Institutional investors are sitting on the sidelines of the commercial real estate investment market, but they are not backing away from the asset class entirely. Instead, they are waiting for the investment sales climate to become less volatile and for asset prices to fall, creating opportunities for better yields, according to industry observers. Many are also biding their time until the tightening lending environment creates situations where they can take advantage of distress.
The slowdown in activity was already starting to become evident last year, before troubles in the regional bank sector created additional caution about risks associated with investing in commercial real estate. At the time, institutional investors were struggling with both the denominator effect—when the value of real estate in their portfolios relative to stocks and bonds made them over-allocated to the sector—and concerns about rising interest rates and the possibility of a recession, according to exclusive WMRE research conducted in the third quarter of 2022. Sixty-six percent of the investors surveyed by WMRE indicated lack of quality deals as the biggest hurdle to meeting their investment goals, and 39% cited the amount of time required to find such deals.
To be sure, some deals are still happening. But these tend to involve some of the biggest, capital-rich institutional subgroups—sovereign wealth funds, large pension plans, life insurers—who can afford to purchase properties directly or form joint ventures with established real estate players, rather than mid-market participants who tend to rely on funds run by outside asset managers for their real estate allocations.
For example, in early April, Safehold Inc., a publicly-traded REIT that focuses on ground leases, announced that it entered a joint venture with an unnamed sovereign wealth fund to acquire new ground leases. The sovereign wealth fund committed to a 45% interest in the venture, for approximately $225 million.
In addition, according to data from MSCI Real Assets, in the first quarter of this year, some of the top transactions involving institutional buyers included Rexford Industrial REIT buying a 1.1-million-sq.-ft. industrial facility in Fontana, Calif. for $365 million; Brookfield Asset Management buying a 1.8-million-sq.-ft. industrial property in San Gorgonio Pass, Calif. for $329 million and Pacific Life buying a 324-unit apartment building in Washington, D.C. for $181.5 million.
In the larger picture, however, institutional investors have tended to stay on the sidelines in recent months. In the first quarter, private equity real estate investors closed 668 deals in North America, according to a new report from London-based research firm Preqin. That marked a 25.8% decline compared to the prior quarter and a 51.7% decline compared to the same period the year before. It was also half of the quarterly average for the past five years.
While they continue to look at potential deals, institutional investors are slow to move on them until the market resets prices on commercial real estate to better reflect true values, according to Nathan Florio, principal, advisory, transactions and business analytics, with consulting firm Deloitte. Some are also watching the mortgage market, with an eye to offering debt solutions if borrowers start having issues securing loans from banks. As a result, institutional investors have largely been in a “limbo” when it comes to real estate.
“I would say that institutions right now are very cautious and moving slowly to allocate capital to new real estate investments,” said Douglas M. Weill, founder and co-managing partner of Hodes Weill & Associates, a global capital advisory firm that focuses on real estate investment. “Over the medium to long-term, they continue to favor real estate and, in many cases, are increasing their allocations.”
Research released this month by Clearwater Analytics, a provider of investment management and analytics solutions, supports this outlook. The firm asked 200 institutional investors whether the current economic environment, including recent troubles in the banking sector, impacted their appetite for alternative assets. When it came to real estate, 58% of respondents said they expected either no change or an increase in their appetite for the asset class. The surveyed investors included insurers, pension plan and endowment executives, wealth and asset managers, corporations and government entities.
Some institutional investors who rely on outside asset managers to purchase and manage real estate assets for them are committing more funds to the sector, in spite of occasionally getting criticized for the decision. For example, when the Office of the Chief Investment Officer of the Regents of the University of California made a multi-billion commitment to Blackstone REIT earlier this year, in spite of the REIT facing heightened redemption requests, some headlines accused it of “bailing out” a private equity giant.
University of California did not return a request for comment in time for the publication of this article.
But the institution is hardly alone in considering commercial real estate to still be a sound investment.
Oregon Public Employees’ Retirement Fund (PERF), for instance, plans to invest between $1.5 billion and $2.0 billion in real estate in 2023, either through funds or co-investment opportunities, reported IPE Real Assets. The pension plan’s real estate investment strategy in recent years involved focusing on core opportunities in the multifamily and industrial sectors. Up to 70% of its portfolio consists of investments through open-end funds and separately-managed accounts, according to Top 1000 Funds.
Recent market volatility and some fallout from the denominator effect notwithstanding, in the medium and long-term, real estate remains a highly attractive investment options for institutional players, according to Weill. Research by Deloitte, for example, found that in spite of the potential trouble spots the sector started exhibiting in 2022, many institutions were either maintaining their real estate allocation targets or raising them. The funds Deloitte looked at raised their allocations by 70 basis points, on average, last year, while actual allocations rose by 150 basis points, to an average of 9.3%.
