Institutions across the board are reevaluating strategies to account for the higher interest rate environment. The Fed has raised interest rates 225 basis points this year, and the market is bracing for another rate hike to come at the next Fed meeting at the end of September. Yet, according to Invesco, real estate has generally remained a top performer from a total return perspective during cycles of Fed tightening when compared with stock and bonds.
WMRE spoke with Bert Crouch, Invesco Real Estate’s Head of North America and Portfolio Manager, to hear more about Invesco’s outlook on challenges and opportunities in the commercial real estate investment market. Crouch is also the Lead Portfolio Manager for the closed-end opportunistic fund series, Invesco Strategic Opportunities as well as a member of the firm’s North American and Asia-Pacific credit committees, North American Investment Strategy group, North American Management Committee, and Global Executive Committee. With $92.0 billion of global real estate assets under management, Invesco Real Estate is one of the largest real estate investment managers worldwide. The portfolio includes $50.6 billion in North America direct real estate, $18.2 billion in listed real assets, $15.0 billion in European direct real estate and $8.2 billion in Asia direct real estate.
This interview has been edited for style, length and clarity.
WMRE: Rising interest rates have prompted a number of institutions to pause on acquisition strategies. What is Invesco’s position and how are you viewing the market?
Bert Crouch: This is probably the number one question we get today. It’s not just about capital flows, but how does this affect our strategic direction and are we leaning in or leaning out? When you think about capital markets more generally, whether it’s inflation pushing rates up, interest rates and the volatility in resulting uncertainty from a macro-economic standpoint, we have seen a significant drop off in the stock market. The majority of institutional capital providers’ portfolios, at least half is publicly traded stock.
Traditional targeted allocations to commercial real estate that were hovering around 10 percent, were effectively at 9 to 9.5 percent going into the year. The stock market dropping off reset allocations from a denominator effect from being under-allocated by 100 to 150 basis points to being over-allocated by 50 to 100 basis points. So, being net neutral in making new investments or selling investments within commercial real estate happened almost overnight. From the end of the first quarter through the end of the second quarter we saw that denominator effect take hold and that is an immediate pullback by your CIO of a public or private pension, although more the former than the latter.
WMRE: How are you seeing inflation and higher rates impact markets?
Bert Crouch: We’ve done a lot of work on inflation and the correlation to private real estate. The good news is that, historically, the correlation to values has been positive. It’s hovered around 0.4 or 0.5 over a long period of time. What people don’t talk a lot about is an elevated balance level of inflation. Where inflation is above 3 percent, or in the current case north of 5 percent, that correlation actually rises to 0.7 or above. In that sense, real estate can be an inherent hedge.
What people don’t talk about on the negative side is that when rates go up, especially with the increase that we’ve seen in the 10-year Treasury, cap rates have to go up. The irony of that over a very long period of time is the correlation in interest rates to cap rates has been high. But what we’ve seen since the early 1990s is that six of the seven times when that’s happened, meaning a quick jump in treasury rates, cap rates have actually fallen. Said differently, the better driver that we have found for cap rates and values in a period like this has really been around capital flows, which goes back to my earlier point around the denominator effect and seeing those pull back.
The other area that is an issue is stating the obvious in financing costs. If you look at where SOFR has gone over the last 60 to 75 days, highlighted by Chairman Powell’s speech (on Aug. 26), the market has really reset. The SOFR curve that was projected to be in the low 3s at the end of first quarter has jumped to 3.75, and more importantly, it is projected to stay there for an extended period of time. Going out to the end of 2024, the Fed Futures Market is projecting SOFR at almost 3 percent, whereas 60 to 75 days ago that was closer to 2.5 percent. Institutional investors like us underwrite to the forward curve, and we look at today’s spreads. Those are both wider over an extended period of time. Fundamentals are still strong, but flows have pulled back, and that is in large part due to the denominator effect and the expectation of rising rates.
WMRE: So, do you think the market is already baking in possible rate hikes ahead in the Fed’s September meeting?
Bert Crouch: It is 100 percent baking it in. The only question is whether the increase is 50 basis points or 75. The market is fairly split on that. Chairman Powell’s speech was clearly more hawkish, and in our opinion, the Fed intends to go above the net neutral rate for a longer period of time to make sure they stamp out inflation. I think the Fed wants to change investor perception that this is going to be a quick pivot back to rate cuts and more of a focus on inflation versus employment.
WMRE: Some market participants point to pricing uncertainty for the pause in transaction activity. Do you think that denominator effect could play a bigger role in holding back transaction activity in the second half?
Bert Crouch: I do. When people talk about capital, they talk about it too generally. Let’s be oversimplistic and look at core and opportunistic capital. There is an ample amount of dry powder that has been raised over the last year to year and a half, whether it is mega-funds or specialist funds, that is not deployed. It is waiting to take advantage of some of the current market dislocations. That said, the market is driven in large part by lower risk, lower return capital. Usually, that capital is more perpetual and open-ended vehicles, and it is more sensitive to the denominator effect.
