Asset managers say the next two years might be the best time during this market cycle to dive into private real estate.
As clients display a growing appetite for outsized risk-adjusted returns, RIAs have been keeping an eye on opportunities for investment in private real estate. For example, Gary Quinzel, vice president of portfolio consulting with Wealth Enhancement Group, noted that his firm is looking at core real estate. “It really is an interesting area that’s been out of favor, and some might find it a little boring because it doesn’t offer yields in the teens,” he said. “But we like those areas of the market that produce very stable returns [and] have lower leverage. They form a good core of the portfolio.”
Christopher Burrows, partner with Cerity Partners, acknowledged that investing in real estate takes patience because the cycles tend to be slow. The firm already invests in real estate debt but “can envision a world where we move toward opportunistic equity.”
Last year, investors from the private wealth channel focused mostly on falling property valuations, according to Julia Butler, managing director in the real estate group of private equity firm KKR and chief investment officer with KKR Real Estate Select Trust Inc. (KREST), an income-oriented 1940 Act REIT that targets both commercial real estate equity and debt. In 2023, KREST had to limit redemptions as investor requests exceeded quarterly limits. Today, institutional investors have already started increasing allocations to some of KKR’s closed-end real estate funds, Butler noted. Individual investors have been slower to join in, but in conversations, they are more focused on identifying the right moment to jump back into the private real estate market rather than worrying about distress contagion, she said.
“They want to see performance really turn around before they start allocating more to the space. So, they tend to take longer to come back into the space than institutional investors. But I do feel the sentiment is turning. In fact, when we meet with advisors and prospective investors, they are all asking: ‘Is now the time to invest in real estate?’ They are trying to figure out if now is the bottom. And that’s a shift certainly in terms of the questions we receive. They anticipate that real estate is going to be an attractive opportunity set, they are trying to bottom-tick the market, which is obviously very hard to do.”
Commercial real estate has generated a lot of negative headlines in the past two years, but concerns of overall distress may be overblown. The office sector faces the biggest challenges but represents only a fraction of the commercial real estate market. Other property types, including multifamily, industrial and data centers, have retained strong fundamental performance. The biggest uncertainty has been the price gap between buyers and sellers in the face of higher interest rates, which has turned into a drawn-out process and suppressed deal volume.
During the decade ending in 2023, US private real estate delivered annualized returns of 6.36%, according to Bloomberg data cited by JLL. Investors putting their money to work in core real estate in 2024 and 2025 might see IRRs in the 10.0% to 12.0% range, said James Corl, executive vice president and head of private real estate group with investment manager Cohen & Steers.
While many investors stayed away from private real estate in 2023 because properties continued to be overvalued, prices on certain segments of the private real estate universe have either bottomed out or are on their way to do so, Corl noted. The process should continue over the next two years, with another 5% to 10% decline in values—and that’s the moment when investors will have the opportunity to realize the highest returns.
"The most important thing in the space is stability,” said Rick Schaupp, a managing director with Clarion Partners, which operates the Clarion Partners Real Estate Income Fund aimed at the wealth channel. "It's hard to buy a long-term asset with a volatile 10-year Treasury rate. When the base rate is volatile, it’s hard to know what yields should be. But since December, the 10-year has been below 4%. It’s been over two months, I think, with the Fed signaling that there are rate decreases coming. Hopefully, stability remains in the 10-year. Private real estate equity valuations have gone down. We've all experienced adjustments. But I don’t think we need to see the Fed cut immediately. We just need stability. We're trying to make smart long-term investments. We're not trying to time the market."
Research by Cohen & Steers shows closed-end real estate funds with a vintage going back to the years immediately after the Great Financial Crisis (2009 through 2014) delivered a median IRR of 14.7%, the highest in two decades. The projected IRR for funds with vintages of 2015 through 2020 is 7.5%.
Cohen & Steers research warns that IRRs will likely be lower this time because the distress won’t be as extensive, but they will still be attractive.
