Many commercial real estate investors have endured a dismal 2023. Soaring inflation and interest rates have caused sudden fluctuations in borrowing and construction costs, valuations and asking rents.
Value-add dealmaking, the lifeblood of many funds, dried up as investors halted new commitments and managers grappled with the challenge of underwriting deals in a rapidly evolving landscape.The headwinds have rattled the sector, causing global deal volume recorded by MSCI to plummet 48% from $1.18 trillion in 2022 to just $615 billion last year, the lowest level since 2012.
Sharp interest rate increases around the world – a dramatic shift from the steady bull market of the past decade – combined with fundamental trends in the real estate sector that have accelerated the transformation of property markets since the pandemic have created a perfect storm of disruption.
Now, as interest rates stabilize, investors and managers are surveying a dramatically altered market environment, looking for opportunities to create value amid the turmoil.
Incredibly unstable
Since 2020, real estate fundamentals and capital markets have been turned upside down, notes Paul White, senior managing director at Hines and manager of the Hines European Real Estate Partners series of value-add funds. “Everything on both sides of the calculus has changed dramatically. It's been scary, and it's taking casualties on the battlefield. But as a value-add investor, it's also creating an opportunity to reorient real estate to new demand patterns.”
Ben Brady, a partner at Boston-based Bain Capital, said the economic outlook is currently “incredibly unstable,” with indicators suggesting a soft landing one day and the risk of a recession the next.
“The results have a wide fan base and alpha generation is valuable,” Brady argues. “One of the biggest risks a manager can take today is to assume that in a recovery vintage fund, they can generate value-add type income simply by acquiring assets at low prices. Many of the cheap assets are cheap for a reason.”
While interest rates appear to have peaked, debt financing will remain relatively expensive and scarce for the next few years, said Julie Ingersoll, chief investment officer of U.S. direct real estate strategies at CBRE Investment Management. As owners struggle to raise equity capital as assets need to be refinanced and lenders retreat, creating capital shortfalls, she argues, that creates an opportunity for buyers looking to add value. Meanwhile, sellers are becoming more realistic in pricing their assets.
“An attractive strategy right now is to find opportunities to purchase well-designed and well-located buildings from sellers who must transact in this environment.”
Matt Brodnick
EQT Exeter
“Since the last adjustment in the fourth quarter of 2023, the book value of assets has reflected the level at which the market is willing to trade,” Ingersoll explains.
Without low interest rates and cap rate compression, successful managers will be able to grow net operating income. “Now is the time to get a lot of return by adding value to assets. The big opportunity today is to invest at higher yields than we've seen historically and really grow those yields through old-fashioned methods like leasing and repositioning.”
Sector Details
In today's market, there is no one rising tide that can float all boats, so it's important to choose sectors and markets with growth potential.
Brady says understanding trends like an aging population, e-commerce, working from home, innovation in biotech and housing growth in the U.S. Sunbelt is the “minimum” an investor needs to do before they can start looking for investment opportunities. “We're focused on what our clients want and need in real estate, today and in the future. That means a narrowing scope of investment opportunities,” he says.
“The big opportunity today is to buy at higher yields than we've seen historically and then actually increase those yields the old-fashioned way through leasing and repositioning.”
Julie Ingersoll
CBRE IM
White adds: “With occupier fundamentals shifting dramatically and across the board, it's more important than ever to have a clear understanding of where sustainable demand is growing and outpacing the ability of supply to meet it,” explaining that fulfilment logistics is one example of an asset class that meets these criteria.
Matt Brodnick, chief investment officer for EQT Exeter's North American industrial real estate investment platform, said the sector remains high on many value-add investors' wish lists. Buyers of anchor logistics facilities have been less aggressive, and the impetus for the rapid decline in cap rates that characterized the market's height has disappeared.
“2020 and 2021 saw a significant uptick in development and a decline in vacant property purchases, as vacant properties traded at roughly the same price as rental properties,” Brodnick points out. “The landscape has changed dramatically, and vacant properties can be purchased below replacement value in many locations. An attractive strategy now is to find opportunities to purchase well-designed and well-located properties from sellers who simply have to transact in this environment due to loan maturities or equity partners they can't stand.”
With development stalled, land is also cheaper, allowing industrial platforms to be built at lower cost for the next development cycle, he adds. But the buying opportunity won't last long, Brodnick predicts. “I've heard of people raising capital to invest in this environment. In my view, they're almost too late.”
The sector's enduring popularity has already started to drive down yields on the most sought-after assets, Ingersoll said. Warehouses with leases expiring within the next three to four years are in demand because they could be quickly re-let at much higher rents. But with most potential buyers looking for the same opportunities, pricing can be much more attractive for buildings that don't exactly fit that profile — say, those with slightly longer remaining terms.
