Volatility, Risk, and Opportunities in Real Assets
The combination of rapidly rising interest rates and elevated inflation has fueled ongoing market volatility and heightened risks, including an ongoing debate regarding the likelihood of a recession and continued price discovery across asset classes.
However, with volatility and risk come opportunities, and given the long-term nature of investments in certain real assets, the sector continues to attract considerable interest.
As pricing comes into focus, there may be attractive opportunities to add and maintain strategic positions of quality real assets in portfolios, especially for long-term investors with a cyclical mindset, Bank of America wrote in a recent report.
With significant crosscurrents in the occupier and capital markets, the commercial real estate market has been drastically different in 2023 than it was in 2022.
Cap rates are affected by benchmark interest rates, which drive them and discount rates higher. This is a distinct headwind for valuations, as it reduces the value of future cash flows and increases the cost of credit for leveraged investors.
Cash flows driven by property market fundamentals and inflation have been up strongly over recent years for many subsectors. Therefore, depending on the subsector and severity of an impending economic slowdown or recession, existing fundamentals may serve as a tailwind and stabilizing factor, noted Bank of America.
Nonetheless, some subsectors and geographies remain well-positioned to withstand economic complications and make sense over the long term, particularly due to diversification advantages and income characteristics.
Regarding the current real estate fundraising environment, J. Carlos Martinez, Economist at Crescent Securities Group, Inc, told Connect Money: “I think real estate investors have been moving back into the market from the sidelines as the CPI and jobs report in 2023 have shown that the Federal Open Market Committee (FOMC) thus far has been able to manage the impact of the rate increases to the economy.”
Martinez highlighted two types of funds that may benefit as we move forward: Diversified Real Estate Funds “with a proven cash flow that are diversified by geography and industry”; and Opportunity Funds, which “may be in a good position to take advantage of the short-term liquidity needs that REIT’s will be seeking in early 2024.”
While some pension funds and endowments reduced their exposure to real assets earlier in the year, they are now testing the waters again. The Texas Employees’ Retirement System, for example, recently committed capital to Longpoint Fund III LP ($55 million), a retail and industrials fund, and Prologis European Logistics Fund ($14 million).
Meanwhile, in a sign of demand possibly picking up, TA Realty LLC closed its oversubscribed TA Realty Value-Add Fund XIII at nearly $1.8 billion. The fund acquires industrial and multifamily assets as well as grocery-anchored shopping centers in the US.
The intrinsic value of CRE remains rooted in long positions in real assets correlated with inflation and cash flow resulting from contractual rent — a potent return driver compounding over the long term — presenting likely strategic opportunities to add quality assets to a portfolio for long-term investors with the mindset and ability to see through market cycles.
Even during periods when valuations are under pressure, as they are now, current yields can be stable and consistent, mitigating the effects of an interest rate-driven market correction, added the Bank of America report.
The opportunities in infrastructure may be even stronger. According to a recent report from industry analyst Preqin, global infrastructure assets under management will reach $1.7 trillion by the end of 2028.
Pension funds and endowments have continued to allocate capital to these funds. The Texas Employees’ Retirement System also recently made a $60 million infrastructure commitment to Digital Colony’s DigitalBridge Partners II – an infrastructure fund focused on the telecoms industry.
Furthermore, Goldman Sachs Asset Management announced on Monday that it closed its West Street Infrastructure Partners IV fund at $4 billion to invest in energy transition, digital infrastructure, transportation/logistics, and social infrastructure opportunities across the middle market.