“REITs have their best year of the cycle in the year immediately after the Fed stops tightening,” Corl said. “About a year or so, plus or minus after that, is when you want to be jumping into private real estate.”
Tough year
Last year, fundraising for private real estate investment took a hit as the sector faced higher interest rates, worries about access to debt capital and stalled sales. In the fourth quarter of 2003, global real estate fundraising fell to its lowest level since the start of the pandemic, with 72 funds totaling $20.8 billion, according to London-based research firm Preqin. Private real estate deal flow in North America fell 21% between the third and fourth quarters to $18.3 billion. Among the private real estate vehicles are ones specifically geared toward the wealth channel, including non-traded REITs, 1940 Act funds, tender offer funds and interval funds that invest in real estate. Compared to traditional private real estate placements, investments in these vehicles have lower minimums, no capital calls, provide simplified tax reporting and feature some access to liquidity.
By November, investors surveyed by Preqin sounded more optimistic about the performance of real estate assets over the coming year. Only 35% of respondents expected performance to worsen over that period—down from 59% in November 2022.
A January note from Eaton Vance, the asset management division of Morgan Stanley Investment Management, stated that real estate assets had already “repriced meaningfully” over the previous two years. Eaton Vance researchers wrote that returns on investment following such periods of price adjustment tend to exceed historical averages.
MSCI Real Assets, a real estate data firm, reported that in 2023, its all-property price index declined by 5.9%. By year-end, cap rates on sales of core property types were averaging 50 to 60 basis points higher than in 2022. The only exceptions included the hotel sector, where values stayed flat, and seniors housing, where cap rates contracted by 20 basis points.
The year also proved challenging for asset managers with private real estate vehicles. KREST’s returns for 2023 were down 6.25%. Brookfield Real Estate Income Trust, a non-listed REIT that invests in debt and equity, reported its first annual loss, with total returns down 6.71%. Returns for Blackstone Real Estate Income Trust (BREIT), another non-listed REIT that targets the private wealth market, fell 0.5% compared to a five-year return of 11%. Starwood Real Estate Income Trust (SREIT), a perpetual life monthly NAV REIT, saw an annual decline of 8.59%.
In December, SREIT launched a 1031 exchange program to sell up to $1 billion in beneficial interests in DSTs to accredited investors to shore up fundraising. The company was planning to use the net proceeds to repay debt and repurchase shares, among other things, according to its SEC filing.
SREIT, like KREST, BREIT and others, had to contend with investor redemption requests exceeding its limits in 2023.
“What happened in private real estate and specifically the non-traded REIT market because it’s a semi-liquid product, was that several investors were trying to get out as valuations were adjusting and these funds generally limit redemptions at up to 5% of NAV per quarter,” Butler said. “Five percent is pretty good flow for an illiquid asset class, but at certain points in the market, and still even to this day, the demand to get out of some of these funds exceeded the limits on a quarterly basis.”
Buy at the Bottom
However, when Jon Gray, Blackstone’s president and chief operating officer, spoke at the company’s fourth-quarter earnings call, he noted that real estate values are bottoming out, signaling a period of opportunity.
“While it will take time, we can see the pillars of a real estate recovery coming into place,” he said. “We are, of course, not waiting for the all-clear sign and believe the best investments are made during times of uncertainty.”
Cohen & Steers estimates that unlevered prices on commercial real estate have already fallen by about 18.5% from their previous cycle peak. With the 10-year Treasury reaching a 16-year high and making borrower costs prohibitively expensive in the 7% range, the market will likely see an increase in forced sellers in 2024 as more real estate owners face loan maturities, said Corl.
Data from the Mortgage Bankers Association and analytics platform CREDiQ shows that $1.2 trillion in commercial real estate loans will reach maturity over the next two years, with $659 billion coming due in 2024. Meanwhile, MSCI Real Assets estimates that the volume of distress among commercial real estate properties in the US reached $85.5 billion by the end of 2023, while the value of assets classified as “potentially troubled” totaled roughly $235 billion. Some of that distress was tied to exorbitant prices investors paid for properties in the cheap credit environment immediately following the pandemic. For example, more than 30% of the multifamily properties added to the “potential distress” list in the fourth quarter were purchased in the last three years, MSCI Real Assets noted.
