The deluge and constant reporting of CRE woes is understandable, but seems over-hyped relative to some other potentially bigger problems brewing. Compared to most asset classes, real estate is funded by a higher proportion of debt, and with the good old days of free money gone for the foreseeable future, repricing to higher funding/discount rates has been necessary.
However, the repricing has been somewhat uneven; in the UK has been marked down anywhere between -5% and -25% as reported by REITs. The shares of REITs are on average down by a lot more – 35-40% – which, backing out the effect of leverage, implies a 25% drop in gross asset value since their recent peaks in 2021. Said differently, there’s plenty more bad news priced in listed REITs than private real estate values. In such circumstance, REITs outperform private market returns.
The sentiment around both private and public real estate is close to the levels of the Dot Com era and GFC. When sentiment is this low relative to broader equity markets, REITs tend to also outperform broad stock indices on a relative basis, especially if we are close to peak interest rates, inflation, and can avoid a hard landing as most now seem to believe.
While the repricing has been painful for investors, it is rational; values need to reset lower to deliver the higher prospective returns in a world where “risk free” government bonds are delivering 4-5% and there is ~200-300bps risk premium on unlevered real estate to deliver total returns of 6-8% depending on the sub-sector.
One saving grace is that the real estate market can operate on lags. Leases and debt both have relatively long unexpired terms; this is especially true of non-private equity structures which use mostly equity financing and often fix/hedge interest rate exposure. This group can ride out market gyrations to some extent.
The same is not generally true at the smaller scale of family offices or wealthy individual investors; their ability to access capital and manage through cycles is lower on average because of assets they own, their high leverage, and mixed banking relationships. Much of the regional bank exposure that we read about appears to be with this group, so if the expectation of goldilocks conditions does not materialize, then further pain can be expected. The silver lining is that, relative to the GFC, securitization/derivatives are not many multiples of the value of underlying assets they represent.
So, where are the bigger problems that don’t make the same types of headlines?
