As higher interest rates and inflation created more anxiety among commercial real estate investors over the past year, they are placing more importance than ever on portfolio diversification.
The U.S. is currently experiencing an economic environment that, in some ways, is more disruptive and more difficult to plan for than the Great Recession, notes BJ Feller, a managing director and partner at Northmarq, a provider of capital solutions for the commercial real estate industry. Back then, all headwinds pointed to a pullback in liquidity and the challenges could be easily understood.
Today, investors are dealing with fears about a potential recession, high capitalizations costs and an economic environment that’s shifting the way different asset classes have performed in previous decades, Feller says.
“Right now, there’s this dynamic and scenario that’s formed that’s caused investors to question everything, including the diversification of their capital holdings in probably a way they’ve never had to do comprehensively before,” Feller notes. “Some of the planning and diversification is more front and center and on a six-to-12-month horizon. But some of it is on a five-year, 10-year and multi-decades horizon.”
London-based research firm Preqin reports that investors’ optimism for the real estate sector that was prevalent at the end of 2021 has now been replaced with a more pessimistic outlook. As the Fed is expected to raise interest rates further, asset values are beginning to fall and that will likely make 2023 a challenging year for the commercial real estate sector, the firm’s researchers note. Some 74 percent of investors surveyed by Preqin in November said real estate is currently overvalued.
Preqin reported that fundraising figures for real estate dropped last year compared to 2021, with 249 funds closed and $101.9 billion raised by the end of the third quarter, compared to 546 funds and $210.7 billion raised during the same period the year before.
Funds with a value-add focus were the dominant investor strategy in 2022—they accounted for almost 40 percent of all funds closed through the end of the third quarter. Those types of funds would be able to capitalize on opportunities like repositioning older office stuck to improve its rental prospects, Preqin researchers note.
Dave Lowery, a senior vice president and head of research insights at Preqin, says the market appears to be in the preliminary phase of a readjustment to higher interest rates and concerns about lower demand caused by an economic slowdown.
“Investors may well sit on their hands and wait for the market to settle before making any new allocations, while fund managers will need to find agreement on pricing for deal activity to increase,” Lowery says.
Greater focus on diversification
Today, passive real estate investors are targeting a wide variety of strategies to achieve their targeted returns, led by some traditional favorites, according to Aaron Jodka, director of research, U.S. capital markets, at commercial real estate services firm Colliers. Collier’s latest Global Investor Outlook, for example, showed that multifamily and industrial remain the top asset types for investment in U.S. real estate.
ESG-compliant office buildings, grocery-anchored retail and luxury hotels ranked the highest within their specific asset classes for investor interest. Life sciences properties, data centers and student housing remain the top alternative asset classes, Jodka says.
“Investors are looking at demographics, and this is causing some to shift capital allocation to specialized assets, such as senior housing, student housing and life science,” he notes. “Meanwhile, they are seeing strong opportunities to be on the lending side of the equation in today’s higher interest rate environment. This is providing equity-like returns, from a historically more stable debt position.”
“There is a clear desire for better quality assets, regardless of asset class,” Jodka says. “Building a portfolio for the long term, that provides diversification, and resilience to market fluctuations, is important.”
In fact, portfolio diversification is now viewed as more of a necessity than it was prior to the COVID pandemic, according to Feller. For example, he recently worked with an investor who sold $90 million in multifamily assets and redeployed the money into a portfolio of net-lease assets that included retail, industrial and school properties.
“We asked the question ‘Are we diversified enough?” Feller says. “Are we too concentrated in risk profiles and tenants as the post-pandemic continues and conditions play out. I just shuffled out $20 million in deals because there wasn’t enough diversification there.”
Many investors are playing “real estate Jenga”—going through their portfolios and stress-testing assets, thinking about what the future might look like and playing out risk-adjusted scenarios and whether they need to reposition their properties, Feller says.
“This is probably the biggest shift we have ever seen because of the pressure of higher interest rates for investors who are saying ‘I can’t go buy an asset that’s either stabilized or not stabilized and lock in 10-year money because it’s too expensive,” Feller says.
Meanwhile, more REITs that have focused on retail in the past are moving to omni net lease properties. They no longer focus just on retail, but on assets that have the capability to serve customers in store and through logistics facilities, he adds. “That’s a great example in real time how funds and institutional investors are shifting strategies and diversification,” Feller says.
In contrast to some other market observers, Darin Mellott, senior director of capital markets research with commercial real estate services firm CBRE, says the firm’s investor intentions survey, scheduled to be published in January, found that 75 percent of those surveyed plan to keep their commercial real estate allocations constant. Another 20 percent say they plan to increase allocations to real estate to some degree, while a small number of primarily larger investors plan to decrease allocations. As a result, CBRE has greater confidence that after a couple of “rough” quarters, uncertainty will lift and capital markets will recover.
At the same time, “People realize the benefits of diversification across asset classes and… a series of interest rate hikes have changed the way they approach investing,” Mellott says. “The most favored property types heading into the uncertainty will be the most popular property types on the tail end of this. We fully expect multifamily and industrial are going to be favored. We’ve had 10-plus years of negative headlines about retail, but while retail was reinventing itself and going through a period of change, there wasn't meaningful supply built, so retail is heading into this with a strong set of fundamentals. Grocery-anchored retail is viewed very favorably.”
One of the biggest changes Mellott expects to see in investor preferences will likely be the search for opportunistic strategies.
Certain asset classes, like multifamily, continue to be in favor in spite of interest rate hikes because they can raise rents every year, which serves as a hedge against inflation, notes Janice Stanton, executive managing director, global capital markets, at real estate services firm Cushman & Wakefield. But that doesn’t mean investors are “ignoring the diversification guidelines and not doing other stuff. It becomes more appealing to buy tactically at that point in the cycle.”
Investors have been diversifying more geographically, by focusing more on the Sunbelt markets, and there has been more of a gravitation to core and core plus assets in general, Stanton says.