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PERE US Roundtable: US investors still hesitant amid ‘shell shock’

November 2, 2023

US investors still hesitant amid ‘shell shock’

Interest rates may be close to peaking, and wider economic indicators are healthy, but real estate market activity remains muted, say participants in PERE’s US roundtable.

Hopes are growing that the US economy could yet manage a soft landing. The US Federal Reserve decided to keep its key interest rate at 5.25-5.5 percent in September, with officials seeking to curb inflation without tipping the economy into a painful downturn, and there are signs the central bank’s strategy is working. Inflation fell to 3.7 percent in August, while unemployment is close to a 50-year low. The latest projections show the economy growing 2.1 percent this year and 1.5 percent in 2024 – more than previously estimated.

But the medicine of 18 months of interest rate rises has tasted bitter for real estate investors. Broker CBRE calculates that US commercial real estate investment volume fell by 64 percent year-on-year in Q2 to just $75 billion. Participants in PERE’s US roundtable, held in New York in September, agree the slowdown has been dramatic.

“Uncertainty around where the rate hikes will stop and level out appears to be keeping volume down, and also creating wider bid-ask spreads than we’ve historically seen,” says Jason Schreiber, investments principal at manager CIM Group.

Few deals are closing on the basis set out in the term sheet at the outset of the process, observes Stephen Rabinowitz, co-chair of the global real estate practice at law firm Greenberg Traurig. “I can’t remember a time when there was this much uncertainty. There’s so much changing, on every transaction.”

“The cost of debt has doubled in 18 months and availability is significantly lower. Originations are close to a 10-year low,” says Adam Berns, US chief investment officer at alternative asset management firm GLP Capital Partners (GCP). “There is still capital that has been raised for private debt strategies seeking a home. But even when there is debt available, there is often disagreement between buyer and seller on the transactable value, or, if they can seemingly agree on a valuation, a seller may not want to transact at that level yet.”

Not only does the high cost and scarcity of financing render many deals on standing investments unviable, but development has been impacted too, says Shawn Lese, chief investment officer for the Americas at manager Nuveen Real Estate. “A lot of transactions just don’t pencil out, particularly as you go higher up the risk spectrum. We are seeing new development activity almost cease at this point.”


Tight credit, reduced liquidity

Back in March, the US banking crisis dominated the business pages. Fears were rife that the collapse of both Silicon Valley Bank and Signature Bank might lead to contagion spreading through domestic and international financial markets. Only six months later, however, the roundtable participants note the topic is rarely raised anymore.

“It seems to have worked itself out,” says Rabinowitz. “You still hear grumblings that small regional banks with lots of medium-sized office loans have yet to feel the full effect of what is happening in that market. But in terms of our clients’ day-to-day worries, it isn’t high on their list. Most have switched to bigger, more secure, money center banks.”

The crisis has squeezed the availability of debt finance, however. “Regional banks are no longer growing their loan books, while larger banks are tightening credit standards,” says Berns. “But because it accelerated the tightening of credit and reduced liquidity, the regional banking crisis may have had a positive effect in shortening the Fed’s campaign of interest rate rises overall.”

Meanwhile, the money center banks that are still lending are able and willing to serve only a shrinking group of borrowers, says Lese. “They are active, but don’t expect a huge amount of new credit. Out of their existing borrowers they are selecting a limited group to which they will continue to lend. At this point, there are haves and have-nots in terms of who can borrow.”

The tightening of banking regulation has created an opportunity for private debt funds to step in and fill the gap, says Schreiber, but they are unlikely to make up the shortfall entirely. “There is approximately $2 trillion of commercial real estate loan maturities in the next two and a half years. I don’t see the private debt market stepping in to backfill the whole share of regional banks and those who have turned off lending or had to tighten their standards.”

Besides, some private debt providers are facing their own constraints, he adds. “Some credit vehicles are financed through the short-term repo market, as a bridge to a [collateralized loan obligation] exit, and those facilities are essentially frozen when interest rates are high.”


Psychological scars

Interest rates may be at, or nearing, their peak, however. “Most players in the market think that we are hitting the top, that there is maybe one more 25 basis-point hike to come, and that rates are then going to stabilize and remain higher for longer,” says Lese. “There are signs that market activity is beginning to come back as sellers and buyers get closer to finding they can finally agree on a price that makes sense for them both.”

But Rabinowitz suggests the psychological scars inflicted by recent events still need to heal for the market to return to full health. “I get the sense from talking to people that there has been so much going on – covid, the office market, interest rates, a major war in Europe, strikes, the climate – that even though we are seeing more activity in the past couple of months, people are generally still more hesitant than they should be in saying now is the time to dive in. There is a sort of shell shock.”

With rates seemingly close to their high point, the cost of debt is easier to underwrite, says Berns, but other obstacles remain. “A year ago, the uncertainty in underwriting was both cost of debt and its impact on growth and cap rates. Today, the cost of debt is easier to underwrite, but there is still uncertainty around whether cap rates have stabilized. It’s less uncertainty, but it is still leading to disparity between the prices at which sellers will transact, and which buyers will pay.”

Market participants sense valuations are still lagging their true levels, says Schreiber. “We believe the spreads Schreiber. “Particularly for real estate equity funds, we notice that LPs want between real estate cap rates and 10 year Treasuries, or BBB corporate bonds, are still very thin, and so there is a belief that there is going to be more cap rate expansion in the future, even if there are no more rate hikes. Getting buyers and sellers to line up their cap rate expectations is still a point of contention.”


