When investors were looking to start off the year with new allocations, commercial real estate was unlikely to be at the top of that list. However, it might be time to take a second look.
Analysts say that while it will still take time for sectors like office space to fully normalize, other areas, including multi-family housing, senior living and industrial, are starting to pick back up. Private credit firms that offer real estate financing are also seeing an uptick in transactions, which could create new opportunities for investors to diversify their private credit exposures.
“It’s no newsflash to anyone that it’s been pretty brutal to be an equity holder of real estate over the past few years,” says Troy Gayeski, the chief market strategist at FS Investments. “But many sectors have bottomed out, so we are entering into a new period of rebuilding our base. If you’re looking at the asset class from that point of view and maintain discipline about where you are investing and what your underwriting criteria are, there are attractive entry points right now.”
Rebuilding is not just happening at the investment level. Julie Ingersoll, CIO for Americas direct real estate strategies at the CBRE Group, says she is seeing more institutional investors take stock of their manager relationships and use this moment to decide which firms they think are going to be able to successfully navigate current and future markets.
“A lot of this comes down to how folks were managing their redemption queues over the past few years,” she says. “If investors were getting in and out of the queue in a reasonable period of time, that goes a long way toward maintaining the relationship. But if you’ve got investors that are in the queue and have been there for a long time, it becomes harder for those folks to consider new commitments now that the market is starting to come back. I think we’re going to see some movement in manager relationships over the next year or so.”
Shifting Focus
Alongside changes in manager relationships, investors are also rethinking where they want to put their capital. Data centers have been a big story—especially over the past year—but they are also a big risk. Ingersoll notes that the investment basis to build a new data center can be quite high and, given recent extreme weather events, there is a bigger focus on insurance costs, asset risk and the overall development plan of the area surrounding any data center project. While they may have long-term value, she says it is important to understand the potential risks of any investment.
“As a real estate executive, I’ve never worked more with my infrastructure colleagues than I have in the past few years,” Ingersoll says. “If you look at some of these assets—data centers, cell towers, specialized manufacturing—you have to ask: Is it real estate or is it infrastructure? Sometimes it’s both. Sometimes it comes down to what specific aspect you own. Are you just the four walls of the data center? Or are you doing something more where you need to understand what the access roads look like or what the power generation needs are? All of those factors can impact investment decisions.”
Gayeski adds that it is also important to be discerning when certain sub-sectors start to attract capital from a range of different sources.
“Given recent market action, I wouldn’t be surprised to see some folks get the heebie-jeebies about existing investments in data centers,” Gayeski says. “Generally, as lenders, when we start to see spreads getting as tight as they are around a certain type of investment, we’re going to take a step back and [ask], ‘OK, does this make sense right now?’ It can be very risky to chase hot dots in real estate.”
Some investors are moving into areas like multi-family housing, student housing and senior living. Douglas Lyons, managing principal at Pearlmark Real Estate LLC,says they are seeing heightened demand across all of these areas.
“When we look at multi-family, there are some areas where we have oversupply, but that is likely to work itself out relatively quickly. We still have broad demand nationally because our total housing stock is underbuilt,” Lyons explains. “That’s a tailwind for investors because we anticipate the returns there are going to be solid over the long term.”
Lauro Ferroni, head of capital markets research for the Americas at Jones Lang LaSalle IP, agrees. The cost of homeownership continues to rise, and that is creating new dynamics within the housing rental market.
“Nationwide, the cost of owning a home is about 60% higher than renting, after you factor in rising insurance rates, property taxes and maintenance costs,” Ferroni says. “So we are seeing more people who are saying, ‘OK, maybe renting makes more sense for me,’ but they run into new challenges there, amid housing affordability issues due to our national housing under supply.”
Ferroni adds that construction loans are starting to pick up, but the overall cost of capital and the cost of building materials are still high, which limits how much new construction will be built in the near and medium term.
“Right now, the market favors acquiring existing assets, and until that changes, we expect the construction pipeline will remain subdued,” he says.
Private Credit
Sources say institutional investors are also taking a closer look at gaining portfolio exposure to the commercial sector real estate through real estate financing. Lyons says commercial real estate as an asset class is capital intensive by its nature, but adds that lenders are starting to shift their approach.
“We’re having more conversations about recapitalizations, [and] we’re seeing less of a willingness to extend and amend” loans, Lyons says. “So that could lead to new joint ventures coming in to take over assets. We might see more sales. Everyone is taking a closer look at the fundamentals of the assets they have exposure to.”
Lyons expects to see more activity from private credit, especially in the middle market, because traditional banks are less willing to do deals between $5 and $50 million, the range in which Pearlmark typically invests.
“Historically, banks have had 50% market share, but they’re staying on the sidelines, and that creates opportunities for private credit to come in and provide those solutions, which is a positive for private credit investors,” he says.
Lyons notes that these investments can match up, in terms of risk profile, with other private credit investments while acting as a source of diversification within a private credit allocation.
“If you can invest in a multi-family deal with a 70% to 75% loan-to-value [ratio], you can capture an interest rate on the whole loan that is in the 7% to 8% range, which is really attractive from a returns standpoint.”
Ferroni agrees. He notes that those returns have been relatively consistent and can also be a diversifier in a credit portfolio.
“We’re seeing a lot of capital from institutional investors and sovereign wealth funds flow into the credit side,” he says. “There’s a sense that the returns are more stable [than direct property investments], especially if you’re in the senior part of the capital stack.”
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Tags: CBRE Group, commercial real estate, data centers, Douglas Lyons, FS Investments, Jones Lang LaSalle IP, Julie Ingersoll, Lauro Ferroni, Pearlmark Real Estate LLC, Troy Gayeski