Amidst Deteriorating Market Conditions, Investors Lean on Essentials, Life Sciences to Navigate the Market

While institutional investors are painfully aware 2023 will be a game of opportunity for commercial real estate, some investors are leaning on lessons learned from the last two years to navigate the market.

Volatility in US commercial real estate stemming from rampant inflation, the Federal Reserve’s hiking cycle and a much more pronounced risk-off sentiment taking hold of the market, is making institutional investors take a stolid approach to commercial real estate, AEW Chief Investment Officer Michael Byrne said.

“We are dealing with rising interest rates which impact property yields, but equally challenging is that severe lack of liquidity in the market,” the CIO said. “Starting with the financing markets, but really moving all the way up to the equity markets where the denominator effect has reduced allocations to real estate. There's not a lot of capital in the system today and there's even less capital interested in taking risk. The entire capital markets have pivoted to a risk-off posture, so both things are really challenging.”

Byrne told Markets Group the accelerated pace of deals for real estate in the U.S. in 2021 and the start of 2022, particularly for multifamily and industrial real estate, has been supplanted by a sentiment that rising interest rates will continue to influence cap rates and ultimately, costs of capital.

As the amount of resources poured into US multifamily and industrial real estate after the onset coronavirus pandemic grew in 2020, competition drove returns lower in an environment already beset by low cap rates. This phenomenon, coupled with the six consecutive interest rate hikes set by the Fed in 2022 has led to increased volatility in pricing for real assets.

Sellers trying to pen deals today have to offer a more competitive risk-return profile than say, Treasurys, while buyers trying to pen deals today must accept that risk-return profiles may change drastically in the short-term and that negative leverage may arise in some cases.

Despite this, AEW’s CIO contends active investors are looking exploit mispriced real assets and lean on sectors such as grocery-anchored retail, cold storage and life sciences to put capital to work.

Even if there is no getting around the short-term volatility, Byrne says these subsectors within retail, industrial and office have shown substantial resilience and even expanded through the coronavirus pandemic.

“Whether or not we are in recession today, clearly we are aware of a deteriorating economic outlook across the United States and that influences a number of different categories. And that intensifying risk has us pivoting away from higher risk strategies and the entire market has become more conservative around how much money we borrow and how we treat interest rate risk.”

Byrne said capital markets interest in housing and industrial sectors has remained strong among institutional investors, but development and redevelopment timelines have to be shrunk to minimize risk. At least in the short-term, AEW is likely to be a more active buyer than developer, he said.

The National Council of Real Estate Investment Fiduciaries, which models and indexes investment performance of commercial properties in the US, said write downs, more than half of properties in the index led to a slowdown of the NCREIF Property Index in the third quarter of 2022.

Write downs in commercial real estate peaked in the second quarter of 2020, bottomed out in Q3 2021 and increased for all consecutive quarters according to NCREIF.

“This [economic downturn] is a disruption that we are all dealing with and is likely to be a very challenging time for some US landlords as they deal with a changing economic environment.” Byrne said. “But if you have already taken the time to get your house in order and if you have the right allocations to the right property sectors, and if you're in the right geographic locations, it's still a pretty good time to be a landlord in United States where fundamentals are solid.

“Most of our tenants are reasonably healthy. And regardless of what type of downturn we may be going into as a real estate community, we are starting off in a much better place than we have in other cycles with the exception of the office market.”

The MSCI US REIT Index declined 26% this year while MSCI Research Senior Associate Michael Savino said the pace of growth in U.S. commercial property prices slowed in September to the weakest annual rate since the beginning of 2021.

Rising financing costs and shrinking trade volumes – office, apartment and industrial sales declined by 21% in the third quarter of 2022 – are leading to declining price growth, Savino said, while deal volume in September fell by 42% on a year-over-year basis.  

Double edged sword

While rising interest rates and inflation have raised development costs and slowed the pace of new development in the second half of 2022, things look a little different for existing asset owners.

During Blackstone’s third quarter earnings call, Jon Gray, the president and chief operating officer of the investment firm, said that while the current environment is bad news for the supply of new construction, owners of existing apartments and industrial space in markets with short supply and high demand may benefit from the slowdown.

“In an environment like this, you start to see a reduction in new supply, which is obviously helpful in the long term; and these hard assets are beneficial because they don't have much exposure to input costs, and there's going to be a [fewer real assets] built,” Gray said. “The challenge of course is in a rising rate environment, if you own a hard asset like… an older office building, then I think you're going to see a challenge to value because the income is not growing much and rates have gone up. On the other hand, if you're in rental housing or logistics you have pricing power where we're still seeing in the U.S., 30% increases in rents, in Europe, nearly 20% increases in rents.”

Much like AEW’s Byrne, Blackstone’s president and COO said the financial position of most real estate investment firms heading into the economic slowdown is better than it has been in previous economic downturns. Low leverage, low rental housing vacancy and shrinking construction starts may all have an accentuated positive effect for existing landlords, Gray said.

Emerging Trends

Ankitt Bhatt, the managing director at Oxford Properties Group, which serves as the real estate arm of the Ontario Municipal Employees Retirement System and Byrne of AEW are betting real estate credit, life sciences and cold storage will outperform the market downturn.

“We see the tailwinds of supply chain and logistics that are here to stay,” Bhatt said. “We see the tailwinds and mega trends of housing shortage that is here to stay. And then we see this boom in life sciences as the Baby Boomers come off age and there is a dire need for pharma and life sciences and that needs a home.”

Oxford Properties has pivoted to a defensive position, Bhatt said, by trimming down its overpriced assets, selling $750 million in US commercial real estate for cap rates ranging from 3.1% to 2.0% in 2022 and not acquiring assets in the US since the first quarter of the year.

And while fundamentals for infill industrial real estate in the Sun Belt, Northeast and Southern California metros, particularly rent growth, remains strong, Bhatt says Oxford also continues to see opportunities in US life sciences and cold storage.

Back in October, Oxford purchased a 250,000 square-foot life sciences campus in San Diego leased to Ionis Pharmaceuticals, which pushed Oxford’s footprint in the metro area to over 900,000 square feet. Oxford also completed a 136,000-square-foot office to life sciences conversion in downtown Seattle this year.

Bhatt said Oxford Properties has also been an active investor in cold storage by way of its investments in Michigan-based Lineage Logistics. The investment firm was part of a US$1.7 billion equity fundraising round by Lineage Logistics that included Healthcare of Ontario Pension Plan, New York State Teachers Retirement System, StepSone and others. Oxford was also part of a US$1.9 billion equity fundraising round by Lineage in March 2021 and a US$.16 billion equity fundraising round in September 2020.

On the other hand, Byrne says AEW remains a strong believer in the longevity of cold storage and temperature-controlled warehouses. The CIO says AEW remains an active investor in the sector via its Scout Cold Logistics affiliate based in Miami. 

Note: This discussion will continue at the Markets Group Real Estate Forum in New York on December 6 and 7. Click here for more information.

 By Mario Marroquin