Peter Rogers said open-end funds are seeing increased redemptions as investors rebalance.
Just when real estate managers felt that the worst of the pandemic fallout was over, they got rocked by volatility and interest-rate increases, forces that combined to hold global assets under management to $1.9 trillion, a 0.4% increase in the year ended June 30.
A year ago, managers reported their first double-digit jump since 2018 in worldwide AUM, Pensions & Investments’ annual real estate money manager survey showed.
Real estate assets for U.S. tax-exempt institutions fared better in the 2022 survey, up 11.6% to $726.6 billion, compared to the 6.8% growth in the prior 12-month period. Real estate equity assets managed for U.S. tax-exempt investors grew by a whopping 16.9% to $586.6 billion.
But most of the other property sectors managed for U.S. tax-exempt investors lost assets under management during the year. Indeed, the only other AUM increase was mezzanine, which grew by 12.2% to $13.9 billion.
“We were coming off of an incredible market, an incredible real estate opportunity,” said Scott Dennis, Dallas-based CEO of Invesco Real Estate, a division of Invesco Ltd.
Transactions have now slowed because buyers and sellers do not know what the price should be due to the slowdown in transactions caused by market turmoil, Mr. Dennis said.
In recent years, if a buyer didn’t bid more than the asking price, the bidder was unsuccessful, he said.
At the same time, the most prolific lenders including banks “are on the sidelines,” making debt limited and too expensive for many managers to achieve the returns that investors require, Mr. Dennis said.
Six months ago, investors were trying to chase their real estate allocation targets, Mr. Dennis said. With the drop in the capital markets this year, investors are now over their real estate targets.
“They’re not going to abandon real estate, but they are trying to figure out how to reallocate their portfolios,” he said.
Some investors are taking partial redemptions from their open-end funds, he said. Across the universe of open-end funds, managers including Invesco are seeing investor redemptions and are using the money to rebalance their portfolios, he said.
“It’s not a run on the bank,” but on the margins investors have redeemed a portion of their capital invested from certain open-end funds, Mr. Dennis said.
Even so, Invesco’s assets managed for U.S. tax-exempt investors in open-end funds rose to 23.7% to $17.2 billion as of June 30. Invesco is ranked sixth for managers of U.S. tax-exempt institutional investors with AUM up 22% to $30 billion.
The other top managers of U.S. tax-exempt assets were Nuveen with assets up 14.8% to $105.8 billion, followed by PGIM Real Estate with assets up 13% to $66.2 billion, J.P. Morgan Asset Management with assets up 15.9% to $51.8 billion, Principal Real Estate Investors with a 29.6% asset increase to $35.9 billion and Clarion Partners increasing 37.2% to $32.8 billion.
Overall, assets in open-end funds managed for U.S. tax-exempt investors were up 21.5% to $339.4 billion.
“Open-end fund AUM growth isn’t surprising given record market performance for private core real estate over the trailing one-year period,” when the NCREIF Fund Index-Open-End Diversified Core Equity hit an all-time record return, said Peter Rogers, Chicago-based director, investments at Willis Towers Watson PLC.
Although it dipped close to 3 percentage points in the second quarter to 4.54%, the NFI-ODCE index was up double digits in the 12 months ended June 30, with a 28.31% return net of fees.
However, given the relative strength of private real estate performance compared to equities and fixed income, many institutional investors are encountering a “denominator effect” in regards to their allocations, Mr. Rogers said. That means that the drop in public market assets is pushing up private market valuations, which are valued as of a quarter earlier than stocks and bonds.
“As a result, we are seeing increasing redemption activity from open-end funds as investors look to rebalance their portfolios,” Mr. Rogers said.
Open-end fund redemptions didn’t really start until the summer when the Federal Reserve increased the interest rates by 75 basis points for the first time in June, said Eric Adler, London-based president and CEO of PGIM Real Estate.
The outlook is that the Federal Reserve will continue raising interest rates and the markets have already reacted in advance, Mr. Adler said. On Sept. 21, the Federal Reserve again hiked interest rates another 75 basis points for the third consecutive time.
The equity and debt markets have definitely slowed down, which impacts all real estate, but open-end funds are affected more quickly because they are liquid, Mr. Adler said. Until February 2022 when Russia invaded Ukraine, all trends were on green across debt and equity real estate, he said.
Before February, PGIM Real Estate had record-breaking fundraising, and pipelines for debt and equity transactions were “as good as we’ve seen them,” Mr. Adler said.
“We really were on trend to have year-over-year AUM that would have been the best ever,” Mr. Adler said.
The 12-month period ended June 30 was marked by two major events: The start of Russia’s war in Ukraine in February “was a cold shower for both debt and equity,” Mr. Adler said.
