Capital allocations to commercial real estate by global institutions remain at elevated levels, despite the market volatility and dislocation caused by the COVID-19 pandemic. Investors’ pipelines continued to build behind an escalating three-year trajectory that CRE economists and experts predict won’t wane any time soon.
Research by Real Capital Analytics (RCA) and others, such as Hodes Weill & Associates and Cornell University’s Baker Program in Real Estate, shows investor sentiment continues to rise, reaching a seven-year high in 2020. Plenty of capital is available, albeit assets are increasingly scarce.
Institutions are also planning to expand their allocations for real estate, reports Hodes Weill and Cornell University in their eighth annual Institutional Real Estate Allocations Monitor. Target allocations increased to 10.6% in 2020 among survey respondents this year. That’s a 10-basis-point bump from 2019 and 170 basis points from 2013. Hodes Weill notes the increase could translate into an additional $80 to $120 billion in future capital allocations to commercial real estate.
Confidence in CRE
The “Conviction Index” in Hodes Weill-Cornell survey, which measures institutions’ view of real estate as an investment opportunity from a risk-return standpoint, increased from 5.7 to 5.9. The steady growth in confidence in the asset class reflects the strong returns investors have realized over the last five years, which were particularly attractive in a yield-starved environment. Though actual investment returns declined 30 basis points to 8.5% in 2019, results continue to outpace average target returns of 8.3%.
The global pandemic and economic uncertainties have caught investors’ attention, yet institutions’ interests have also been piqued by the potential of distress and dislocation, creating additional buying opportunities. That may be good news for some, given the scarcity of assets and heated competition for deals that pencil as the economic expansion continued.
The Hodes Weill-Cornell survey points out in recent years that institutions remained meaningfully under-invested relative to target allocations, largely either 1) primarily attributed or 2) attributed mainly to the lack of assets sellers were willing to surrender . The gap closed a bit in this year’s survey conducted earlier in the year, as actual allocations increased meaningfully year-over-year from 9.4% to 10.0%, with institutions under-invested by an average of 60 basis points. That compares to a 110-basis-point gap in 2019. The full impact of a COVID-19 economy has yet to be factored into investors’ allocations, but early indications are the opening may be widening again.
Strategies & Deal Flow
Value-add strategies remained the strongest preference globally for capital deployments. But a shift to higher-return, opportunistic strategies to capitalize on anticipated dislocation resulting from the pandemic is also an investor approach emerging.
APAC investors led the shift to opportunistic, with 73% of institutions from the region focused on opportunistic investments – up from 40% in 2019. Roughly 75% of Americas-based institutions and 62% of EMEA-based institutions are actively allocating to opportunistic strategies – compared to 65% and 51% in 2019, respectively, reports Hodes Weill-Cornell.
Commercial real estate investment fell sharply in Q3 2020 from the pace of activity experienced a year ago. RCA reports the dollar volume of properties changing hands in Q3 2020 dropped 57% from a year prior, with transaction volume standing at $68.4 billion.
Cross-border investors were behind $3.5 billion of deal volume in Q3 2020, down 71% from the level of Q3 2019, reports RCA. Still, this third-quarter level is better than the low of $0.5 billion seen in the depths of the Global Financial Crisis. And RCA noted there was reason for optimism too.
Conditions aren’t seeming to get any worse, and indications suggest improvement is not far-fetched. The quarterly rebound looks promising when you consider the high portfolio activity experienced in Q3 2019 and the devastating effects to sales when the coronavirus hit earlier in 2020. Individual asset sales in Q3 20, sales were down only 49% YOY.
Investment activity increased in Q3 relative to Q2 by a more considerable margin than would usually be expected because of seasonal trends, as well. The third quarter’s deal volume is typically higher than what is seen in second quarters, notes RCA, a pattern that usually follows the end of a slower summer period. Deal volume in Q3 was 37% higher than that of Q2.
Haves & Have Nots
Market bifurcation emerged across the commercial real estate assets classes. There was a clear line drawn between the ‘haves and have nots.’ For example, favored asset classes encompassed industrial, data centers, and life science sectors, which experienced strong demand from debt and equity and will likely benefit from cap rate compression. Conversely, hotel, retail, and office assets are likely to continue facing liquidity challenges until the pandemic ends and the economy recovers.
Economists describe the recovery as K-shaped, depicting the top-performing sectors separating them from poorly performing ones. RCA reports the clear winners in the U.S. were the industrial and apartment sectors, as reflected in property prices by industry throughout 2020. Through October, the RCA CPPI for the industrial sector was up 7.1% from the starting point of December 2019. The apartment sector was up 5.8% in this time frame.
The retail sector experienced the most formidable challenge in 2020, with prices down 5.2% from December 2019. The office and hotel sectors fared better, showing total declines of only 1.4% and 2.7%, respectively, but current investors in these sectors may be wise not to read too much into the “little lift” in trends through October, cautions RCA.
While pricing reflects where capital is being deployed, it is also interesting to look at the deal flow. Deal volume is down from a year earlier for both the industrial and multifamily sectors, notes RCA, mostly because of the mechanical challenges of completing deals while socially distancing. Despite these challenges, investors are hungry for the steady income provided by many of these properties in this uncertain climate. Deal volume in the Americas through mid-November was 42% lower than the same point in 2019. The count of commercial property deals was down 36% compared to 2019.
Dallas was the top market for investment in RCA’s rankings for commercial property deal volume in the first nine months of 2020. Typically, Manhattan or Los Angeles claims the top spot, though both dropped significantly more than Dallas, leaving that market No. 1.
An interesting aspect of how institutions are deploying capital is that roughly 85% of new investment allocations are being outsourced to third-party managers. That is driving the continued double-digit percentage growth in assets under management for the investment and fund management industry. Allocating capital to existing manager relationships continues to be a favored approach, too. The Hodes Weill-Cornell survey showed 62% of 2020 investments were earmarked for groups with whom an institution had a previous relationship.
A willingness to invest with emerging managers remained low at 12% among all respondents, which likely reflects a strong preference to go with established managers during times of uncertainty. The trend to select larger managers led boutique and mid-cap managers to increasingly pursue strategic transactions by aligning with larger, global platforms that provide operational support and access to global institutional client relationships.
Depending on the asset class, quickened investment pacing is expected in the coming year, while liquidity is projected to increase. Those factors will likely sustain asset pricing at elevated levels, drive transaction volumes, and support capital costs. Economists predict real estate will deliver attractive risk-adjusted returns, thus remain a haven for investors even in times of uncertainty. That adds up to a continued full capital allocation pipeline in 2021.