Fundraising pinch

With differing price expectations making it difficult to deploy capital, it is no surprise that capital raising has been affected. “The first half of this year was down 50 percent versus last year,” says Berns. “A lot of capital was raised 12-18 months ago, but LPs aren’t seeing that deployed. They’re also seeing denominator effects and lower realizations, so they have less ability to make future commitments. Those are all contributing to less new capital being raised.”

The fundraising pinch is not affecting all managers equally, notes to put their money with experienced managers who they believe have the judgment, the foresight and the proven track record to navigate rocky cycles like this.”

The participants believe the environment for capital formation is likely to improve, however. Lese argues the denominator effect is reversing, and predicts that when more capital begins to flow into the core space, some of the investors currently queuing to redeem their interests in open-ended funds will change their minds and leave their capital where it is.

“With interest rates close to peaking, we hear more optimism about capital commitments in 2024,” says Berns. “At some point the transaction market will pick up and current funds will probably be a pretty attractive vintage.” In the meantime, most investor demand is for opportunistic and value-add strategies. “That is reflective of how challenging it is for income-oriented strategies to generate historical target returns in the current interest rate environment.”

Rabinowitz observes fund formation is one of the “bright spots” for his practice at present. “We are seeing a trend where clients who would have done individual deals are doing specialty funds instead to secure a more permanent source of capital. They might identify a narrow thesis like building hotels in secondary markets, for example, and only plan to do a few deals, and then raise a fund around it.”


Office meltdown

The meltdown in the US office market has been well documented, with values falling by a third to a half and leasing activity weakening. “We don’t have any clients actively looking into office right now, other than best-in-class assets,” says Rabinowitz.

He identifies a clear “flight to quality” as occupiers and investors focus on a small minority of modern, well-located buildings. One Vanderbilt in New York, the venue for the roundtable discussion, is identified as one such asset. Developer SL Green’s Midtown skyscraper 245 Park Avenue, in which Japanese investor Mori Trust bought a 49.9 percent stake in June, is cited by the participants as another example of the type of office asset in which investors will continue to show faith.

“If you can deliver office buildings like that, you will be able to fill them,” says Lese. “Demand for space remains strongly positive for offices built or renovated after 2015. Older vintage properties have a much higher vacancy rate.”

The extent of the slump in office property values can be explained by the scale of the capital expenditure required to bring dated assets up to the standard expected by contemporary occupiers, he argues.

Reuse for residential apartments has been proposed as a potential strategy for swaths of obsolete office buildings, but the practicality and viability of such projects is often questionable, suggests Schreiber.

“We have done about a dozen conversions over the years, and you really need a perfect trifecta to do it,” he says. “It needs a floor plate that is conducive to residential because of building laws about fenestration, light and air, access and emergency exits. The building needs to either be empty, or able to be emptied out. And on top of that, you need to have a seller, whether it is the bank or the owner, who is going to sell at a low enough price for it to pencil. It doesn’t just happen overnight. And it happens to very few buildings.”


Cracks in the ice

With two of the largest real estate asset classes, office and retail, out of favor, investors in US real estate have increasingly broadened their investment portfolios to encompass smaller, less established sectors.

“Niche strategies are probably the most interesting place to be looking to acquire assets right now. Some of them have already become mainstream, so you no longer need to go through an educational process where you explain the fundamentals of that industry to investors,” says Lese. “The question is, how niche do you want to go? Which are the best ones to select? For me that comes down to how scalable they are, as well as what their growth prospects look like.”

The growth of data centers as an asset class has been one of the “shining lights” of the real estate industry in recent years, says Schreiber. CIM Group began investing in the sector eight years ago. “We have seen tenant demand being driven by AI, as well as the growth of cloud services. The supply of developable land with low-cost power is constrained, and the buyer market is increasingly deep as more institutions raise money for that space. Niche asset classes that tell a good story and have a good outlook can have higher growth than more established sectors.”

GCP also identifies the sector as offering attractive opportunities to managers with the necessary skills: “There are lots of barriers on the investor side, because it is very technical, very capital intensive and mission-critical for the customers, so counterparty expertise matters. It is one of the few areas where you can say there are still real secular tailwinds to growth, and real supply constraints,” says Berns.

Other appealing niche sectors picked by the participants include life science, medical office, new-generation senior living, recreational vehicle parks and self-storage. Lese suggests adding affordable housing to the list: “We have been doing it for about 30 years. It is complicated because the regulations are different in each municipality, and it is operationally intensive. The benefit though is that as well as doing societal good, investors achieve a return profile that is more bond-like in nature, with a high degree of durability, and also an inflationary uplift.”

As the discussion draws to a close, the participants consider when the market will succeed in shaking off its sluggishness. “We are seeing some cracks in the ice and some thawing already,” says Lese. “Next year should see a bounce back in terms of activity, and stabilized valuations in most sectors.”

Banks may be the catalyst for activity as regulatory requirements bite and force them to stop extending loans, predicts Schreiber. “There are lots of maturities coming up. When the banks foreclose or sell non-performing loans, we believe that should provide a reset basis for the market and spur activity, as long as there is debt available to finance purchasers.”

Berns adds: “It’s hard to imagine that volume isn’t going to be higher next year, whether that’s because there is more distress, or because there is more liquidity available, and it is just a more functioning market.”

Similar predictions have been made in the recent past without the hoped-for recovery ensuing, however, cautions Rabinowitz. “While I am optimistic that next year will be better, it seems that a lot of people have been looking for the next excuse not to do something, and we have a big election coming up in November next year.”



“US investors still hesitant amid ‘shell shock’” was originally published in PERE.


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