Portfolio construction is an ever-evolving science dictated by investor needs and economic events. Today, as institutional investors shed equities to build resilient late-cycle portfolios, inflows to real estate have risen. But the typical mix of private equity funds focused on core office and retail sectors has been replaced by an institutional approach with many layers to aid diversification and attempt to extract the income-driven returns needed in this environment.
Investing in an uneasy equilibrium
In this case, the chyrons flashing across the bottom of cable news do tell the full story: the interplay between panic and pragmatic has sent equity markets up and down for the last eight months. It includes the late-2018 slowdown caused by recession-fearing sentiment; the July dip on the back of the Federal Reserve’s hesitancy to map out future rate cuts; and a nearly three percent fall on China’s currency devaluation in early August.
A growing contingent of institutional investors want off the wild ride – with 74 percent believing that equity markets have peaked.1 Their focus now lies in a responsible, resilient portfolio strategy that looks to persevere amidst moderating return forecasts and elevated volatility. Not all is lost, however, as real estate fundamentals remain strong, and the asset class is potentially well positioned to re-take the mantle of “safe haven” that crumbled after the housing-driven 2008 recession.
Institutions are leaning into real estate
According to a recent study, institutional investors were looking to pull more than $7 trillion from public equities in 2019.2 Fifty-four percent of those surveyed targeted an increased allocation to real estate – a legion that led all asset classes.3 In fact, institutional investors increased their holdings in real estate by one percent already from 2017 to 2018 before it came into greater focus this year.
Why the shift? Real estate historically has generated stable yields and an attractive return profile when late-cycle appreciation falls. The asset class also helps diversify a portfolio through relatively uncorrelated public REITs and uncorrelated private funds.
A shift away from predominantly core
Core private equity real estate appreciation has been moderating for some time, but Q2 2019’s stark drop off requires further examination. The NCREIF Open End Diversified Core Equity Index’s (ODCE) Q2 2019 total return gross of fees was just 1.00 percent, down from 1.42 in Q1 and 2.05 percent from this time a year ago. While the income return of 1.01 percent was well below 10- and 20-year averages of 1.25 and 1.47 percent respectively, the real story was negative appreciation in the index for the first time since 2010.4
Real estate private equity funds rely on third-party appraisals to set net asset values (NAVs), and these appraisers are notorious for slowly adjusting to market conditions. In this environment, it appears that appraisals have lagged the rapid changes taking place in the retail sector, and are only now lowering valuations to reflect higher cap rates, slower growth, and higher CAPEX requirements. As a result, the NAVs of some mall properties are being marked down by as much as 50 percent in recent quarters.
Also, most private funds use fixed-rate leverage to enhance returns. When rates decline, the value of the debt rises, which results in a lower fund NAV. However, the rising value of fixed-rate liabilities has historically been more than offset by higher building values from lower cap rates, boosting NAVs. Because cap rates were already near historical lows at the end of 2018, this latest bout of falling rates had a more pronounced impact on private fund NAVs.
Institutional investors are paying attention to these dynamics. Quarterly ODCE investor net cash flows were -$73.7 million for Q2 2019 and -$904.6 million for Q1. The one-year annual investor net cash flow was -$854.7 million.4
From core to coupon … and other opportunities
The prospect of a low-return environment over the next decade is pushing many institutional investors into private credit across the liquidity spectrum. Managers are reassessing their liquidity budgets in search of yield-based returns.
Real estate debt has experienced tremendous growth in a short period of time. There were 37 more debt funds through September 2017 compared to three years earlier, with total aggregate capital raise up $12.9 billion.6 Due to tightened banking regulations post-recession, as a proportion of market funds and insurances, real estate debt funds now represent around 25 percent of all lending to real estate compared to just three percent in 2012.6
Institutional investors like real estate debt’s historically consistent coupon, its higher position in the capital structure, and its currently healthy loan-to-value (LTV) ratio. For example, if a debt investment has a LTV of 65 percent, the real estate asset would have to lose 35 percent of its value before its senior loan strategy would start eating into investor capital. That’s a potentially sound risk mitigation strategy at this stage of the cycle.
As mentioned above, institutional investors are also examining niche and value-add strategies driven by long-term demographic factors instead of economic metrics. While office and retail are corporate sectors reliant on economic growth, sectors like apartments and self-storage are tied more closely to the consumer. You can see the stark divergence in growth below, especially over the last two years.
Taking a 2019 institutional approach to real estate investing
In building a late-cycle portfolio, more institutional investors are exploring outside core strategies. Real estate debt may offer steady, resilient income, while value-add and niche strategies offer the potential for late-cycle appreciation, especially as core funds are delivering close to none.
Institutional investors also recognize that active management may further enhance value, supported by a strong, diligent investment process that wades through multiple risk scenarios and stress tests to meet today’s investment challenges.