- Private real estate (PRE) could be seeing early signs of pressure, requiring a deeper look at risks
- Inflation and rising interest rates vs a cooling economy could make it challenging for managers
- This environment could deal a double whammy on the riskiest opportunistic and value-added strategies
- We encourage investors to carefully assess their PRE investments on their fundamental merits
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
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.
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.
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