Wrestling with Real Estate

Telemus Weekly Market Review February 13th - February 17th, 2023

Public real estate was among the worst performing sectors of the S&P 500 last year, as it fell by -26.2%. The sharp rise in interest rates during 2022 created a challenge for real estate investors. Real estate tends to be financed with greater percentage of debt given the steady nature of real estate cash flows. In fact, it’s not uncommon to see anywhere from 30% to 70% of the real estate value finance with debt. As interest rates rose during 2022, the cost of financing a property increased from somewhere in the 3-4% range (depending on the property) to north of 6%. Given the higher cost of debt, by mid-year 2022 it had become hard justify adding debt to a real estate purchase as the cash flows generated from it were not always enough to support the debt service. This effectively resulted in leveraged buyers (or those who finance a portion of a real estate acquisition with debt) exiting the market and the only buyers that remained were all cash equity buyers. 

What transpired because of this was a freezing of real estate activity as sellers weren’t ready to ask less for their property and buyers needed a lower price for the economics to pencil out given the higher cost of debt. As we progress into 2023, the market remains challenged. However, our more recent discussions with several real estate investors indicates that price discovery is beginning to occur as sellers are recognizing the need to reset their expectations. The pace of transactions is slowly improving, and real estate lenders have returned to the market. Given the recent half a percent uptick in Treasury yields over the last few weeks, we’ll see if this level is able to sustain itself. 

This backdrop has created a challenging environment for some but not all real estate investors. It also makes the near-term picture less clear. During 2022 publicly traded real estate investment trusts, or REITS, were among the worst performing sectors of the S&P 500. During the year public markets quickly reset prices to reflect expectations that the value of the underlying real estate was likely worth less given higher borrowing costs. Private real estate assets, however, did not experience notable declines in value. The primary reason has to do with how their valuations are established. The common practice within private real estate is to have regular third-party appraisals, which consider prices and valuations on comparable properties. Given that transaction volume dried up, there was a lack of comparables to justify resetting prices lower. It’s likely those valuation adjustments for private real estate will occur in 2023 as more datapoints establish where market valuations currently stand. 

This dynamic has led to what we viewed to be an attractive relative valuation for public real estate versus private real estate. Given that public REITS already reflected some level of a valuation adjustment, they look more attractive than private real estate. However, owning public real estate adds incremental volatility to portfolios since public REITs trade each day, while private real estate at best has monthly liquidity and often requires multi-year investments with no liquidity. 

Near-term, pressure from higher interest rates is likely to pressure commercial real estate prices. We would not be surprised to see that pressure continue into 2023 as the market has yet to find a true equilibrium given what remains as subdued transaction volume. Our base case expectation is that any growth in a property’s net operating income would likely be offset by valuation compression in the value of the real estates. This would, per our base case expectation, leave the return from private real estate in the next year to be derived solely from income (dividend) distributions. 

Longer-term, we see some attractive secular trends that make the asset class attractive. First, within the multi-family (apartment) and industrial (warehouse) sectors, there is insufficient supply to meet long-term demand projections. As such, high quality properties are likely to maintain pricing power and be able to maintain attractive valuations. Second, trends around the need for additional medical office building, life science office space, and a growing need for self-storage create opportunities for niche sectors of the real estate market. Lastly, migration patterns, enhanced by COVID, have led to increased demand for real estate in the sunbelt region of the United States. Collectively, these trends leave us optimistic about the long-term opportunity in both public and private real estate. 

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