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Institutions Work to Readjust Real Estate Allocations Amid Uncertain Valuations

The “denominator effect” put institutions in a position where real estate allocations exceeded target levels, but observers expect that issue has begun to resolve itself as values of other investments have recovered.

Institutions that have been steadily raising commercial real estate (CRE) target allocations higher in recent years are now opting to stand pat as they focus on rebalancing portfolios and wait for pricing to reset in the higher rate environment.

Results from the 2023 WMRE Institutional Investor Survey (brought to you by AppFolio) reveal that a majority of respondents (59%) see institutional investor allocations to CRE that are now flat, while 23% report an increase and 18% said that allocations have declined. That is a significant shift compared to the 2022 survey, where nearly half of respondents (48%) reported rising allocations. (The methodology for the 2022 survey was slightly different, but the shift is notable nonetheless). The typical respondent reports an estimated mean 13% average real estate allocation for institutional investors.

A big reason that institutions are taking a step back from higher allocations is likely because many are either at or above their current targets. Strong real estate portfolio returns in 2022, combined with the denominator effect, are contributing to an overallocation in institutional portfolios. According to the Institutional Real Estate Allocations Monitor, nearly one-third of institutions surveyed (32.0%) said they were above their target allocations in 2022 compared to 8.7% that responded that way in 2021. The report is published by Hodes Weill & Associates and Cornell’s Baker Program in Real Estate.

“That result has followed a steady climb for 10 years in target allocations and is really the first time we have seen actual allocations exceed target allocations,” says Doug Weill, founder and co-managing partner of Hodes Weill & Associates, a global capital advisory firm. That shift has occurred for obvious reasons, including the performance of public equities and fixed income, and other asset alternatives that performed poorly in 2022. In fact, 2022 was the first time since the 1930s that both fixed income and public equities had a negative return in the same calendar year, notes Weill. “That really whipsawed institutional portfolios and put institutions largely at or over-allocated relative to their target allocations, and that has resulted in a real dramatic slowdown in allocations to funds and transactions,” he says.

It is important to note that the overallocation due to the denominator effect has been remedying itself over the last two quarters as real estate valuations have declined and equities and bonds have rebounded to some degree, notes Todd Henderson, co-global head of real estate at DWS, a global asset management firm. In addition, institutions are taking advantage of opportunities to generate liquidity within their real estate portfolios to help rebalance allocations. However, institutions are not leaving the asset class. They still like the benefits real estate offers in terms of income, diversification and a hedge against inflation, he says.

Henderson has also seen some institutions that are increasing their targets to real estate. Investors in that boat like the inflation benefits associated with real estate, and they also believe the asset class, outside of office, will perform well both during and following the current choppiness of the economy. “Most institutions are beginning to get ramped up for making allocations in second half of this year or first half of next year,” he adds.

Headwinds to higher allocations

Rising interest rates remain a top concern for institutions. Overall, 61% of respondents believe that rising interest rates are likely to have the greatest negative impact on institutional investors’ allocations to real estate. Despite continued talk of a potential recession, fewer respondents are concerned about a recession or real estate downturn negatively impacting allocations to real estate at 38% and 34%, respectively.

“What we’re hearing from our institutional clients is that they’re going to stay the course and keep current allocations, which is somewhat predictable, given that interest rates have been increasing pretty rapidly,” says Mike Sebastian, industry principal and director of investment management, at AppFolio Inc., a firm that provides software, services, and data analytics to the real estate industry. In the higher interest rate environment, it also makes it harder to find deals and predict what returns will be in the future. Institutions, of course, need the return, but they also need the safety. So, it is not surprising that more institutions are holding allocation targets in the current environment, he adds.

According to survey respondents, the two biggest hurdle institutions face in meeting their real estate investing goals is the lack of quality deals (54%), followed by the time required to source/manage deals (40%).

Another big hurdle for institutions in deploying capital in the current market is uncertainty around a myriad of issues, such as asset pricing, impacts from a slowing economy, migration shifts and changes in consumer behavior that are creating new headwinds and tailwinds for different property sectors. “When there is uncertainty for institutional investors, most of them prefer to wait until they see some level of stabilization and some ability to predict the future,” says Craig Spencer, CEO of the Arden Group, a commercial real estate fund manager and operator. “The more certainty we get about the future and interest rates, you’re going to see activity pick up fairly quickly because there’s an awful lot of capital available to invest in real estate,” he says. That capital wants to invest in real estate, it is just waiting for the right time, he adds.

Real estate isn’t the only asset class that is sensitive to interest rates. Other assets, including equities, fixed-income investments and other alternatives all trade based on the cost of capital, adds Henderson. “So, interest rate movement or volatility doesn’t cause permanent or longer-term shifts away from the real estate asset class,” he says. Most institutional investors are sophisticated enough to know that a diversified portfolio that includes real estate is the right way to invest. That being said, there is real dispersion in terms of performance across the different property sectors that is impacting where institutions are allocating their capital. And investor expectations regarding returns have also increased along with higher intertest rates, he adds.

The full report will be published in July.

Survey methodology: The WMRE Institutional Investor Survey (brought to you by AppFolio) was conducted via an online survey distributed to WMRE readers in May 2023. The survey results are based on responses from 120 participants that directly work with institutional investors. Survey respondents represent financial advisors (67%) and CRE professionals (33%). Real estate industry participants included a cross-section working in different areas. The biggest group, 22%, identified as leasing or investment sales brokers. Overall, 41% described their role as an owner/partner/president/chairman/CEO or CFO-level executive. Respondents operate in all regions with 68% in the West / Mountain / Pacific, 57% in the South / Southeast / Southwest, 41% active in the East and 30% in the Midwest / East North Central / West North Central. Respondents are active across property segments, and most are involved in retail at 78%, industrial at 65% and multifamily and office each at 59%.

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