Welcome to this month’s edition of Jack’s insights. Today we’re breaking down the latest trends in CRE investor behavior to assist you in developing your own investment strategy amid ongoing uncertainty.
Key Take-Aways
- Identifying investments that balance risk and return is an art and a science. Snaring such elusive prizes takes creativity, rigorous due diligence, market expertise and proper timing. Landing an asset with an attractive return is particularly challenging in the current environment of record-low rates. Under these conditions, CRE assets continue to appeal to investors seeking higher yield and acceptable risk. In addition to distressed debt, investors are becoming familiar with alternative niche properties such as life science, student housing, cold storage, and data centers. However, these higher yield properties also come with elevated risk.
- Investors face multiple uncertainties. The Delta variant, regulatory agendas associated with changing leadership and the threat of rising inflation are just a few. Nevertheless, institutional investors remain committed to CRE. In fact, many expect to increase their allocations to new investments over the next 12 to 24 months.
- Considering the geopolitical and regulatory risks in many countries, cross-border capital flows remain resilient. North America continues to be the largest recipient of capital allocations, followed by Continental Europe.
Investors Expect to Boost CRE Allocations By More than $80 billion
COVID-19 curbed investment activity in the first half of 2020. CRE has withstood this volatility. As economies recover, many investors are allocating more capital to their real estate portfolios. Data reported in the 2020 Allocations Monitor underscores the rising interest in CRE assets — institutions reported an average target allocation to real estate of 10.6% in 2020, a 10-bps increase from 10.5% in 2019. [1] This equates to an additional $80 to $120 billion of capital allocations to real estate in 2020. Institutions anticipate an increase of 30 bps in 2021.
Steady Ascent in Allocations to CRE
Rising allocation to commercial real estate (10 bps in 2020 and 30 bps in 2021) follows the investment patterns registered in prior recovery cycles. It also continues a long-term commitment by institutional investors to CRE. In 2018, for example institutions with more than $50 billion AUM reported an average target allocation of 10.4%, up 30 bps from their target allocations to the asset class in 2017.
More institutional investors are targeting CRE as they pursue higher yields with acceptable levels of risk. Looking to 2021, 29% of institutions expect to increase target allocations over the next 12 months, up slightly from 24% in 2020.
A Slight Turn Inwards
Considering the elevated level of geopolitical risks, cross-border capital flows have held up relatively well. The global pandemic is spurring a modest shift towards “home country” investments, though. While willing to bet on higher-return strategies, investors often hedge against risk by investing in the regions they know best. Many North American investors facing travel restrictions and attractive home-market returns are expecting return premiums in exchange for venturing offshore.
Large pension funds in California and Kansas have increased their target real estate allocation in the past year, according to a report from the Wall Street Journal. The article cites James Corl, the head of private real estate at Cohen & Steers. Corl said the shift isn’t necessarily surprising, given that asset allocators and fund managers are seizing opportunities to take advantage of the state of the real estate market. Corl attributes the increased real estate allocations to several factors: the shift away from fixed income; the increased sophistication of professionals who invest in the asset class and the cyclical economic behavior of real estate Finally, Corl highlighted real estate’s status as a hedge against inflation as a bonus.
Growing Appetite for Higher-Return Strategies Suggests Risk Aversion is Moderating
Investors continue to explore the entire spectrum of risk profiles — core, value-add and opportunistic investments. Value-add and core assets still receive more investments but as more economies stabilize and risk aversion moderates, investor appetite for high-return strategies such as distressed assets have expanded. Value-add strategies remained the most-favored investment strategy, with 84% of institutions reporting that they are actively allocating to value-add investments. This represented a decrease from 91% in 2019. Similarly, institutional allocations to core strategies fell from 66% in 2019 to 62% in 2020. Investors expect to redirect some of their capital to higher-yielding, opportunistic real estate in the upcoming year with a focus on distressed assets.
Final Thoughts & Conclusion:
- Targeted allocations to real estate continue to rise globally. The pace of year-over-year growth moderated in 2020 but is expected to pick up in 2021.
- Commercial real estate is still generating favorable investment returns relative to expectations.
- Investors continue to reach for yield by pursuing core, value add and opportunistic strategies. Given the additional risk associated with CRE and each strategy, investors need to be diligent in deciding which options will best match their risk tolerance and return expectations. In the next Jack’s Insights, we will discuss how to evaluate and measure these risks.
Conclusion:
Investors are very active, despite elevated uncertainty. The pursuit of higher yields will push more investors to increase allocations to commercial real estate.
Considering the growing competition for assets, investors must be ready to seize opportunities that align with their risk tolerance and return benchmarks. Hitting the appropriate balance between risk and return will require a rigorous approach to due diligence and market expertise.
[1] (Based on research collected from 212 institutions with combined total assets under management of $1.6 trillion and real estate portfolio of $1.3 trillion