Investors Are Taking on Real Estate Risk in the Search for Higher Returns
March 01, 2021
By Joseph Rubin
The search for yield has caused many commercial real estate investors to change old habits. Even before the pandemic struck, declining interest and capitalization rates drove investors up the risk curve to achieve higher returns. A recent study by Hodes Weill & Associates showed that in 2020 institutional investor risk preferences shifted from core/core-plus to value-add and, depending on the investment mandate, to opportunistic. According to Doug Weill, co-managing partner of Hodes Weill, this shift is reflective of the low interest rate environment and late-cycle investing. The pandemic has forced investors to further refine their hunt for new deals, shifting property type and market preferences while continuing their search for relative yield. Some have diverted capital from more traditional outlets to distressed opportunities.
The real estate industry entered the pandemic with strong fundamentals and abundant debt and equity capital. Private equity firms had raised record amounts of cash, and rising equity prices have caused institutional investors to move more capital to real estate to keep their portfolio allocations in balance. Drew Fung, head of the Debt Investment Group at Clarion Partners, points out that although capitalization rates had compressed during the past few years, the spread between capitalization and Treasury rates still provides relative value for real estate investment over other asset classes. Additionally, real estate is often seen as an inflation hedge. The resulting flow of capital into the sector has put further downward pressure on investment yields.
While there was a pause in capital raising and investing when the pandemic hit, within a few months investors were ready to deploy funds again; a startling contrast to the Great Financial Crisis when it took years for capital and liquidity to return to the real estate sector. In fact, Weill believes that all the available capital will somewhat mitigate the potential decline in property values caused by the economic fallout of the pandemic. Still, the pandemic has caused investors to redirect their real estate dollars.
According to Fung, the search for yield has forced investors into new types of deals, properties, and markets. In addition to core, institutional players are now investing in “develop to core” situations, building high end properties to capture increased demand in secondary lifestyle cities. Core investors had largely avoided development in the past and ignored smaller markets. However, these markets have become particularly attractive for their climate, low cost of living and low/no income taxes and have seen the type of population and job growth that fuels real estate demand. To achieve yield, the investment thesis has evolved from balanced income and appreciation to primarily appreciation.
The pandemic has made finding real estate deals more difficult as the risk profile of traditional investment options has changed. Capital is being reallocated from retail and hospitality to the more “COVID-resistant” industrial and multifamily sectors. With so many investors chasing those deals, prices are up and returns are down. And office has not proven a safe harbor; unless the property enjoys long term leases with credit tenants, investors have taken a wait-and-see attitude on the office sector, unsure of the pandemic’s long-term impact on leasing and valuation. As opportunities in traditional property types fade, investors have sought specialty property types. Weill notes that life sciences and laboratory space, and TV and movie production facilities are attracting a lot of capital. Investors are also focusing in on data centers and cell towers. These special use properties in secondary and tertiary markets had not been the traditional targets of major institutional players in the past.
Achieving higher yields often means buying property at a discount, but despite the sudden turn in the economy most sellers are not willing to give up their equity and their option on future appreciation. With transaction volume significantly reduced since the second quarter of 2020, price discovery has become far more difficult. “In the midst of the pandemic underwriting value is almost guesswork, with leasing ground to a near halt and pre-COVID-19 ‘comparables’ of little use going forward,” remarked Craig Solomon, CEO of Square Mile, in the EisnerAmper-Preqin Real Estate Private Equity Study. Moreover, because the downturn was not due to a real estate supply and demand imbalance, many owners believe the behavioral changes associated with the health crisis will reverse and values will ultimately be restored. As a result, if the seller is not in a severe liquidity crunch, bid-ask spreads remain wide. And even those owners who are strapped for cash are seeking rescue capital rather than selling outright.
That rescue capital is not cheap. Investing in distressed situations, a place larger institutions such as pension funds tend not to go, can still achieve opportunistic returns. Michael Ashner, CEO of Winthrop Realty, agrees that, overall, real estate investors are discounting risk more than they have in the past. A distressed investor for decades, he notes that the real estate industry is currently diverging between well capitalized properties and sponsors, and those where either or both the property or the sponsor are experiencing some level of distress, particularly the illiquidity caused by falling rental revenue. The “have not” situations are difficult to price and require higher risk adjusted returns.
During the past few years, traditional equity investors have sought higher risk adjusted returns in debt. Many real estate companies and private equity firms created debt funds, and those funds are now raising significant capital to provide bridge, mezzanine, and even hard money loans to real estate owners needing liquidity. Again, the large institutions are less willing to move into more opportunistic debt strategies, but will provide debt capital in situations with more predictable cash flows. Property valuation remains an issue on the debt side as well. As Fung notes, lenders need benchmarks to underwrite and track the performance of higher yielding debt strategies, and those benchmarks have been elusive. Those debt funds that enjoy a low cost of capital and are able to more accurately price and structure around credit risks could achieve what may be the most attractive risk adjusted yields available in the real estate sector if the performance of the collateral sufficiently recovers.
The hunt for higher yields in real estate investments began before the pandemic, forcing investors to change their behavior. As Weill notes, institutional investors are now relying more on appreciation than income to achieve required returns, and that necessarily increases the risk of the deals. The pandemic has further narrowed the places investors can go, funneling capital to fewer property types and fewer markets that are considered to still have value appreciation potential. Thus, the imbalance between available capital and available deals is growing, making it even more difficult to achieve higher returns. Despite the difficulty and continued unpredictability of sector performance, real estate still provides relative value over many asset classes, and capital allocations are likely to continue to rise.