuation declines from higher interest rates,” he added.

Sectors mattered in 2023. The best performing of the five main property types tracked by NCREIF Property index was hotels at 10.3%, followed by retail at -0.9%, industrial at -4.1%, apartments at -7.3% and office, -17.6%.

Real estate debt

Not even the relatively newer sector of real estate debt was completely invulnerable from the impact of higher-for-longer interest rates in 2023.

According to the results of P&I’s money manager survey, real estate debt AUM managed for U.S. institutional tax-exempt investors grew by 32.7% to $116 billion in 2023 from the year before. However, some managers say that fewer transactions have had an impact.

For instance, Nuveen is also a real estate lender with $50 billion of commercial real estate mortgage loans on its books, Tripp said.

“Last summer, the pipeline for commercial mortgages was 30% of normal,” she said. Since then, mortgages have come back to “a healthier range,” Tripp said.

One of the many managers in P&I’s survey to see its real estate equity AUM managed for U.S. institutional tax-exempt investors decrease last year was PGIM, the money management business of Prudential Financial. PGIM’s U.S. institutional tax-exempt AUM decreased 12.3% in the year ended Dec. 31 to $37.2 billion.

AUM dropped across its entire real estate business, said Cathy Marcus, co-CEO and global chief operating officer of PGIM Real Estate.

“Like pretty much everyone else our AUM went down in 2022 and 2023 largely because of value declines,” which were entirely interest rate driven, Marcus said.

Real estate fundamentals such as occupancy rates were up, she said.

Income and risk are two components of capitalization rates, meaning a property’s rate of return, Marcus said. “Income is not the problem here,” she said. “It is the raising of the interest rates, which results in a domino effect of cap rates.”

“Borrowing costs went up very precipitously in 2023” in many regions around the world, Marcus said.

“We’re looking at negative leverage in the first couple of years, which is not a great buy signal for a lot of people,” she said. Negative leverage is where the cash-on-cash return of property without leverage is greater than that of levered real estate. “Borrowing costs are not very accretive at this point and that impacts buyers,” Marcus said.

'Be prepared'

“The best thing you can do in this environment is to be prepared” and PGIM Real Estate was very prepared, she said.

PGIM Real Estate executives can’t take credit for predicting the rapid pace of the interest rate increase, “which was surprising for most people,” she said. However, they did think that the trajectory of interest rates after a very long cycle of nearly zero interest rates was up, not down, Marcus said. So, PGIM Real Estate came into this period with lower leverage having refinanced its properties in 2021 and up through the first quarter of 2022, she said.

“It was a really, really great time to lock in longer-term debt,” Marcus said. “Everyone tried to get the longest term possible during that time.”

PGIM also has been underweight office for at least 10 years, she said.

Office values were down 35% and 40% in 2023 from before the pandemic, Marcus said.

"If you look across the board. Therefore, the less of that you have the better … Our core strategy is very much underweight at this point,” Marcus said.

“It’s not that we had great vision that the office market would wildly fall apart, but if you look at office in the NCREIF Property index, office performance is not great” due to the expensive improvements owners need to make to attract tenants, she said.

When tenant improvement costs started ratcheting up in the years before the pandemic, office lost about 25% of net operating income to those expenditures, Marcus said.

“It’s hard to make money and core funds are about distributing income,” which managers can’t do if it's losing close to a third of a property’s income in office, she explained.

And Marcus said that she is not particularly worried about 2024.

“I’m feeling very positive about where we are in the cycle and it really does feel like we’re going to hit the bottom midyear this year,” Marcus said.

PGIM executives are starting to see early positive signs. Open-end funds, unlike closed-end funds, mark their portfolios to market every quarter and some multifamily properties have sold, or are in the process of being sold, at prices that are higher than appraised values, she said.