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Institutions May Deploy Dry Powder for Real Estate Heading into 2023

Big investors may hunt for value-add and opportunistic plays in the coming year amid rising allocations.

It sounds counterintuitive to the slowdown in new investment activity seen in recent months, but a new industry survey shows that institutions are continuing to raise their target allocations to commercial real estate.

Rebalancing is occurring now, but there also is some “wait and see” on reinvestment as private market valuations are still transitioning relative to the higher cost of capital, notes Todd Henderson, co-Global Head of Real Estate at DWS Group, which has $38 billion in AUM in the U.S. REIT values have already reset, and that repricing is beginning to roll through appraisal based valuations. “So, institutions are not necessarily making a lot of new allocations today,” he says.

However, unlike past downturns, institutional investors recognize that commercial real estate (CRE) sector fundamentals remain strong, with the exception of office. There is some expectation that there will be buying opportunities ahead created by distress or dislocation in markets. “Institutions are trying to ensure that they have dry powder to take advantage of the backside of what we expect to happen throughout next year,” says Henderson.

Looking ahead to 2023, investors are seeking risk-adjusted returns that favor opportunistic and value add strategies to hit their desired returns. “The best risk-adjusted returns are with those opportunistic prospects where they can take advantage of liquidity and lower leverage in the market,” says Trisha Connolly, a principal and chief operating officer, U.S. Capital Markets Group at Avison Young.

In addition, investors are on the hunt for distressed opportunities or special situations where they can capitalize on an opportunity, adds Connolly. “Right now we’re in the early stages of seeing these distressed opportunities, so investors are getting creative with opportunistic capital to deploy in these special situations,” she says.

After hitting a 10-year high of 10.8 percent in 2022, institutions are preparing to lift targets by another 30 basis points to 11.1 percent in 2023, according to the annual Institutional Real Estate Allocations Monitor published by Hodes Weill & Associates and Cornell University’s Baker Program in Real Estate. Target allocations have been on a steady upward trend since 2013 when targets were at 8.9 percent. “So, we were not surprised to see continued growth,” says Douglas Weill, Managing Partner at Hodes Weill & Associates. “What’s interesting over the past few weeks is that we’ve seen a number of institutions announce that they’re raising their targets further in the face of the opportunity to maybe take advantage of some distress,” adds Weill.

The biggest obstacles are market uncertainty, rising interest rates and shifts in portfolio values that have triggered a “denominator effect”. The strong performance of real estate in 2021 combined with a decline in other assets has pushed many institutions over target allocations.

Despite the possibility of a recession ahead, results from the Allocations Monitor also reinforce the business case for investing in U.S. CRE. When looking at the five-year average returns, the Americas outperformed other regions with an average of 10.4 percent per year—190 basis points higher than target returns of 8.5 percent. Five-year returns were bolstered by an exceptional year in 2021 with portfolio returns in the Americas that averaged 19.1 percent. “However you benchmark these returns, real estate is significantly outperforming expectations and targets,” says Weill.

That performance is helping to support overall investor sentiment of CRE, which did not go down as much as one would expect given some of the market challenges. On a 10.0 scale, the survey’s Conviction Index for the Americas dropped from a 10-year high of 6.5 in 2021 to 6.2. As a result of uncertainty, many investors are sitting back and waiting until the market corrects, notes Weill. However, sentiment remains modestly optimistic with levels that are higher than the past several years.

“The U.S. is viewed favorably as a market of relative stability and good growth prospects,” adds Bernie McNamara, head of client solutions for CBRE Investment Management. The U.S government is very deliberately trying to engineer a mild recession to contain inflation. Yet, there is an expectation of a fairly robust recovery given the strong labor market and broad demographics, whereas there is likely to be more of an acute recession in Europe and a weaker recovery in that region, he says. Investors also are wary of China, which is struggling with its zero COVID policy.

“There is some consideration around the strength of the dollar for those investing from outside the U.S. But in general, we see a lot of investors interested in the U.S.,” says McNamara. Institutional investors are looking for globally diverse portfolios with an overweight to the U.S. and overweight to AIPAC, perhaps excluding China, due to the growth prospects in those regions, he says.

According to the Allocations Monitor, investors active in the Americas prefer value add strategies at 81 percent, 73 percent opportunistic and 54 percent core. Breaking down those CRE strategies a bit further, there is continued interest for certain strategies with favorable fundamentals and good tailwinds that are supporting rent growth and demand, such as industrial, multifamily and single-family rentals, self-storage and data centers, according to Weill. (Those results are also similar to what WMRE found in its research earlier this year.)

There also is building interest from institutions to allocate capital to strategies that can take advantage of repricing in the market, whether that is distress or adjustment in values. “There is a view that the next couple of years, 2023 and 2024, will be good vintage years to deploy capital. What the market is trying to figure out now is whether we are at the doorstep for those opportunities, or whether it will take six to 12 months to play out,” he says.

A lot of investors are favoring value-add because they expect opportunities to form to take advantage of selective stress or distress in the market, such as the need for recapitalization or gap equity, agrees McNamara. Some value-add investment opportunities have income in place, which also offers added defensive characteristics in the current environment where cash is king, he says. However, CBRE Investment Management’s view is that core will continue to be the foundation of most investors’ allocations. On the opportunistic end of the spectrum, there also continues to be interest in build-to-core strategies, particularly in growth sectors such as logistics and residential, he adds.

CBRE Investment Management also is seeing institutions exhibit a bigger appetite for public REITs, which is a continuation of a trend that gained momentum during COVID. Institutions that didn’t have a listed real estate strategy couldn’t take advantage of the buying opportunities that emerged at the onset of the pandemic. “You could argue that we’re in another window of opportunity with such pricing dislocation versus private market values, but also more broadly with the REIT market being down 15 to 20 percent,” he says. “So, we are starting to see investors act on the listed side, and that is something that we’re doing as well in some of our strategies.”

Another notable finding of the Allocations Monitor is that ESG continues to be a growing factor in investment decisions, with 56 percent of institutions now reporting that they have implemented a formal ESG policy. “Despite all the headlines of what some U.S. states are doing in terms of pulling back on ESG, the majority of institutions now have formal ESG policies and it is front and center,” says Weill. “It’s not the reason that an institution will make an investment, but it is driving decisions and there is a prevailing view that strategies and management companies that have ESG as an objective are expected to outperform over the long term.”

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