Higher interest rates are changing the environment for real estate investments. The recent turmoil surrounding Blackstone’s BREIT highlights the looming risks of private funds. Investment strategies must be adapted to new market conditions.
It is not surprising that an abrupt turnaround in interest rates can lead to lower property valuations. This is what happened in 1974, which is still considered the year of the «Great Property Crash» in Great Britain. Prof. Peter Scott 1 documented that commercial real estate values fell by about 20% in nominal terms and 40% in real terms in the year following the first oil price shock.
While equity and bond markets recorded a significantly negative performance last year, the impact on real estate valuations is more complex. The effect on real estate portfolios may also depend - at least in the short-term - on the type of investment vehicle chosen.
Listed REITs and real estate funds are traded on stock exchanges; accordingly, they are subject to valuation fluctuations similar to other equities. They represent the result of forward-looking expectations but often overshoot in both directions.
Internationally active institutional investors usually invest indirectly in real estate through non-listed funds. Core real estate strategies are largely represented via open-ended structures (real estate funds or, in Switzerland, investment foundations). However, listed REITs internationally or real estate funds in Switzerland may also play a role in the portfolio.
For unlisted indirect real estate investments, performance is based on distributions (dividends) and changes in the valuation of the underlying portfolio. Investors can purchase and redeem their shares directly from the vehicle manager at the net asset value. These vehicles also differ in terms of redemption periods. Quarterly or annual liquidity is the rule.
Two events in recent weeks have attracted attention. On the one hand, most open-ended real estate funds in the U.K. have frozen the ability of investors to redeem shares, as they faced redemption requests of many pension funds. This was a consequence of the move to higher cash ratios of investors after the October crisis. Such measures were more or less to be expected, as they already were put in place after the Brexit vote in 2016 and in April 2020.
On the other hand, industry leader Blackstone surprisingly not only limited redemptions at its giant private property fund BREIT, but had to take balance sheet risks in a transaction to guarantee a minimum return of 11.5% p.a. for six years for a large institutional investor (UC investments). The goal was to get a larger subscription of $4 billion.
BREIT and similar non-listed open-end private REIT structures by other investment managers have been a model of success in recent years. They provided investors with a lower minimum investment the opportunity to tap the risk-return profile that typically institutional investors get when investing in real estate. The product provides monthly liquidity, but limits redemptions to 2% of NAV per month or 5% per quarter.
Last October, due to the strong liquidity needs of investors, they received more than the 2% or NAV in redemptions, so not all clients could be serviced. The above-mentioned transaction with UC was intended to create room for maneuvering so that no «fire sales» would have to be made in case of further redemptions. In fact, we are aware of several transactions in which BREIT acted as a seller of real estate portfolios last year.
Typically, investors would be expected to redeem their shares when the product performance does not meet expectations. This does not apply here. Until October, BREIT’s portfolio has hardly been devalued and is invested in those sectors that are favored by investors. BREIT was not an isolated case. Many other European and American funds with excellent track records received a significant level of redemptions of shares.
So what happened? On the one hand, such redemptions are driven by investors’ liquidity needs. On the other hand, they are driven by the fact that real estate valuations react with a delay to underlying changes in the market. Figure 1 shows the development of total returns for open-ended real estate funds (blue curve) and listed REITs (orange curve) since the end of 2004. While the index of listed REITs has corrected by around 25% since its peak, the index for open-ended real estate funds has held steady.
Some argue that REIT performance is in line with overly negative expectations in equity markets, and real estate will continue to be supported by higher inflation and solid rental market performance. This may be true in the medium-term. However, such argumentation is contradicted by the fact that the risk premium between real estate and bond yields has melted away due to the higher interest rate level. Yields on 2-year government bonds in the Eurozone and in the United Stated are at similar levels as the dividend yields of open-ended real estate funds.
Direct real estate transaction markets tend to respond more quickly than valuations. Based on transaction data, 2022 saw at least a 75-100 basis point increase in net yields in the US and EU. Even in Switzerland, JLL’s latest office market report showed that 2022 net office yields in Zurich have increased by 50 basis points.
As Figure 1 shows, during the GFC, real estate valuations of open-ended real estate structures reacted with a lag of six quarters relative to listed REITs. We assume a delayed reaction in this cycle as well. Accordingly, in 2023, real estate capital markets are likely to be further characterized by redemptions and less by new capital raised.
Not all investment managers are in a comfortable position of being able to offer special deals to large investors. International open-ended real estate funds and even investment foundations in Switzerland will likely be found on the selling side accordingly. We are likely to see successively lower valuations both in Switzerland and internationally over the next few quarters, as more transactions are completed at lower prices.
For long-term-focused real estate investors, this is not a negative development per se, as it may offer exciting entry points in some quarters down the road. Investors in non-listed real estate structures should also not confuse the low volatility in 2022 with the typical lagged adjustment process of real estate valuations. Like it or not, the macroeconomic environment that will affect real estate markets over the next few years has changed. The modus operandi of the past years has to be abandoned, which requires an adaptation to the new environment.
1 Prof. Peter Scott is Professor of International Business History at Henley Business School. In his book The Property Masters: A History of the British Commercial Property Sector (London: Spon, 1996), he also reviewed, among other things, the real estate crisis in the 1970s in Great Britain.