A Case for Private Real Estate Opportunities
Private real estate as an asset class sits atop many market unknowns. Many of those are the same themes and questions that affect markets broadly: inflation, rising rates, and other challenges within the financial sector. Some factors are unique to real estate, for example, will office spaces left vacant as a result of increased remote work as a result of COVID quarantines be leased again? Or, will the continued ESG trend continue to push capital toward projects that have a lower carbon footprint and what will that mean for older, less environmentally sustainable buildings? In a broad market that seems nervous and unsure of what the near-term future holds, real estate as an asset class appears to be especially complicated. However, complicated is not necessarily a bad thing when thinking about investing in real estate opportunities. Often, complicated means that there will be value to be captured. The challenge for allocators becomes sourcing managers that can navigate the challenging macro environment and also have the scale and structure to invest in different subsectors of the private real estate market. In this article, we explore what the current environment means for real estate opportunities for investors and examine some specific trends that are redefining the asset class.
Private real estate is not siloed from the challenging environment of higher interest rates. Mortgage rates and development borrowing costs have increased commensurate with the Fed target rate and have slowed investment and slowed activity within residential markets.
First, within residential markets affordability remains a problem. In late 2022, the average rate for a 30-year fixed rate mortgage topped 7%, a level not seen since the early 2000s. At this level, many prospective home buyers were pushed back to the rental market, not being able to afford the increased monthly payments of a mortgage. Housing median home prices have come down, according to the St Louis Fed’s housing data with the increase in mortgage rates. But it is important to note that housing prices likely have a floor that is not entirely related to individuals buying homes for personal use. Since 2010, large institutional investors and private real estate funds have become increasingly active within the single-family home market, buying significant numbers of single-family homes and renting them as part of their real estate strategy. So, although mortgage rates increased, price drops have not been enough to make up for the increased borrowing costs for the individual; rather, large private real estate funds can deploy cash offers and take more supply out of an already supply-constrained residential market.
30-Year Fixed Rate Mortgage Average in the United States
Commercial real estate faces a similar challenge, higher borrowing costs, but it has been even more complicated with the stress we have seen within regional banks. Regional banks make up a significant portion of financing for commercial real estate developers. An analysis from Citigroup found that banks represent 54% of the overall $5.7 bn commercial real estate market and of that small lenders make up approximately 70% of the dollars lent. If credit conditions continue to tighten and smaller banks are required to de-risk their balance sheets, then the effects will almost certainly impact the corporate real estate sector and specifically impact funds and developers that do not have scale and rely on smaller and less mature financing relationships. Less readily available financing could be a trend that yields many real estate opportunities for private funds that have scale, established presences and a large footprint of capital and financing options.
The pandemic had some wide-ranging impacts on all asset classes. For example, slowed supply chains were felt across asset classes and sectors. However, there were some themes that were especially pronounced and impactful on specific asset classes. One of these themes was work from home. The real estate market still has not figured out the future for the huge amounts of unused and unleased office space that exists. As of beginning of May, according to Axios, the vacancy rate for U.S. office space was 12.5%, the same place it was in 2010, a year after the GFC.
U.S. office space available for lease
Already high vacancy rates are expected to continue to increase as we see more layoffs. There has been and will be more companies who begin to offer subleases, to try to take advantage of empty office space. Though anecdotal, we are seeing examples of this within the San Francisco market, with large tech companies trying to release unused spaces within their downtown San Francisco buildings. For example, Salesforce is currently working to sublease 700,000 square feet of office space in downtown San Francisco alone. Similarly, in another tech-heavy market, Denver, office vacancy rates have reached 19%. Combining these record high vacancy rates with the macro backdrop, we already discussed many building owners and operators may have to rethink their economics. Higher borrowing costs are cutting into a larger portion of what, at a high level, seems to be a shrinking pool of rental and leasing income. If a real estate investor’s original thesis included expectations that they would sell a particular property after development or renovation, then the sale price will be adjusted accordingly for lower anticipated net income generated by the property. It’s possible investors can stomach the environment and practice patience with the hope that prices and income rebound, but if history is instructive, then we will likely see investors require liquidity at some point and want to sell their stake in these properties at what are likely to be discounts. These discounts could offer compelling value to buyers with established opportunity sourcing networks that are looking to deploy capital into commercial real estate opportunities and can practice price discipline.
Real estate is one of the many sectors where ESG has entered and not left the conversation. Sustainable building practices are heralded as best practices, and nearly all new commercial buildings seem to be hyper-focused on energy efficiency, carbon footprint and gaining the coveted LEED certification. There is data that suggests adopting best-in-class environmental practices can be accretive to profits. “Green” buildings are estimated to consume 29 to 50% less energy when compared to their “non-green” peers, according to a recent analysis from Deloitte. These energy savings and therefore, operating cost savings, can be significant. But, for older buildings, the costs of converting to “green” can be substantial. The decision of whether to undertake these efforts can be complicated and, as discussed above, where there are complications, there is potential for seasoned managers to unlock value. ESG and sustainability within real estate is another long-term enduring trend that can create opportunities for investors with flexibility, capital, and a track record of taking on development and redevelopment projects.
Potential relationship between sustainability and factors affecting building value
Private real estate has a complicated macroeconomic backdrop and some enduring trends that are likely to define the space in the short to medium term. The trends of work-from-home and sustainability continue to push capital toward some projects and leave some specialized developers in the lurch as sectors like office space become out of favor. In addition, the macroeconomic backdrop tells a story of uncertainty. Daily, markets seem to trade based on partial answers to questions like "has the Fed hiked for the last time this cycle?", "will inflation continue to subside toward the long-term target?", and "will there be additional fallout from the banking crisis?" Answering these questions with high conviction is near impossible, but as markets start to answer these questions, we believe there is a high possibility that there will be real estate opportunities for established managers who have the ability and expertise to act nimbly and with conviction.
For US regional banks, commercial real estate is seen as next big worry - Thomson Reuters Institute
Real Estate Investing at an Inflation Inflection Point - Blackstone Private Wealth Solutions
Emerging trends in real estate 2023: PwC
Amount of office space available for rent hits new record high (axios.com)
These Firms Are Trying to Shed Massive Amounts of San Francisco Office Space (sfstandard.com)
Median Sales Price of Houses Sold for the United States (MSPUS) | FRED | St. Louis Fed (stlouisfed.org)
Sustainability in Commercial Real Estate | Deloitte US | Real Estate