In Europe, the real estate debt and equity markets reacted right away to the war in Ukraine, he said. In the U.S., real estate debt transactions slowed when the war in Ukraine broke out, but the real estate equity markets didn’t start tapping on the brakes until June with the Federal Reserve’s first 75-basis-point interest rate hike, Mr. Adler said.
“There’s been no drama, no disaster, no big falling off a cliff,” because the real estate markets are more mature than they were in past cycles, Mr. Adler said. In other real estate cycles, so-called “hot money” moved into real estate at the top of the market and then panicked when there was a downturn, he said. The full impact of the current slowdown on real estate managers’ assets under management won’t be reflected in P&I’s survey results until 2023, Mr. Adler said.
All types of institutional investors around the world are fairly sanguine, Mr. Adler said.
Although they acknowledge that “liquidity will be lower and values might drift down a little bit … everyone is taking that in stride,” he said.
Among the debt categories, mezzanine assets grew while the other real estate debt categories tracked by P&I slumped.
PGIM Real Estate’s mezzanine portfolio more than doubled in the period to $1.2 billion from $531 million in the year-earlier survey. This put PGIM Real Estate in the fourth spot on P&I’s list of the top 10 managers of mezzanine assets for U.S. tax-exempt investors.
PGIM has an “incredibly strong” mezzanine business, especially in Europe, and PGIM raised its biggest-ever real estate debt fund in 2021, Mr. Adler said. A fair amount of U.S. institutional capital is invested in PGIM’s European mezzanine strategies, he said.
“Our mezzanine business is punching above its weight right now,” Mr. Adler said.
The manager with the most mezzanine assets managed for U.S. tax-exempt investors was Nuveen, with mezzanine assets dipping 1% to $6.7 billion.
The slowdown in transaction volume came despite everything “flashing green” for investing in debt, said Jason Hernandez, New York-based head of real estate debt at Nuveen.
Up until the beginning of this year, it was a low-yield environment, less volatile world, Mr. Hernandez said. It was a good time for real estate equity owners to borrow but not as good for real estate debt returns.
The situation reversed at the beginning of the year. Leverage levels are down and returns rise as interest rates rise, he said. “Debt eats equity,” Mr. Hernandez said. The challenge is that transactions are down and “there isn’t enough of it,” he said.
Prices have reset but there aren’t enough sellers willing to sell properties at lower prices, Mr. Hernandez said.
The higher cost of debt is also stalling transactions.
“Two-thirds of the capital structure of the real estate market is debt,” said Michael Levy, Dallas-based CEO of Crow Holdings, a real estate manager and developer. “The debt capital market began to react, and the cost of financing began to go up as the availability of financing began to go down.”
“We started hearing in March that people weren’t able to get things (deals) done because of the higher cost and less attractiveness of financing,” Mr. Levy said.
From April through August, investors’ ability to obtain debt financing continued to contract, he said.
“And there was a decline in the attractiveness of the financing as it relates to everything from interest rates to proceeds to returns,” Mr. Levy said.
Meanwhile, real estate investors seemed to stick closer to home with non-U.S. assets managed for U.S. tax-exempt investors up 3.4% to $43.8 billion.
In Europe, for example, the economy is already heading into a recession as a result of inflation and the war in Ukraine among other factors, said Paul Stewart, head of Europe and APAC real estate research and strategy at Barings.
Barings’ non-U.S. real estate assets for its clients worldwide rose 1.5% to $6.9 billion in the 12-months ended June 30.
And the combination of weaker economies and rising interest rates is “pretty negative” for real estate prices, Mr. Stewart said. However, Barings does not expect property markets in Europe to crash because crashes are associated with high leverage levels and leverage is currently modest, he said. And interest rates are close to a peak, Mr. Stewart said.
Barings is focused on thematic investing such as its investments in ESG, he said. Climate change in the form of extreme weather events and rising sea levels leading to flooding are impacting all property types in Europe, leading to stringent energy efficiency regulations, he said.
For example, the European Union has regulations requiring climate change-related disclosures including the amount of money spent on climate change mitigation, according to a Deloitte LP report. Some 85% of the EU’s building stock was built prior to 2001 and therefore, are not energy efficient, the report said. By 2030, 35 million buildings should be renovated, Deloitte said.
“If companies are remotely serious about ESG” they will have to shift to buildings that comply with these new regulations, Mr. Stewart said. However, modern, ESG-compliant buildings are in short supply and that situation is expected to get worse, in part, due to increases in construction costs, he said.
“People who want ESG space will have to pay for it,” Mr. Stewart said.
Barings had $40.8 billion in global real estate AUM down 5.3% from a year earlier, and $5.7 billion managed for U.S. tax-exempt institutional investors, a 1.7% dip in AUM.
