Core Real Estate on the Ropes, but Fighting Back
A recent white paper, Current State of Core Real Estate, by consulting firm Meketa, described a real estate landscape that has provided a consistent opportunity set for institutional investors this century, with the exception of the Great Financial Crisis (GFC) in 2008 and the COVID-19 shutdown. In fact, certain allocators, as reported by Connect Money, have been redirecting their real asset portfolios toward infrastructure investments in lieu of real estate. Nevertheless, the consultant is urging investors to maintain their current course of action.
A significant number of the firm’s clients continue to be involved in real estate, particularly in niche strategies. For instance, Meketa advised the Fairfax County Educational Employees’ Supplementary Retirement System to allocate funds to Sabal Investment Holdings’ SIH Debt Opportunities Fund III, which concentrates on the small- and mid-balance commercial real estate market. The strategy is centered on senior secured loans or debt investments that are supported by commercial real estate loans, with a particular emphasis on affordable multifamily properties and the workforce.
Meketa also provided the District of Columbia Retirement Board with guidance on a $75 million investment in the Elion Industrial Fund II, a value-add real estate fund that is managed by Elion Partners, a Latino-owned company, earlier this year.
Core real estate’s negative return period has already persisted for one quarter longer than the GFC downturn, with 21 months and holding. Derek Proctor, Colin Hill, and Lauren Giordano of Meketa’s real estate team wrote that the period of retrenchment in the early 1990s, which lasted nearly three years, is not entirely comparable to the current one.
Commercial real estate has been a well-publicized drag on returns due to its close correlation with the interest rate cycle. This time, office buildings have suffered most; industrial assets have done far better. Meketa expects overall return within the office sector in 2024 to be losses of 9.9%, followed by a 2.3% yearly drop in apartments. With yearly total returns of 3.2% in 2024, the retail sector is the shining point. Only six of the last 46 years have core real estate investors seen negative yearly returns; 2022 marks the beginning of the current downturn, noted Meketa.
The consulting group also stated that low returns are accompanied by a surge in redemption queues inside core real estate funds. As of the first quarter of 2024, the NCREIF Fund Index – Open End Diversified Core Equity (NFI-ODCE) was redeeming approximately 19.3% of its net asset value. In comparison, this percentage is more than double the 9.2% recorded in 2020 during the pandemic. During the GFC, the redemption backlog hit a high of 15%. Redemption requests exceeded new contributions for two years after the GFC, Meketa added.
“We expect the underlying property type allocations to continue to evolve, as certain property types experience stronger demand and generate higher returns and thus attract more institutional capital than others,” the team wrote. “The recent period of negative returns and the increase in redemption queues among core real estate funds in the NFI-ODCE universe reflects cyclical repricing across the real estate universe.”
The larger the redemption queue is as a percentage of the fund’s net asset value, the longer it is expected to take for that manager to pivot from playing “defense” back to being able to play “offense,” the researchers added.
In the past, open-end fund investors have stopped their redemption requests when the real estate market seemed to be at bottom. Some investors may even want to put more dollars into funds during periods of distress.
The concern is that if redemptions do not match incoming contributions, managers may be forced to liquidate property to acquire funds. So, the recent buildup in the core real estate redemption queue, together with how long it has existed, could explain why managers are hesitant to sell properties at the depressed valuations that are afflicting the office market.
Interest rates will determine much of the path forward. Meketa found that certainty about long-term interest rates, together with economic growth and ongoing tenant demand, may help increase the prospects of these real estate portfolios in the future.