“Over the course of the year, we expect to see some of these maturities impact otherwise great real estate, forcing more equity owners to sell their assets. In addition, certain assets are already trading at a material discount to replacement cost. Given that we expect construction costs to remain high, we believe this represents an attractive buying point for investors with a longer-term horizon since the shortage of supply from 2026 onwards should provide landlords with real pricing power. We are excited to buy some of these assets that we think are going to come to market,” said Butler.
Cohen & Steers has already begun to see attractively priced acquisition opportunities in the private real estate market, particularly in the shopping center sector, where price correction is likely near the bottom because retail has been out of favor with investors longer than most other property types. The property price index for retail declined by 5.5% year-over-year by the end of 2023, compared to a decline of 0.5% for industrial properties, according to MSCI Real Assets. But deal volume in the sector went up 111% in the fourth quarter compared to 2022, more than for any other asset type.
In 2021 and 2022, it was commonplace for commercial real estate sales to close at cap rates in the 4% range, according to Corl. “We never believe that’s a good idea,” he noted. Today, the firm is looking for and finding assets priced in the 7% to 9% range. “We are very enthusiastic about the investment environment we are seeing right now,” he said.
Similarly, Butler noted that KREST has been getting more calls from sellers about potential acquisition opportunities, though she added that investment sales activity is still below its normal pace. She said that might be a function of people waiting for interest rates to stabilize before they start transacting.
Typically, investment managers would advise their clients to expect returns of 8.0% to 10.0% from investment in core real estate through the private market, Corl noted. But he said those who get the timing right and invest right near the bottom of the market could reasonably expect returns of 10% to 12%.
The catch is that newly formed funds will likely benefit more from the price adjustment than existing funds that may be saddled with their own legacy issues. Corl said that in many of the deals Cohen & Steers is looking at right now, the sellers are core funds that must meet their redemption requests. He noted that many of those funds bought assets at peak valuations two or three years ago and now have to sell at much higher cap rates.
“The more you read about headwinds and issues [ranging from rising expenses to decreased credit availability], the more it presents a buying opportunity,” noted Marc Zahr, co-president of Blue Owl Capital and head of the firm’s Real Estate platform. “From our perspective and based on our strategy, those problems can create a massive buying opportunity. It allows groups that are well-funded, as we are, and have a disciplined approach to investing and financing to potentially capture some of that market dislocation.”
Blue Owl Capital’s real estate vehicles, which focus on single-tenant net leased properties with investment-grade tenants and long-term leases, escaped many of the issues that plagued private real estate funds last year. That was largely due to the company’s conservative investment criteria, according to Zahr. Blue Owl’s real estate funds, including Blue Owl Real Estate Net Lease Trust (ORENT), only use fixed-rate debt, Zahr noted. In addition, the company’s entry point for new acquisitions tends to hover around 7%, higher than the cap rates many of its peers have ended up transacting at over the past few years.
The firm’s joint venture with Singapore’s sovereign wealth fund GIC to buy STORE Capital for $15 billion propelled it to the top of the most active real estate buyers’ list in 2023. Inflows were six times higher than redemptions and its Blue Owl Real Estate Fund VI is on track to exceed its $5 billion cap.
“In spite of the very difficult backdrop for real estate fundraising, our latest triple net lease fund was the single largest U.S. real estate fund raised in 2023,” said Marc Lipschulz, co-chief executive officer, during the company’s earnings call on Feb. 9. “We expect to exceed our hard cap of $5 billion, more than doubling the size of the predecessor fund. Furthermore, our overall real estate platform performed admirably on both a relative and absolute basis, returning 9% for the year.”