December 16, 2024
Charles Allen, Head of European Real Estate, recently spoke with IREI regarding the prospects for real estate in 2025, with a particular focus on emphasising the importance of property allocations. Charles also highlighted the value between relationships within real estate teams, how they can operate more efficiently and are better equipped to respond to market changes.
Up until around the middle of 2024, a certain thesis within real estate investment circles held sway.
It went something like this: Once the era defined by inflated valuations and investment strategies reliant on cheap capital and liquidity blew up in 2022, institutional investment committees took a large step back from real estate allocations. Having already been spooked by the seismic shock that lockdowns had delivered to office markets, they were now dealing with financing costs that were making deals prohibitive, while fixed-income investments of every stripe were riding a wave of central bank tightening.
Compounding this, says Adnan Ozair, head of capital markets at Delancey in London, was the illiquidity of real estate, which inevitably comes to the fore in tough times and causes significant frustration. “Whether in open-end or closed-end structures, liquidity at acceptable pricing often necessitates acknowledging steep losses, further souring sentiment,” he says.
But this theory is now being consigned to the history books. As Chiang Ling Ng, Hines’ co-head of investment management in Singapore explains, investor confidence is moving to a better place. With Japan the exception, central banks have started cutting rates, indicating a synchronised easing cycle. This has lowered debt costs, leading to a positive shift, which in turn is supporting investor demand.
“It’s fair to say that the United States and Europe, and to a lesser extent Asia, are deep into the ‘bottoming’ process,” she says. “Investors now have a compelling opportunity to invest for the long term and benefit from favourable pricing.”
London-based Ben Sanderson, managing director of real estate at Aviva Investors, has experienced this change when interacting with the manager’s client base. “There are three phases we have been through, generally speaking,” he says. “We’ve passed the period of asking investors about deploying in 2023, when many kept replying with a ‘no’. Then maybe six to 12 months ago, they were saying ‘maybe’. Now, we’re definitely in the phase of them saying ‘yes, where?’”.
Todd Henderson, head of real estate, Americas, at DWS, backs up Sanderson’s experience. “I’ve been out on the road a fair amount recently, domestically and globally, and I would categorise [this chapter] as one where investors are picking their pens back up,” he says. “We’ve gone from virtually frozen in terms of inflows to a nascent capital formation cycle that will build momentum throughout 2025.”
Sanderson believes the market is now at an inflection point that has reinstated investor confidence. “It does appear to be the case to us, both on a relative value basis and when you talk to investors, that they have come to the view that now is a good time to start thinking about equity investment in real estate, because the relative value argument is much stronger in favour of real estate equity than it was, certainly 12 months ago.”
Investors are likely to see a retention of value in real estate debt going into 2025 as well. “Rates have probably not fallen as sharply as many expected at the start of 2024,” says Sanderson. “There is still value in debt for sure; if you look at recent movements in the 10-year and the five-year swap rate, there’s still an elevated level of the price of debt.”
Different courses, different horses
For some observers, however, the theory that all investors have kept their powder dry for the past two years and more does not work as a global assertion.
Brian Chinappi, partner and head of real estate at Act is in Hong Kong, argues that the thesis jumbles together generalist, negative headlines about real estate, which inevitably lack nuance, and are also very tilted towards western real estate markets.
There is no doubt, he says, that western real estate markets have witnessed a cyclical correction driven by a rapid increase in interest rates and the office sector coming to terms with the hybrid-working revolution.
However, not all sectors and regions are in the same position. Markets and sectors where leverage was not a primary driver have not necessarily been negatively disrupted and in some cases have been enhanced.
“Investors increasingly understand this, and their investment committees are able to differentiate more between different markets and sectors within real estate,” he says. “While some LPs remain over-allocated and are reducing their real estate allocations, others are increasing those allocations. We believe that the resilience of new-economy real estate in Asian growth markets remains attractive to investors, for example.”