Of those investor groups who still experienced a gap between their target and actual allocations to real estate in 2022, insurance companies and foundations fell the most off their goals, with a difference of 1.5% and 1.4% respectively. Public sector pension funds, on the other hand, came the closest to their goal, failing to reach their target by just 0.4%.
Institutional investors tend to have longer-term investment horizons, and so are less concerned about what they view as short-term volatility, Deloitte researchers noted. After all, last year, core real estate investments still delivered an annual return of 7.5% vs. a 19.2% decline for U.S. equities or a 14.6% decline for fixed-income investments. In addition, institutions continue to view real estate as an inflation hedge.
Case in point: when the California State Teachers’ Retirement System (CalSTRS) released its third quarter 2022 report this March, it noted that when it came to the time-weighted rate of return, its real estate portfolio outperformed the ODCE benchmark return by 110 basis points over a 10-year period, at 11.0%. Over the most recent one-year period, however, the portfolio, excluding legacy investments, underperformed the benchmark by 40 basis points. As of the end of third quarter, CalSTRS’s allocation to real estate was at 17.2%, above its target of 15.0%, but within the pension plan’s policy range of 12.0% to 18.0%.
During CalSTRS board meeting, which also took place in early March, the pension plan’s executives noted that they expect returns on real estate investments to continue to moderate over the next two quarters because of the anticipated write-downs in book values. However, with property fundamentals in most sectors (with the exception of office) continuing to show strong performance, they also expect the current dislocation in the capital markets to lead to both “threats and opportunities” that CalSTRS should be ready to take advantage of.
CalSTRS declined a request for an interview.
The timeline CalSTRS executives gave during the meeting for when they anticipate the pricing dislocation will work itself out jibes with Weill’s assessment of when institutional investors will start showing greater activity. He noted that investors have been telling him and his team they expect to start ramping up deals in the second half of 2023 or in 2024, once assets are re-priced.
What are they looking for?
Facing new market conditions, institutions are changing up their strategies.
“We are seeing redemptions come from open-end funds that are [more focused] on core and core-plus,” Weill said. “I’d say institutions are much more focused on higher risk/higher return strategies—value-add and opportunistic are increasingly in favor.”
New research from international asset management group MPG supports this outlook. When the firm surveyed 100 institutional investors across Europe and the U.S. this March, 88% said they plan to increase their focus on yield as opposed to growth over the next five years. Of those, 35% anticipated a “dramatic” increase in their focus on yield.
WMRE’s research also found that institutional investors were citing total returns as, by far, the most important factor in their decisions.
In their search for higher returns, institutions are increasingly committing their money to funds with value-add and opportunistic strategies, those focusing on more niche real estate sectors and those planning to take advantage of distress opportunities in the market, according to Weill. Blackstone Real Estate Partners X, which closed on April 11, is a good example—with its $30.4 billion in commitments, it became the largest real estate drawdown fund ever. The fund got a $125 million commitment from the City and County of San Francisco Employees’ Retirement System and Blackstone has reportedly indicated that in its investment strategy going forward, it will focus less on core office and retail properties and more on emerging real estate sectors, including life sciences and data centers. There’s also an expectation that it will be targeting distressed credit, Weill noted.
Brookfield Asset Management has also recently launched its fifth real estate investment fund, also expected to take advantage of distress.
According to a survey conducted by Preqin in November 2022, institutional investors identified opportunistic real estate funds as presenting the best opportunities going forward, followed by distressed and value-add funds. In fact, 35% of those surveyed said that high-risk adjusted returns were their main reason for investing in real estate. The biggest share—26%–said they were targeting returns in the 8.0 to 10.0% range.
Data for closed-end private real estate fundraising in the first quarter of this year bears this out—Preqin found there were 25 funds closed, with an aggregate value of $6 billion, focused on value-add strategies, and 17 funds closed, also with an aggregate value of $6 billion, focused on opportunistic investment. In contrast, there were 23 funds closed targeting core and core-plus strategies, with an aggregate value of just $2.6 billion.
Just this week, South Carolina Retirement System approved a $75 million commitment to Stockbridge Value Fund V, which plans to have a focus on value-add real estate opportunities in the U.S., reported IPE Real Assets. Meanwhile, Ohio State Highway Patrol Retirement System committed $15 million to Oakstreet Real Estate Opportunities Fund IX, which describes itself as a distressed credit fund, reported Pensions & Investments.
Deloitte’s institutional clients are definitely thinking about stepping in and offering debt solutions to real estate investors if the troubles in the banking sector lead to a sizeable gap between borrowers’ refinancing needs and what senior lenders are willing to provide, according to Florio.
“I’d say what we are starting to see is increasing level of interest in credit, in particular distressed credit,” said Weill. “And we are also seeing broad interest building in distress strategies. There are signs that assets are beginning to trade, debt is repricing, couple of large portfolios of distressed debt [are] coming to market—and there’s interest from investors in taking advantage of that opportunity when it presents itself.”