While institutional investors are painfully aware 2023 will
be a game of opportunity for commercial real estate, some investors are leaning
on lessons learned from the last two years to navigate the market.
Volatility in US commercial real estate stemming from
rampant inflation, the Federal Reserve’s hiking cycle and a much more
pronounced risk-off sentiment taking hold of the market, is making
institutional investors take a stolid approach to commercial real estate, AEW
Chief Investment Officer Michael Byrne said.
“We are dealing with rising interest rates which impact
property yields, but equally challenging is that severe lack of liquidity in
the market,” the CIO said. “Starting with the financing markets, but really
moving all the way up to the equity markets where the denominator effect has
reduced allocations to real estate. There’s not a lot of capital in the system
today and there’s even less capital interested in taking risk. The entire
capital markets have pivoted to a risk-off posture, so both things are really
challenging.”
Byrne told Markets Group the accelerated pace of deals for
real estate in the U.S. in 2021 and the start of 2022, particularly for
multifamily and industrial real estate, has been supplanted by a sentiment that
rising interest rates will continue to influence cap rates and ultimately,
costs of capital.
As the amount of resources poured into US multifamily and
industrial real estate after the onset coronavirus pandemic grew in 2020,
competition drove returns lower in an environment already beset by low cap
rates. This phenomenon, coupled with the six consecutive interest rate hikes
set by the Fed in 2022 has led to increased volatility in pricing for real
assets.
Sellers trying to pen deals today have to offer a more
competitive risk-return profile than say, Treasurys, while buyers trying to pen
deals today must accept that risk-return profiles may change drastically in the
short-term and that negative leverage may arise in some cases.
Despite this, AEW’s CIO contends active investors are
looking exploit mispriced real assets and lean on sectors such as
grocery-anchored retail, cold storage and life sciences to put capital to work.
Even if there is no getting around the short-term
volatility, Byrne says these subsectors within retail, industrial and office
have shown substantial resilience and even expanded through the coronavirus
pandemic.
“Whether or not we are in recession today, clearly we are
aware of a deteriorating economic outlook across the United States and that
influences a number of different categories. And that intensifying risk has us
pivoting away from higher risk strategies and the entire market has become more
conservative around how much money we borrow and how we treat interest rate
risk.”
Byrne said capital markets interest in housing and
industrial sectors has remained strong among institutional investors, but
development and redevelopment timelines have to be shrunk to minimize risk. At
least in the short-term, AEW is likely to be a more active buyer than developer,
he said.
The National Council of Real Estate Investment Fiduciaries,
which models and indexes investment performance of commercial properties in the
US, said write downs, more than half of properties
in the index led to a slowdown of the NCREIF Property Index in the third
quarter of 2022.
Write downs in commercial real estate peaked in the second
quarter of 2020, bottomed out in Q3 2021 and increased for all consecutive
quarters according to NCREIF.
“This [economic downturn] is a disruption that we are all
dealing with and is likely to be a very challenging time for some US landlords
as they deal with a changing economic environment.” Byrne said. “But if you
have already taken the time to get your house in order and if you have the
right allocations to the right property sectors, and if you’re in the right
geographic locations, it’s still a pretty good time to be a landlord in United
States where fundamentals are solid.
“Most of our tenants are reasonably healthy. And regardless
of what type of downturn we may be going into as a real estate community, we
are starting off in a much better place than we have in other cycles with the
exception of the office market.”
The MSCI US REIT Index declined 26% this year while MSCI
Research Senior Associate Michael Savino said the pace of growth in U.S.
commercial property prices slowed in September to the weakest annual rate since
the beginning of 2021.
Rising financing costs and shrinking trade volumes – office,
apartment and industrial sales declined by 21% in the third quarter of 2022 –
are leading to declining price growth, Savino said, while deal volume in
September fell by 42% on a year-over-year basis.
Double edged sword
While rising interest rates and inflation have raised development
costs and slowed the pace of new development in the second half of 2022, things
look a little different for existing asset owners.
During Blackstone’s third quarter earnings call, Jon Gray,
the president and chief operating officer of the investment firm, said that
while the current environment is bad news for the supply of new construction,
owners of existing apartments and industrial space in markets with short supply
and high demand may benefit from the slowdown.
“In an environment like this, you start to see a reduction
in new supply, which is obviously helpful in the long term; and these hard
assets are beneficial because they don’t have much exposure to input costs, and
there’s going to be a [fewer real assets] built,” Gray said. “The challenge of
course is in a rising rate environment, if you own a hard asset like… an older
office building, then I think you’re going to see a challenge to value because
the income is not growing much and rates have gone up. On the other hand, if
you’re in rental housing or logistics you have pricing power where we’re still
seeing in the U.S., 30% increases in rents, in Europe, nearly 20% increases in
rents.”
Much like AEW’s Byrne, Blackstone’s president and COO said
the financial position of most real estate investment firms heading into the
economic slowdown is better than it has been in previous economic downturns.
Low leverage, low rental housing vacancy and shrinking construction starts may
all have an accentuated positive effect for existing landlords, Gray said.
Emerging Trends
Ankitt Bhatt, the managing director at Oxford Properties
Group, which serves as the real estate arm of the Ontario Municipal Employees
Retirement System and Byrne of AEW are betting real estate credit, life
sciences and cold storage will outperform the market downturn.
“We see the tailwinds of supply chain and logistics that are
here to stay,” Bhatt said. “We see the tailwinds and mega trends of housing
shortage that is here to stay. And then we see this boom in life sciences as
the Baby Boomers come off age and there is a dire need for pharma and life
sciences and that needs a home.”
Oxford Properties has pivoted to a defensive position, Bhatt
said, by trimming down its overpriced assets, selling $750 million in US
commercial real estate for cap rates ranging from 3.1% to 2.0% in 2022 and not
acquiring assets in the US since the first quarter of the year.
And while fundamentals for infill industrial real estate in
the Sun Belt, Northeast and Southern California metros, particularly rent
growth, remains strong, Bhatt says Oxford also continues to see opportunities
in US life sciences and cold storage.
Back in October, Oxford purchased a 250,000 square-foot life
sciences campus in San Diego leased to Ionis Pharmaceuticals, which pushed
Oxford’s footprint in the metro area to over 900,000 square feet. Oxford also
completed a 136,000-square-foot office to life sciences conversion in downtown
Seattle this year.
Bhatt said Oxford Properties has also been an active
investor in cold storage by way of its investments in Michigan-based Lineage
Logistics. The investment firm was part of a US$1.7 billion equity fundraising
round by Lineage Logistics that included Healthcare of Ontario Pension Plan,
New York State Teachers Retirement System, StepSone and others. Oxford was also
part of a US$1.9 billion equity fundraising round by Lineage in March 2021 and
a US$.16 billion equity fundraising round in September 2020.
On the other hand, Byrne says AEW remains a strong believer
in the longevity of cold storage and temperature-controlled warehouses. The CIO
says AEW remains an active investor in the sector via its Scout Cold Logistics
affiliate based in Miami.
Note: This discussion will continue at the Markets Group Real Estate Forum in New York on December 6 and 7. Click here for more information.