At the beginning of 2023, ‘wait-and-see’ remains the overarching investment philosophy. In part, this is driven by a fear of blinking first, particularly amongst low-risk capital. Those requiring debt financing, such as private equity, are largely forced into this strategy however, given the current arithmetic of borrowing costs relative to property yields. Many institutional asset managers who are beholden to the scrutiny of investment committees will also remain on the sidelines, as it remains difficult to articulate why any asset won’t be cheaper in six months’ time, albeit we are starting to see this change in some markets, as pricing becomes increasingly compelling.
 

Positioning for the recovery

At some point, those investors currently in hibernation will emerge and start taking on more risk. There is plenty of capital ready to deploy when the market does recover, with an estimated US$811bn in dry powder sitting in the accounts of unlisted funds globally, enough liquidity to underwrite two-thirds of the total market last year (chart 4). This stock of unallocated capital remains well above pre-pandemic levels, despite a challenging environment for fundraising which underpinned a 30% decline in total capital raised last year. Value-add and opportunistic funds have performed better than other strategies, providing more flexibility, and more freedom, to deploy in distressed markets. Meanwhile, major global institutional funds continue to favour real estate as an asset class, with average target allocations expected to rise again in 2023. Middle Eastern investors in particular are likely to be active, with the regions Sovereign Wealth Funds (SWF) benefitting from a major cash windfall due to higher energy prices.

There is unlikely to be much deal origination early this year. Cash-rich, discretionary equity funds and private investors are selectively bidding on assets, ‘averaging in’ to the market downturn and leveraging purchasing power given the lack of competition. But they are in the minority; and given a typical transaction can take upwards of three months to complete, it will probably be the second half of the year before we see any sustained recovery in investment volumes. But the general consensus is that there is a more active market around the corner, providing two preconditions are met:

1. More certainty in the economic outlook Interest rate volatility underpinned a rising share of terminated deals in the second half of last year. So peak inflation and interest rates will provide more stability in 2023. But we remain in a bear market for commercial real estate, and the consensus baseline global economic outlook is a low conviction view, with risks skewed to the downside. This makes it difficult for investors to have confidence in their ability to underwrite new deals.  
2. A further decline in valuations The perception of portfolio diversification in private real estate is somewhat misguided; in aggregate, it is a pro-cyclical asset class, providing leveraged exposure to GDP growth (Chart 5). This relationship is intuitive; returns are in aggregate determined by underlying tenant demand, which is driven by trends across employment, consumer spending, and trade etc. Investors generally recognise that, where it hasn’t already, pricing needs to adjust to reflect the reality of a global recession. In the listed-sector for example, REITs continue to trade at steep discounts to their net asset values. 

A period of price discovery

The sharp rise in interest rates has squeezed risk premiums on real estate (Chart 6). At the same time, public markets are signalling that investors require higher returns to take on risk. Property prices have already started to adjust, particularly in Europe and to a lesser extent North America, underpinned by a simple arithmetic to the higher interest rate environment. But while buyers are forward looking, sellers are predominantly backward-looking in their price expectations, and are not fully discounting future economic weakness (especially those who acquired assets at the peak of the market).

The period of price discovery that has characterised the market recently will continue to support a more circumspect investor in early 2023. More certainty in the economic outlook means accepting that we are on the verge of a slowdown in rental growth prospects, and that borrowing costs will remain elevated. In some markets, this probably means the adjustment process has further to run. 

The eye of the storm

Direct real estate is slow moving. Valuations are infrequent, and piecemeal in nature; those expecting a cliff edge event triggered by year-end 2022 valuations are likely to be disappointed. The adjustment in pricing will however accelerate through this year. Valuers follow the market, which means valuations are a lagging indicator. As some seller attitudes switch from a position of reluctance to necessity, more supply should come to the market. This will provide an opportunity for buyers as there will be a price realism, particularly in some cases these assets will be owned by sellers with limited bargaining power.

Many of these ‘motivated’ sales will be triggered by refinancing events. Loan distress is yet to materialise; as of Q3 last year, the delinquency rate of commercial real estate loans held by the largest 100 banks in the US was just 0.7%, compared with a peak of 10% in the aftermath of the global financial crisis. But there is a significant quantum of debt – originated at rock bottom rates – that needs rolling over in 2023. Again in the US, around US$ 16bn of office mortgage backed bonds (CMBS) are due for refinancing in 2023, double the equivalent volume of debt due last year. In Asia Pacific, investors are watching Australia and South Korea with interest, with the latter already seeing some signs of distress amongst the domestic Limited Partners (LPs).