Reversing the denominator effect
Back in the West, the gradual lowering of interest rates has not only reduced financing barriers to entry but also tilted portfolio ratios in favour of real estate once again.
Henderson outlines this change from a US perspective. The Fed, he recalls, wrongfooted the real estate market by saying it was not going to raise rates at the start of 2022. Only a few short weeks later in March 2022, the central bank began its historic rate increase, which created significant pricing disruption.
“Values did not adjust until late 2022, while the equity and fixed income markets performed poorly throughout 2022.This rebalanced portfolios and resulted in portfolios being significantly overweight to real estate,” says Henderson. “With the strong performance of the equity markets and real estate prices having reset since 2022, many institutional investors are now underinvested in real estate — contributing to their desire to get back into the market.”
Given this dynamic, Antonio Marquez, managing partner and principal at Comunidad Partners in Texas, says his firm is seeing increasing allocations to real estate, particularly in the value-added and opportunistic segments of investment portfolio allocation strategies.
Meanwhile, Boston-based Michael Acton, managing director and head of research and strategy at AEW, reveals that he and his colleagues have noticed a measurable uptick in queries about allocating into core segments of the market.
“You can see it in terms of investors turning dividend reinvestment programmes back on in open-end funds,” he says. “You can see it in investors going to the secondary market and trying to negotiate for shares and the discounts on those negotiations have more or less evaporated in the last six months. You can see it in new search activity. It’s a pretty big change.”
Not all plain sailing
Nevertheless, as Keith Breslauer, managing partner at Patron Capital in London, says, there are a number of challenges for investors looking at re-engaging with real estate.
One of these is the flip side to falling interest rates — namely, that there are now fewer people under pressure to sell.
“You might be looking at lots of assets, but it’s much harder for the pricing to come down, and therefore, it’s not clear you’re going to have the same transactional experience that you would have had before,” he says. “The market is projecting a 75-basis-point or so fall in UK rates over the next 12 months. And what that means is that those reliant on credit who have a building that is operating and paying rent are not going to foreclose. Why would you? You might as well wait and make the bet that with rates falling, cap rates will fall.”
Sluggish or non existent economic growth is also a concern. With China not rebounding and Germany remaining in the doldrums, weaker demand could play a major factor in 2025.
Nevertheless, there could still be opportunities to take advantage of, particularly as stringent ESG requirements could push assets onto the market at attractive prices and REITS are still trading at significant discounts and need to sell assets.
“There remains a very good case to buy interesting assets,” says Breslauer. “The question is, are there lots of deals of big size? It’s not obvious. I would say probably not.”
Need to drill down
Hines’ Ng says it will take time for interest rates to normalise, so the focus must be on disciplined investment. “In this environment, rent growth will likely drive value creation across sectors and geographies — highlighting investors’ need to execute at the asset level,” she says.
John O’Driscoll, global co-head of real estate at AXA IM Alts, agrees. Although AXA IM Alts can see a good macro story in European real estate, the potential for strong returns is not completely uniform across all sectors or geographies. Stocks election is always crucial, he emphasises, but in the next cycle it will reach a new level of importance.
“You’re going to see a huge range of performance in offices, in logistics, in residential. And it’s really about picking the assets. And that’s not just geographically. It’s submarkets, it’s micro-locations. That’s going to be a feature [of this cycle].Whereas if you look at previous recoveries, it was far more uniform.”
It is also important to think outside the box, argues Chinappi. The days of generic thematic investing are probably behind us, he says, and there needs to be more focus on precisely how strong global themes — digitalisation, supply-train transformation, health and wellness, and climate transition —are generating economic growth and demand in specific sub-markets and sectors. “Relative value matters even more,” he says. “To do this well, consistently, is also going to require greater localisation, an operating mindset and deeper relevant experience.”
Charles Allen, head of European real estate at Fiera Capital, says this development in mindset has already taken place.
