Real estate markets are entering a period of sustained weakness for the first time in over a decade. If this is the first time you have experienced a downturn in your investment management or real estate career, here are five things to be aware of as you traverse the changing landscape.
1. Know That Downturns Are Normal
Real estate is cyclical. For as long as people have invested in real property, there have been peaks and troughs in values. These cycles tend to last years or even decades, so you may need to work in the industry for a long time before experiencing a downturn. But they are a feature, not a bug, so while difficult times may lie ahead, downturns are manageable.
In part, the cyclicality of real estate reflects the fact that the fortunes of real estate assets are tied to the broader economy. Occupier demand — and therefore rental growth — depend on the general health of the economy as well as the labor markets.
Additionally, real estate values are especially sensitive to interest rate changes. Today, high inflation is necessitating higher rates and higher discount rates are pushing values down.
While demand for real estate can change quickly as the economy expands and contracts, supply can be slow to respond, because developing real estate or repurposing assets can take years. This means that supply and demand can remain mismatched for prolonged periods, heightening the cyclicality of real estate. On top of this, the use of leverage serves to amplify volatility.
Given how real estate is impacted by economic performance, rising rates, oversupply and assets laden with debt, cycles and downturns are inevitable features of the asset class. You should not expect the value of investments in risk assets, such as real estate, to go up in a straight line. The path to long-term positive returns is bumpy, but think of the extra return real estate offers over lower-risk investments (like government bonds) as compensation for the emotional turmoil of seeing values rise and fall.
2. Know That This Downturn Has Only Just Begun
While many CRE asset classes and geographies have already seen material declines in real estate values, price depreciation is likely to continue for some time. Downturns affecting real estate assets can last years. For example, in the wake of the Global Financial Crisis that began in 2007, values in most markets declined for two or three years. In the 1990s, many markets saw values decline for longer periods, although generally at a more gradual rate.
Property values are based on appraisals informed by both current and slightly historic transaction activity. Generally, valuations tend to be “smoothed” relative to transaction pricing, and in a downturn when transaction activity tends to slow, valuation declines do not keep pace with falling prices. This delay can add to the length of the downturn.
In the case of this cycle, capital declines to date reflect the direct impact of higher interest rates on net present value calculations. But there are probably further declines to come as the consequences are felt of debt becoming more expensive and less readily available. And given widely held expectations of a recession, prices may need to adjust to reflect the higher risk attached to rental income streams.
These slowly changing dynamics mean that real estate investors are only just beginning to feel the consequences of the downturn on their businesses.
3. Know When to Realize a Loss
If you are making a decision about whether to hold or sell an asset today, the key is to look forward when acting. There is a real danger that investors will anchor to historic valuations or prices. Realizing losses always hurts, even if it is just relative to peak valuations, rather than entry prices.
People generally feel losses more keenly than gains, and such loss aversion can lead us to be excessively hesitant to sell assets at a loss. But what feels hard emotionally may be right for an investor, so make hold or sell decisions based on a dispassionate, data-driven assessment of future returns.
4. Know That Capital Will Be Scarce
For much of the past decade, extremely loose monetary policy brought about an abundance of capital. Investors came to expect returns on cash to be approximately zero for a very long time (more than a decade), making it unusually easy for any investment offering a positive cash flow to seem attractive. Both equity and debt capital flowed freely into risky assets, including real estate.
Such tailwinds are unusual, and now they are over. Recently, financial conditions have tightened at an extraordinary pace. Higher government bond yields mean investors are no longer as hungry as they were for real estate exposure.
Of course, real estate continues to boast attractive attributes. High quality assets provide stable income; some assets offer a degree of inflation protection; and many investors look to real estate to bring diversification to their portfolios.
However, real estate investors will likely need to work much harder to retain and attract capital during a downturn. The criteria by which real estate investors are judged will change. For example, during an economic uptick, investment managers may emphasize their ability to deliver a real estate asset for investment quickly, but in a downturn, they need to stress their ability to be highly selective and identify the very best investment opportunities in the asset class.
This will require them to have a robust investment assessment process in place that tests what could go wrong with a proposed acquisition from every angle. Investors will need to be able to illustrate a thorough understanding of the risk characteristics of the markets in which they invest. A clearly articulated investment — strategy and the discipline to stick to it — are essential.
In a downturn, investors will be risk averse and may need the reassurance of an augmented investment process and enhanced investment strategy to commit to real estate.
5. Know That Downturns End and Create Opportunity
A high degree of cyclicality creates opportunities for active investors, particularly because lack of transparency around pricing can provide attractive entry points for well-capitalized and highly informed parties. Understanding the current stage of the cycle — and adjusting strategy accordingly — is critical for overperformance in real estate.
There are times to play offense and times to focus on defense. When cycles seem to be well advanced, investors should adopt a more cautious approach. They should act to limit potential future losses rather than seek full participation in gains. The investors best positioned today will be those with limited debt, limited ground-up development exposure, low vacancy and few short-term leases in their portfolios.
But as the downturn progresses, investors will be rewarded for selectively taking on more risk. The trough of the cycle may provide excellent investment opportunities. With market participants fearful and risk appetite low, property assets are likely to be underappreciated, particularly if they have some degree of vacancy risk.
Timing the trough of the cycle with precision is impossible. But there are some indicators that may point to an approaching recovery. For example, if capital values have declined to levels where they look cheap — in a historical context and relative to other asset classes — the possibility for further declines may be waning.
Indications of risk aversion can also be telling. As the bottom of a cycle nears, the spread in pricing between prime and secondary real estate widens, and portfolios are sold at discounts rather than premiums. More generally, investment activity focuses on core cities and traditional, well-understood asset classes.
Know that the cycle will end. Many market participants will remain highly risk averse for too long and this reluctance to invest will be a source of great opportunity. Look for indicators that the trough of the cycle may be close. Be bold enough to play offense while others are still in a defensive mindset. Such counter-cyclical moves are likely to be highly rewarded.
So, while this downturn will likely be very challenging, know that the best investment opportunities of the cycle lie ahead.
Credit: Source link