By Joel Kranc
Earlier this year, the California State Teachers Retirement System (CalSTRs) told the Financial Times it would be writing down the value of its $52 billion in real-estate holdings because higher borrowing costs on the heels of Federal Reserve interest rate hikes have lowered property values.
In the office sector alone, values are likely down 20% just based on the rate move, Christopher Ailman, CalSTRS chief investment officer, told the FT.
Overall, 39% of the 100 investors from 14 countries surveyed for the Q1 2023 Pulse Report by AFIRE — an association for international investors focused commercial property in the US — said they planned to reduce their US holdings at least somewhat in 2023, compared with 27% that intend to increase their positions.
Why? The post pandemic commercial real estate market has been nothing if not interesting. The International Monetary Fund says the current market conditions and rate increases have had a direct impact on commercial property prices by making financing more expensive. Also, it may be that large investors are holding onto past valuations that may not reflect current conditions.
“What we’re likely to see is public and private markets converge over time,” says Brandon Perra, senior real estate specialist with Mercer. “I don’t think there are large valuation gaps but because of the current economic uncertainty the range in property value outcomes — the future values — that range has increased.”
He adds that office as a percentage of the larger real estate portfolio is between 15% and 30% of the portfolio, at least for Canadian investors. “And that portion of the portfolio is facing the largest amount of headwinds due to uncertainty coming out of COVID and work from home. But the rest of the portfolio has positive operating fundamentals but is being re-priced because of capital market headwinds with increasing interest rates as well as interest rate volatility.”
But headwinds are affecting different investors differently. For example, Blackstone in March blocked investors from cashing out their investments at its $71 billion real estate income trust (BREIT).
BREIT said in a letter to investors it fulfilled redemption requests of $1.4 billion in February, which represents only 35% of the approximately $3.9 billion in total withdrawal requests for the month.
The total BREIT redemption requests in February were 26% lower than the approximately $5.3 billion reached in January, the firm said.
“While gross redemptions for February are consistent with prior management commentary, the overarching data continue to align with our view around decelerating retail-oriented product organic growth broadly,” Credit Suisse analysts, led by Bill Katz, said in a note to investors.
Costs of Capital
David Salem, managing director of capital allocation with Hedgeye Risk Management in Stamford, Conn., says that the rising cost of capital in the debt and equity markets as well as the healthy development in secondary markets in “just about everything,” are both affecting valuations.
“Most allocators who has material exposure to real estate, the problem they have and the one thing they cannot do is change real estate valuations willy nilly. They have to be reasonably uniform over time,” says Salem. “If pensions allow markdowns and a more conservative approach, once you get on that path you cannot get off of it,” he adds. “I don’t think institutional investors have reached that point as a group with respect to commercial realty yet, but they may have to.”
One thing that might change the attitude, he notes, is a publically conspicuous sale, likely under duress conditions, of an asset that is comparable so people in a legal fiduciary seat will not sign the valuation unless there is a markdown.
Perra adds that the speed of interest rate increases and the volatility of government bond and financing, there hasn’t been an easy and uniform way that the appraisal community has approached this. But as time passes and more valuation cycles pass, this will be captured more broadly. So far, he adds, there has not been a large scale sell-off of commercial real estate.
In the short term, the market will still be interest rate driven and there is still a wait-and-see approach to the market. But Perra says he is expecting offices with incredible demand and some that suffer in this process. There will be a divergence of “in-favour” or “out-of-favour” real estate, which can include other things such as multi-family or industrial, with office remaining as the most volatile.