The combination of higher debt costs and a decline in valuations will make some deals impossible to refinance without injections of new capital, something not all investors will be willing or indeed able to do. Interest coverage multiples are back in vogue for lenders given the sharp rise in debt servicing costs, and in any recession there will be a rise in corporate failures, which will hit tenants, pushing more assets to the market as landlords struggle to finance payments on their outstanding debt.

The denominator effect

There will be other drivers of increased liquidity coming to market. Nearly one-third of global institutions were over-allocated to real estate at the beginning of 2023, compared with less than 9% at the same time last year, after incurring outsized losses on listed and credit portfolios last year. Most investors will prefer to wait for a rebalancing between public and private portfolios as real estate valuations catch up. But some funds may need to liquidate their more resilient private assets to rebalance portfolios, especially if equity markets face further selling pressure. Cash-flow will also be important for many open-ended funds, where redemptions will likely encourage sales, even if the underlying funds remain profitable. And then there is the normal process of exits, with around US$ 345bn in liquidations expected next year as some funds come to a natural termination.

Alpha is king

Looking ahead, there is a renewed focus on fair value in a world of higher interest rates. The new world order is probably characterised by lower excess returns to commercial real estate, with pricing settling at a level where there is limited or no accretion from taking debt. Investors, who were encouraged into the market by the outsized returns of the last decade, will struggle to hit historical targets as a consequence, particularly those cash-on-cash driven investors, which probably means fewer active market participants returning to the market and a lower base for investment activity. This will take time to wash through an increasingly saturated marketplace, and probably requires some consolidation of General Partners (GPs); there were nearly 1,800 funds actively raising capital at the beginning of 2023, up by one-third on 12 months prior, while 509 funds closed last year. According to data from Realfin, LP’s are less likely to engage new managers than they used to be.

There are plenty of commentators out there prophesying a new age of alpha in investment markets; i.e., a focus on outperforming the market. This is true for real estate as much as any other asset class. Asset prices have been supported by a common global driver, ultra-loose monetary policy, but this era is now shattered. Never before has rental growth been more important to the market. Experience will tell; investors with dedicated teams and a strong track record will be better positioned to outperform in this environment. The good news is that there is plenty of room for alpha in private markets, underpinned by information asymmetries and a lack of transparency. And there remains plenty of interest in real estate as a source of alpha from the major LPs (chart 7).

‘Buy the supply side’

Moving through 2023, sectors where supplydemand imbalances exist will continue to attract investors. But while the weaker economy hits occupational demand across all sectors, supply dynamics may be more important in differentiating across individual assets and locations.

This favours core CBD offices in Europe and Asia Pacific, prime logistics in good locations, multi-family, and high street luxury or nondiscretionary retail. Shorter lease lengths in these supply-constrained sectors/locations provides investors with some reversionary upside opportunity through rental growth, but also adds to leasing risk in a market downturn, highlighting the importance of building quality.

Sectors where investment opportunities can be underwritten with good, stable structural trends will also do well as thematic investors hold true to their investment theses (which shouldn’t change much in the current environment). Demographic trends for example – important in multifamily – can be forecast with relatively high conviction and it’s very difficult to find someone who doesn’t back the growth of e-commerce retail over the long term, so much so that it could be self-fulfilling.

The impact of ESG is also moving in one direction and will continue to permeate through the decisions made by tenants and investors. Institutions will become increasingly vocal in how their GPs identify, acquire, and operate assets in line with their ESG mandates.

Cross border investors will likely remain cautious this year; geopolitics is an increasingly important component of due diligence, and currency movements will remain volatile. Large Middle East and Asia Pacific investors driven by leveraged cashon-cash returns will struggle to meet targets in an environment where the cost of debt exceeds the initial yield. Higher domestic interest rates will also deter some private investors; in the Middle East for example, cash deposits can yield as much as 6% in some markets.

However, some cross border investors will still be actively looking for discounted assets, particularly while there is limited competition. USD-denominated investors should be able to continue to extract relative value this year in a strong dollar environment, supported by a hawkish US Federal Reserve and continued safe-haven capital flows. The relatively fast adjustment in pricing across European markets may support a quicker ‘V-shaped’ recovery, especially if the economic outlook continues to improve, while rental indexation remains a unique proposition for investors concerned with inflation. Equally, Japan looks particularly attractive for international investors given low interest rates and the weak yen, however it is a difficult market to access without a local partner.