Simply put, my expectation is that you will see a lot more of the high-return capital that has already been raised and not deployed that will be looking to exploit some of the inefficiencies of these dislocations that we’re seeing in the market. At the same time, the core capital is the larger buyer, and I don’t see them jumping back into the market, because that capital has already been pulled out and/or is part of a redemption queue.
WMRE: How are elevated inflation and interest rates impacting the overall appetite for CRE?
Bert Crouch: Number one, it depends on the sector. We talk about CRE too generally and the definition has expanded even more over the last three years. If you look at Nareit and the publicly-listed real estate market, over half of it is what the private market would call “non-traditional” sectors. The sectors that are most attractive from a fundamentals standpoint are those that can quickly and efficiently adjust to periods of high inflation—those where you have shorter lease terms and/or the fundamentals are stronger. A great case in point today is self-storage. Just looking at pure fundamentals, it has been incredibly hot for an extended period of time.
Single-family rentals are another area where we remain extremely bullish due to the affordability. Suddenly, with mortgage rates jumping significantly over the last six months, the affordability is about 30 percent cheaper to rent versus buy. On the negative side are cash-on-cash returns. Rewind to late last year and you could finance a single-family rental portfolio at 75 percent loan-to-value at 2+ percent. That cost has jumped up to 5+ percent. Due to the higher cost of leverage, you’ve gone from a cash-on-cash in the low double digits to sub-5 percent. You can drop the cost of that financing, but then you have to put in more equity. Either way, it’s more or less accretive financing. We still like the fundamentals, but your cash-on-cash is down, and your total return is down. We have seen institutional investor purchases of single-family rentals drop from 28 percent to 20 percent quarter to quarter. So, we have already seen that pullback, especially in that middle market segment that is most sensitive to the financing costs and the resulting cash-on-cash yield.
WMRE: There has been a lot of capital targeting residential strategies. What is your outlook for that sector?
Bert Crouch: We continue to find multifamily to be favorable. Invesco North America has a portfolio of just under 40,000 units. Of those, 6,000 are affordable. That is an area where we have found that we can partner with local municipalities in a public-private partnership where we are able to allocate up to half of the units for an affordable component tied to AMI in exchange for a tax abatement and/or agency-like financing. So, it’s a win-win in an area where we can still harness the benefit of multifamily fundamentals, but at the same time partner to affect a better outcome in what many believe is still an affordability crisis.
Build-to-rent is another offset of single-family rental that is often overlooked. It’s an area where new starts have come down fairly significantly quarter over quarter as costs have continued to rise. Similar to SFR, we have tried to make some strategic, vertically integrated pushes, i.e. buying into platforms and buying into the actual operating company for areas of the market where we are strongly convicted that fundamentals are highly fragmented and highly specialized. We did that in single-family rental with Mynd, and we also did with Avanta in build-to-rent. They are going out and providing an affordable solution of 200 to 300 units that are highly amenitized. We felt that buying into these platforms was more advantageous to us to allow us to scale and generate the highest quality product that we could.
WMRE: Are you interested in engaging in similar partnerships going forward?
Bert Crouch: We absolutely are. A good example is in affordable manufactured housing where we are in the process of launching with Homestead Communities. We’ve already made a handful of investments with this group. Again, we are looking to provide an affordable option in areas, where similar to build-to-rent, where we are providing an amenitized community feel for a certain income bracket. Going back to my previous point, for a large institution like us we need to scale, and we need to do it quickly. We feel like when we scale, we provide a better product because we are suiting the end user better. So, it is important that we have that ownership interest and manufacturing housing is a good example.
WMRE: We’re seeing increased interest and more capital coming into CRE from retail investors. How do you think that capital could impact the market more broadly?
Bert Crouch: When you think about what’s happened over the last 20 years in the institutional space, real estate went from a private equity portfolio to a sub-part of an alt portfolio. Over the last decade, it became its own asset class, and more recently, it has its own classification. As that’s happened, the allocation of your average institution has risen to low single digits to over 10 percent. The retail space is back where institutions were 10 to 20 years ago in the average allocation. Especially as you get below the high-net-worth to the traditional retail investor, the percentage of their portfolio that is in commercial real estate is in the low single digits, and the vast majority of that is in the public REITs.
So, what we’re now trying to do is provide, democratizing if you will, that will allow the retail investor to invest like a high-net-worth individual and get that exposure to alternatives. Number one, real estate provides needed diversification. Two, there is an inherent inflation hedge if you are investing in the right asset classes with the right financing. Three, what investors want in periods of high inflation is that they desperately want income. Four, they want stability.
Now we see retail investors having the ability to come in with proper economics to create commercial real estate portfolios. So, what does that mean going forward? Capital flows drive value just as much as fundamentals. I gave you the stats on that historical correlation. The caveat is the differentiation that I mentioned earlier. There is a sense of urgency for that capital to be deployed, number one. And number two, it is more income-focused than your traditional capital flows.
That also speaks to your earlier question about capital on the sidelines—the total return capital.
Retail capital is less focused on total return. It’s a component for sure, but if you’re not meeting a minimum yield objective, it’s not interested. To get that today with the higher cost of financing, it has lessened the number of asset classes that qualify. Accordingly, investors like us are gravitating towards those asset classes because that’s where we expect those retail flows to go.