“Investors are approaching real estate allocations with a lot more diligence and nuance than they did in the low rate environment, where cheap money and mega trends such as the ecommerce boom and a housing crisis in most European cities made the case for real estate a bit easier,” he says. “In this respect, they’re looking beyond the beta.”
Allen says there is also a greater focus on how relationships between committees and managers operate at the most basic level, assessing factors such as the size of the team, responsiveness and how resources are shared. Boutique, midsize managers are boosting their appeal as they offer efficiencies in a lot of these areas.
An underappreciated store of value
With the return to a more traditional monetary environment, where fundamental valuation, rigorous underwriting and active asset management are essential to create and protect value, many investors have found themselves reassessing the appeal of real estate, says Delancey’s Ozair.
How, then, can those in charge of real estate portfolios make the best case for the asset class to their investment committees?
For Nick Pink, head of European real estate equity at Barings, they should emphasise the need for diversification, particularly amid the mono-culture and rate risks of fixed income. While fixed income has its place, it offers no protection against inflation compared to property, he argues. Real estate benefits from a stable yield and a growing cashflow, particularly when an asset has long-term support via demographics, technology and other societal changes. “We have just left behind an inflationary surge, and while prices will hopefully settle in the near term, nothing is certain. That’s particularly the case amid the geopolitical situation.”
“Secondly, it’s about remembering the opportunity that property provides. If you include residential property assets, global property is a vastly bigger sector than the equity and bond markets combined. Best-in-class assets that benefit from structural demand tailwinds — such as logistics, residential and prime offices in good city-centre locations —should see strong returns,” he predicts. This could reach 7percent to 8 percent annually for core property, to 10percent for core-plus and mid-teen returns for value-added.“[This means] an appropriate blend ought to perform more strongly than fixed income on both a nominal and risk-adjusted return basis,” adds Pink.
Real estate’s hard asset store of value proposition is also under appreciated at the moment, argues Marquez at Comunidad Partners. “We view real estate as a prime candidate for capital allocation, as assets can be purchased significantly under replacement cost, and operational expenses are starting to normalise coming out of a once-in-a-generation anomalous expense escalation period,” he says. “Reversion to the mean is highly likely, and significant revenue and NOI growth is anticipated in the more desired asset classes of multifamily, industrial, and data centres over the next three to seven years.”
Then there is the positive social impact property can have on communities. Urban real estate investments drive meaningful social benefits — improving infrastructure, housing and community well-being — especially in high-density areas, says Ozair. “Combining financial returns with measurable societal impact, real estate uniquely aligns with the growing demand for purposeful investments.”
Advancements in property management technology and enhanced data analytics are also a major plus point for real estate. With these innovations, owners can improve efficiency and transparency, says Jacob Feingold, managing director and head of originations, at Canyon Partners in New York City. New technology, therefore, has the potential to mitigate issues traditionally associated with operational complexities, making real estate a more attractive option for investment committees.
John Berg, global head of private real estate at Principal Asset Management, who also works out of New York City, says timing is also a strong argument to make during investment committee meetings at present.
In addition to the diversification benefits of adding private real estate to a multi-asset class portfolio, the roughly 20percent repricing that has occurred in private real estate offers a good entry point into diversified portfolios, he explains. After the savings and loans crisis, the NFI-ODCE Value Weight Index increased for 15 consecutive years, generating an average annual return of 11.3 percent. After the global financial crisis, the index increased for 13consecutive years, with an average annual return of 11.1percent. “The current cycle property valuation adjustment is less severe than the GFC, thus a more shallow recovery maybe expected for diversified funds,” he adds.
“Real estate credit offers attractive opportunity today, particularly as investors reach higher into the capital stack but at repriced valuations. For more targeted investments, certain single- sector strategies such as data centres remain interesting from both fundamental and portfolio construction perspectives,” says Berg.
“2025 could be a good entry point for such investments.”