Though investors across all asset classes have been preparing for a wave of distress, thus far, aggressive stimulus measures and accommodative Federal Reserve policies have averted these highly anticipated fire sales.
Currently, 10-year U.S. treasuries are yielding approximately 1.68 percent and the S&P 500 is trading at a record high of 4,121. Despite the frothiness in U.S. bond and equity markets, however, commercial real estate transaction volume during the 12-month period ending February 2021 was down about 40 percent from the previous 12 months.
The multitrillion-dollar flood of capital that has been pumped into our financial system since last year has yet to make its way into commercial real estate, though investors are poised to capitalize on the relative value it offers compared to more traditional investments such as stocks or bonds.
Whereas the average institutional commercial real estate fund raised between 2012 and 2015 was capped in the $250 million to $500 million range, multibillion-dollar funds offered by the industry’s leading investment managers have become the norm. For example, despite successfully securing $7.5 billion for its 11th flagship fund in 2018, Starwood is now raising Fund 12, which is expected to top out at $10 billion.
According to the 2020 Investor Report by Private Equity Real Estate, Blackstone raised $65 billion to deploy across all of its commercial strategies between 2015 and 2020. To put these staggering numbers into perspective, in 2010 the entire commercial real estate fund universe consisted of $84 billion of “dry powder.” Today it is estimated that upward of $250 billion is waiting to be deployed into commercial real estate.
THE DENOMINATOR EFFECT
In a normal capital markets environment, record fund raising might signal that private commercial real estate allocations are at, or may even be above their requisite targets. PERE’s 2020 Investor Report survey, however, indicated that 66 percent of institutional investors remain under-allocated to commercial real estate.
While this may seem counterintuitive, it is important to recognize the role of the “denominator effect” in institutional asset allocation strategies. To illustrate, many public pension funds have been steadily increasing their average commercial real estate allocation targets to approximately 10 percent of their portfolios over the last decade, causing them to trim their real estate holdings when stock and bond markets are down, and increase them when stock and bond markets are up.
The S&P 500 is up almost 28 percent from its pre-COVID-19 peak in January of 2020, and bond prices, which are inversely related to yields, have skyrocketed during the same period. It stands to reason that record-breaking fund raising in commercial real estate will continue if the paradigm of ever-increasing asset prices remains.
The lack of available investment opportunities in commercial real estate is creating a supply/demand imbalance as too much capital chases too few deals. Anecdotally speaking, many industry participants who were seeking a “COVID-19 discount” to transact six to nine months ago seem to be shifting their expectations to a potential “post-COVID-19 premium,” if the goal is to deploy a meaningful amount of equity.
THE IMPACTS OF DEMAND
Even during the worst of the pandemic, demand continued to increase for certain asset classes, such as industrial and multifamily. It is possible that a lack of available inventory, record low borrowing rates, and investor concerns about future inflation could begin to push up office, hotel and retail property prices as the effects of the pandemic subside and underwriting clarity is restored.
Remarkably, even hotel assets, whose operating performance was decimated to a greater degree than any other property type during COVID-19, managed to post a slight pricing uptick of 0.8 percent during the same period. The only commercial real estate asset class to decrease in value during the 12 months leading up to February 2021 was retail, which was down 1.4 percent.
Barring any significant changes in capital markets conditions, the commercial real estate space should continue to experience increased demand as institutional investors rotate a share of their portfolios out of low-yielding bonds and record-high stock investments into alternative assets.
The combination of strong liquidity, an above-average spread between borrowing costs and cap rates, and commercial real estate’s historical performance as an inflation hedge with tax benefits should allow commercial real estate to outperform other asset classes that already appear to be priced to perfection in the early stages of the current expansion cycle.