Despite concerns about oversupply in the U.S. multifamily market, some residential properties still have attractive features for buyers looking for added value.
Wes Fuller, chief investment officer at housing platform Greystar, is focusing on the European multi-family rental market, where supply remains constrained, as well as student housing and purpose-built single-family rental homes.
He argues that while university enrolments are growing in both the US and Europe, supply is not keeping up, while rising mortgage rates are making homeownership more expensive than renting.
“As the current generation reaches their mid-30s, we will see a dramatic increase in demand for larger single-family homes, and we believe the majority of them will be renters rather than homeowners,” Fuller predicts.
“The results have a wide fan base and the alpha they generate is valuable.”
Ben Brady
Bain Capital
But current market conditions make it harder to add value by buying and renovating older U.S. apartment buildings. Fuller says, “Right now, we're being a little more cautious about capital investments to generate rental premiums. The higher cost of leverage and inflation makes those investments more expensive. We also need to be cautious about whether residents can afford to pay the rental premium and whether those assets will compete with new construction.”
Separate strategies
Much has been written about the opportunities to pursue brown-to-green strategies to modernize outdated office buildings, but the outlook for all but the best assets remains circumspect, particularly in the United States.
Ingersoll warns: “AI could be a second drag on U.S. office demand. AI could take over 25% of repetitive office tasks. We like responsive offices, life sciences and medical offices, but traditional commoditized offices are going to have a long, hard fight. And even for the best offices, it's unclear when liquidity will return. So the key question for value-add investors is, where are the exits?”
Hines' White argues that the situation is different in Europe, where people tend to go to the office and city centres are not as bad as some U.S. cities.
Meanwhile, the supply of sustainable, next-generation office buildings in European gateway cities is “extremely limited,” and Hines believes in “focused investments” in the best office buildings in the U.S., White added.
There is also the prospect of a small-scale revival of value-add retail investment due to an almost complete lack of development, historically low prices, extremely low rents and a tenant base that has been narrowed to the most resilient operators.
“The time frame to take advantage of the opportunity to secure intergenerational ownership of some of the best retail assets across Europe may be quite short.”
Paul White
Hines
“The time window to take advantage of intergenerational ownership of some of the best retail assets across Europe may be quite short,” White said.
“Last year, we did two retail property transactions with the Value Add Fund that were the first since 2016,” Ingersoll says. “What’s great about these deals is that the rents haven’t been marked to market for 10 years.”
Investors of all stripes are by nature optimistic and wired to sniff out opportunity even in the darkest of times, but the turmoil of recent years has not been forgotten.
“The concern for all investors in terms of underwriting and capital allocation remains the potential for changes in the macro environment that are outside of our control,” Fuller said. “Until there is certainty on monetary policy, there will be a risk premium attached to all investments.”
Value-add fund raising could rebound in 2024
The willingness to take advantage of market dislocations could lead to improved prospects for capital formation, managers said.
It's been a tough year for private real estate fundraising in 2023. Value-add fund capital formation was no exception, with $42.4 billion raised, compared to $57.87 billion the previous year and $71.69 billion in 2021. Only $8.3 billion has been raised through the first quarter of 2024, according to PERE data.
“From our own experience and from what we've heard from peers and competitors, fundraising is extremely hard to come by,” says Hines' Paul White.
The manager's latest Hines European Real Estate Partners fund series exceeded its target of €1.5 billion by about €100 million when it closed in November 2023, but the process involved a higher ratio of investor meetings to commitments secured than in the past, he noted.
“We spend a lot of time convincing investors that their instincts may be wrong in moments like these. If they don't commit during the darkest hours, they may look back and realize they missed the greatest period of opportunity in the cycle. The paradox for many institutional investors is that it's hard to double down on a market where they may be feeling pain in their existing portfolios.”
However, after a “wait and see” year in 2023 with both capital formation and deal volumes falling dramatically for almost all private property management companies, 2024 is set to see a significant increase in institutional commitments to the real estate sector, says Greystar's Wes Fuller.
Many of them will be keen to invest through value-add strategies, he predicts. “Investors are very focused on capitalising on stress and distress. The common theme is absolute return and how to generate it.”
CBRE IM's Julie Ingersoll says value-add investing, aimed at accessing “generational” opportunities at the bottom of the market, is a “top priority” for investors, but a lack of liquidity is likely to limit the amount of capital investors can deploy.
“The check sizes are getting a little smaller,” Ingersoll says. “A $200 million check has become $150 million. A $100 million check has become $75 million. That's because some investors are having trouble recycling traditional value-add capital because they're taking a little longer to sell or they're having difficulty pulling capital out of their core strategies.”