You’ve likely heard the buzzword used to label today’s real estate investment landscape: “unique.” While it aptly describes fundamentals on the ground, it may not go far enough in alerting investors to the potential bottom-line moderation: core private equity returns may be flat-lining.
The set-up: Why this “unique” cycle presents a smooth landing
While market rents continue to climb, supply growth is here to stay through the remainder of this current cycle. Apartment, industrial, office and lodging sector supply growth is running at or above historic norms. In fact, “supply-constrained” gateway markets are the ones with the most cranes. Why the pivot to these bigger, historically supply-constrained, densely populated markets? First, there’s the psychological safety and perpetual growth expectations of the Manhattans over the Milwaukees, leading to a flood of private capital into these markets post-financial crisis. Also, historically low interest rates have reduced at least one barrier to entry. This capital infusion along with healthy job growth has driven up real estate values to potentially unsustainable levels, and as the expression goes, the faster they rise, the harder they may fall.
Net operating income (NOI) growth has also stalled for a variety of reasons, including near-full occupancies, shifting demographics and technological disruptors. Core sectors like office and retail are receiving ever-changing tenant demands to compete with the “Amazons” and “WeWorks.” This may require significant cap ex to fill occupancy, cutting into bottom-line cash flow and building valuations. The resulting decline in appreciation may make core real estate values vulnerable moving forward.
The fallout: Declining asset values, Fed-induced debt issues
A potential vacuum was created by heavy gateway market supply, moderating NOI growth, and propped up core private equity values. And the fallout could be stark.
The NCREIF Open End Diversified Core Equity Index (ODCE) has seen a demonstrative drop in gross total returns over the last three quarters, including negative appreciation in Q2 2019, a first for the index in nearly a decade. The NCREIF Property Index (NPI) is also pointing to decelerating building value returns with two out of the last three quarters posting the lowest total returns since the cycle started in Q2 2010.
We believe this drag is stemming from two factors: inflated net asset values (NAV) and mark-to-market debt on a borrower’s balance sheet.
A large part of the decline in current NAV came from a slow-moving, haphazard appraisal process. For example, the public market was a full two years ahead on deterioration in retail values, just as the private market continued to flood the space. Some private markets are just starting to catch up, revising retail values down some 20 percent in a quarter, significantly contributing to the ODCE’s paltry Q2 returns. The key word in this analysis is “starting”, as appraisers are finally ripping off the band aid in retail by pointing to sufficient comps to appropriately lower values. We believe a broad-based adjustment will likely happen over the next three quarters, so there’s the good possibility of more pain to come. In fact, the public market is now signaling that office may be next, as it’s trading at some 10-15 percent below private market NAV.
Also, the Federal Reserve’s about-face on interest rates had an impact on core investment values. With the decline in rates during Q1, fixed-rate debt was marked to market. When fixed-rate debt is an asset (i.e. an investment) and rates drop, the debt appreciates for its owner. However, when that debt is a liability on a borrower’s balance sheet, it depreciates the asset base of the borrower.
Together, these two factors significantly contributed to a drop that would have been even more precipitous if not for the appreciation from multifamily and industrial. Public apartment REITs and Industrial REITs are trading at approximately 5-10 percent above private market NAVs, and should continue to benefit diversified private equity returns in the near-term.
Is the definition of institutional access evolving?
We have started to see institutions rush out of core, curbing fund flows into the ODCE and instead pushing dollars into value-add and niche strategies with greater potential NOI upside, as well as debt investments that may help balance interest rate exposure. Investors looking for access to institutional real estate and its uncorrelated, income-focused returns should be wary of 100% core equity strategies tethered to the troubling signs coming from the standard-bearer indices. Instead, we believe access to real estate offers many paths, perhaps by following institutions into value-add and debt strategies not hampered by today’s “unique” late-cycle environment.