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Why core private real estate now?

July 10, 2023
  • Thomas Miller for USQ


    Thomas Miller

    Managing Director
    USQ Interval Funds

    Kennett Square, PA


For many years, institutional investors have made allocations to private real estate, with many allocating approximately 10% of their assets1. In most cases, these institutional investors set long-term strategic allocations and occasionally make investment decisions based upon short-term opportunities. However, the environment today creates a potentially attractive entry point for commercial real estate. The asset class, as measured by the NFI-ODCE NR, has drawn down by about 11% from its peak, which is one of its largest declines in the past five decades. Before getting into the details, it is important to remember that commercial real estate is much broader than just office towers. In fact, office now represents only 20% of commercial while industrial and multi-family combined make up almost 2/3rds of the real estate market across the country.

Historical lack of correlation

Private real estate has long been a favorite asset class for pensions and institutions for its low volatility, stable cash flows, and consistent return stream. The chart below makes it clear why; there have only been two periods throughout its recorded history where the asset class has suffered any significant drawdown and both those periods (Savings and Loan Crisis and Global Financial Crisis) were characterized by over-leverage and over-supply. These characteristics are not present today even though the asset class has experienced negative returns over the past three quarters; leverage remains below historical averages and supply/demand fundamentals are very healthy, with the exception of office. That said, rising interest rates and cap rate expansion have been a headwind that have led to modest valuation declines.

Net operating income growth in inflationary environments

As mentioned, rising rates have been a challenge, though it is important to remember in this environment why interest rates were rising to start. An oversimplistic explanation is that rates have risen to curb inflationary pressures resulting from too many years of low interest rates and too much stimulus as a result of the COVID-19 pandemic. One of the many reasons that commercial real estate demonstrates such resiliency is its ability as an asset class to grow income in inflationary periods. The increase in income during these periods allows capitalization rates to push higher to account for higher interest rates.

As the chart below demonstrates, net operating income (NOI) growth in the NFI-ODCE has been substantially higher over the last two years relative to long-term averages. On average, NOI growth has been almost 3 times higher during this inflationary period. This increase in income has helped to offset a portion of valuation declines despite a drawdown of about 11% for the asset class as a whole. When rates do start to decrease, demand for commercial real estate will likely increase as financing costs are reduced and yields will again become attractive relative to fixed income. That said, the current distributions are still compelling given the tax advantages. Additionally, since new construction is muted in periods of rising rates, we expect core real estate to be a highly sought after asset class as rates retreat.

Subsequent 10-year return during a drawdown

Arguably the most compelling point as to why private real estate should be considered today is informed by its last major decline. As previously mentioned, private real estate has not suffered many substantial losses since 1978. The worst decline was from the period of 2009-2010 as a result of the Global Financial Crisis. When evaluating the appropriate entry point during that period, investors were better off investing early, before the trough, rather than waiting for the “bottom.” The following chart demonstrates investors’ subsequent 10-year return when investing in the NFI-ODCE before the trough, at the trough, or following the trough. Investing one quarter prior to the trough was more beneficial than waiting until one quarter after, with even more diminishing returns by waiting longer.

One final point worth mentioning is that many headlines may lead you to believe that commercial real estate is poised for a wave of defaults. It is true that some specific sectors within real estate may face challenges when debt is refinanced because of higher rates and tighter lending standards, especially those that are highly levered. However, that is not the case for all real estate sectors or many core real estate funds that hold high quality, low-leveraged real estate with long-dated debt maturities. Before rates began to rise last year, many core private real estate managers were able to lock in historically low interest rate debt that does not mature until after 2026. Therefore, core assets should not face the same challenges as highly-levered or more speculative real estate that focuses on development.

Final takeaways

  1. Core private real estate consists of multiple property types including industrial, multi-family, retail, and office. The asset class has almost no correlation to broad equity and fixed income markets. Additionally, the asset class offers tax-advantaged distributions.
  2. Rent growth is an inflation hedge. Additionally, supply is slowing as a result of higher interest rates, which will drive demand higher for core real estate in coming years.
  3. While you cannot time asset classes, today may be a good entry point. Even though the asset class may experience another slightly negative quarter, history demonstrates it’s better to be early rather than late.

Learn more

For more information about why private real estate is an attractive asset class in today's market, contact USQ’s experts:

[1] Source: Hodes Weill & Associates, 2022


NCREIF Fund Index — Open-end Diversified Core Equity (NFI-ODCE) consists of private real estate equity funds that meet certain criteria with respect to such things as leverage (less than 35%), operations (at least 75% invested in properties that are 75% or more leased), sector and geographic diversification, and investment in core real estate (at least 75% in office, industrial, apartment and retail properties).

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