Evaluating Risks in Private Real Estate
With most public markets in the red throughout most of 2022, the prevailing trend of thought was that private assets were a comparative safe haven as there was no need to face “mark-to-market” losses in investors’ portfolios. However, rapidly rising interest rates and a cooling economy are impactful developments that would unlikely leave private market investments above the fray. To imagine that absence of volatility implies the absence of risk is akin to the proverbial ostrich burying its head in the sand to hide from danger, and we would encourage investors to exercise more prudence in their risk assessment to be better prepared for potential stresses in these illiquid markets.
One area that could perhaps be seeing early signs of pressure is private real estate (PRE), for example, with top investment managers experiencing withdrawal requests from retail investors concerned about the sector’s outlook. Soaring borrowing costs are causing some property owners to struggle, as a year of rate hikes has perhaps spelled the end of an era for employing cheap leverage to amplify returns. Meanwhile, heightened inflation has pushed up construction and property enhancement costs, while growth headwinds could make it more challenging for some managers to manage vacancies and rents. Given the interplay of these movements, we believe this warrants a deeper look into the risks in PRE.
Types of PRE investment strategies. The following diagram illustrates the broad categories of PRE strategies and some of their significant features:
Source: Pitchbook, DBS
Risks in PRE investing
1) Inflation resulting in higher costs of capital improvements and operating costs
Construction costs have risen significantly since the pandemic, due to rising labour and material costs. For example, property manager CBRE estimates that construction costs rose 11.5% in 2021, well above the 2-4% historical trend. Investments in underlying assets undergoing construction or other capital-intensive enhancements would be most impacted, as rising construction costs erode their profit margins.
Fully operational properties are also not spared the impact of soaring inflation, as inflation is also working its way into rising operating costs, which would have the greatest impact on sectors that are operationally intensive. PRE managers unable to adjust rents upwards to keep pace with rising costs would be most at risk in an inflationary environment.
Figure 1: Inflation in construction material costs
Source: Bloomberg, Bureau of Labor Statistics, DBS
Figure 2: Rising rates weighing down property values
Source: Green Street Commercial Property Price Index, DBS
2) Rising interest rates resulting in higher financing costs
In our 4Q22 Private Assets Outlook, we called for calibration in private market investing given the rapidly rising interest rate environment and the pervasiveness of leverage to amplify returns in private market investment structures. As with other private market investments, the PRE space is not exempt from these risks, considering financing used in asset acquisition and property development.
While managers that have already locked in long-term financing at prior low rates would be insulated, assets financed using floating rate, short-term borrowings typical in properties still undergoing development and construction face the greatest detriment as rising costs of interest and debt servicing become increasingly onerous. Managers seeking refinancing or fresh borrowings to support new property acquisitions are also facing challenges given the limited availability of debt as lenders tighten their credit standards.
3) Rising interest rates weigh on property values
According to the Green Street Commercial Property Price Index, US and Europe commercial property values have fallen 16% and 11% respectively in 2022 as rising financing costs and limited availability of capital has weighted on deal flow and asset valuations. Managers, facing mounting pressure to generate returns to compete with risk-free yields, are treading carefully to avoid overpaying for assets, spelling a challenging exit environment. Beyond mark-to-market losses in property holdings, falling property values could compound challenges in financing, for example, due to maximum loan-to-value provisions and loan covenants linked to property values.
Caution warranted for riskiest PRE strategies. In summary, we believe that high inflation and rising borrowing costs in the current environment are expected to deal a double whammy on the riskiest opportunistic/value-added strategies in PRE, with portfolios exposed to properties undergoing construction, and assets that are highly leveraged using short-term floating rate loans. While falling valuations could soon provide attractive opportunities for managers seeking to purchase quality assets at discounted prices, this would only benefit managers with the strongest track records and sufficient dry powder to deploy.
Nonetheless, we also note the potential for pockets of resilience in core strategies exposed to high quality assets, particularly in sectors benefitting from secular shifts like logistics properties in the US from the onshoring of supply chains and e-commerce demand. While PRE strategies have shown good risk-adjusted returns and diversification benefits over the long run, we would still encourage investors to carefully assess their PRE investments on their fundamental merits, and not be lulled into a false sense of security based on stagnant prices alone.
Figure 3: Attractive risk-adjusted returns of PRE
Source: Preqin, DBS
Based on y/y returns for 10 years up to March 2022
Figure 4: PRE provides diversification against public equities over the long run
Source: Preqin, DBS
Based on y/y returns up to March 2022
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