2023 Year in Review

INTRODUCTION

In 2023, the commercial real estate (CRE) industry witnessed some notable trends that shaped its landscape. The sector saw a surge in debt investment opportunities, with investors increasingly seeking to benefit from the higher yields provided by private credit strategies. Concurrently, institutional allocations to CRE experienced a slowdown, influenced by the denominator effect within institutional portfolios and concerns over rising mortgage rates impacting pricing and creating distress in certain markets. In addition, alternative real estate sectors continued to gain traction as investable institutional products. The state of the office sector continues to be a focal point as remote work trends continue to reshape demand and usage patterns. Rising insurance costs were another significant factor impacting the industry, adding a layer of complexity to risk management strategies.

In our latest blog, Alliance Global Advisors (Alliance) examines the prevailing trends that influenced the institutional real estate landscape throughout the past year. While these trends may offer insights into the shifting dynamics of the CRE sector, predicting their continuity into 2024 remains speculative. We believe investors and stakeholders should continue to closely monitor these variables to make informed decisions amid the evolving landscape.

We would like to thank Kyle Jeffers, Chief Investment Officer of ACORE Capital, and Susan Swanezy, Partner of Hodes Weill & Associates, for their contributions to this blog.

RISE OF DEBT INVESTMENT OPPORTUNITIES

In 2023, there was a notable surge in debt investment opportunities within the institutional real estate sector. Institutional investors concluded that real estate debt opportunities represented a strong value proposition in 2023, largely due to debt investments providing the ability to invest at debt-level risk and generate equity-like returns. Alliance had the opportunity to hear from Kyle Jeffers of ACORE Capital on the best opportunities in today’s market environment. ACORE Capital is one of the largest commercial real estate debt managers globally, originating CRE debt, mezzanine debt and preferred equity.

Q. Where do you see the best opportunities for debt funds in today’s market environment?

Kyle Jeffers, ACORE Capital: “Although origination volume has not yet rebounded, ACORE believes a stabilization of interest rates will bring buyers and sellers back to the table. In this new environment (higher rates and less competition), ACORE believes there is a tremendous opportunity to originate new loans that offer risk-adjusted returns at lower LTVs and higher spreads and opportunistically provide gap financing to borrowers with broken capital stacks. Sector-wise, we are excited about opportunities in multifamily, specifically infill migration markets such as the Southeast and Southwest, where there is high demand for multifamily. We are also excited about well-located industrial assets (close to major roadways, airports, etc.) that capitalize on retail’s transition to e-commerce.”

SLOWDOWN OF INSTITUTIONAL ALLOCATIONS

Fundraising for real estate investments continued to encounter difficulties in 2023. According to PERE estimates, 2023 fundraising volumes will be the lowest since 2012. The average time to reach a final close on a closed-end fund is 23 months, according to Preqin, the longest timespan on record going back to 2000. Real-time feedback from the Institutional Real Estate, Inc. (IREI) 2024 Visions, Insights & Perspectives (VIP) Americas conference further reinforces this point, with 66 funds closing in 2023, a 60% decrease in number of funds and 24% drop in volume compared to year-over-year. Notably, the capital closed was concentrated in a small number of mega funds, with five funds representing 50% of total capital raised, including 30% from Blackstone's $30b opportunistic fund. IREI captures this fundraising data in its database, IREI.Q, which tracks more than 5,000 global institutional real estate programs.

Institutional investors were impacted by the denominator effect and remain defensive in terms of their portfolios with many anticipating additional write-downs, constraining subsequent commitment activities. While the denominator effect is abating, a substantial number of investors are grappling with market and valuation uncertainties, delaying their commitment decisions. Most of the transaction volume in the market currently is through re-ups with existing managers and remains concentrated around a few of the larger managers.

In late 2023, Hodes Weill & Associates, a global capital advisory firm focused on real estate, infrastructure and other real assets, launched its 11th annual Institutional Real Estate Allocations Monitor (the “2023 Real Estate Allocations Monitor”). The 2023 Real Estate Allocations Monitor focuses on the role of real estate in institutional portfolios and examines how institutional allocation trends influence the investment management industry. Alliance had the privilege of receiving insights from Susan Swanezy firsthand to dive deeper into the 2023 Real Estate Allocations Monitor and the current state of institutional allocations.

Q. What categories of institutional investors have been more active than others lately?

Susan Swanezy, Hodes Weill & Associates: “The denominator effect and cautious sentiment have slowed institutional allocations globally. We have seen some activity amongst the larger institutions, including Sovereign Wealth Funds like GIC, with large take private transactions of publicly traded REITs, but even their deployment volume was down about 50% in 2023 from the prior year. Capital from the gulf region is still plentiful but investors continue to be highly selective. Some of the larger groups, such as Norges Bank, have increased their target allocations over the last year, signaling they believe current market dynamics will lead to strong opportunities. Large Institutions (defined in our survey as those with more than $50 billion of AUM) responding to this year’s Allocations Monitor survey noted a higher conviction in the real estate asset class expecting some good vintage year investments ahead, with a Conviction Index Score of 6.5, compared to Small Institutions (with less than $50 billion of AUM), who reported a Conviction Index Score of 6.3.* We are starting to see some green shoots from endowments, who have been quiet on the real estate front in recent years. Given the strong appetite for credit, we have some good activity from investors across the board, especially insurance companies.”

2023 Real Estate Allocations Monitor, Conviction Index, By Type of Institutions

*Source: Hodes Weill & Associates*
* The Allocations Monitor asks investors to rate on a scale of one to ten their view of the investment opportunity in real estate from a risk/return perspective (one being the least favorable, ten being the most favorable).

Q. Which strategies do you anticipate seeing investors most active in the next 12 months?

Susan Swanezy, Hodes Weill & Associates: “We expect investors to be increasingly active in allocating to value-add and opportunistic strategies over the next year as distress and dislocation play out in the marketplace. Investors will be looking for deep-value buys and will be increasingly focused on accessing assets through different parts of the capital stack. Managers who are able to adapt quickly to changing landscapes with strategies that allow for flexible and creative structuring will be well positioned over the next 12 months. We have also seen an increased appetite for real estate credit strategies given the high interest rate environment, and institutions are seeking to take advantage of the opportunity to generate equity-like returns with lower risk. Lastly, we expect investors will continue to favor sectors such as industrial, build-for-rent single family, student housing and data centers, which are sectors that continue to benefit from favorable operating fundamentals.”

IMPACT OF HIGHER MORTGAGE RATES ON PRICING AND DISTRESS IN THE MARKETS

The commercial real estate industry faced a heightened risk of economic distress in the markets with the impact of higher mortgage rates throughout 2023. The challenging debt markets resulted in 2023 marking the lowest investment volume in decades. The rising cost of debt is one of the largest factors in creating widening bid-ask spreads from market participants. Kyle Jeffers of ACORE Capital shared his sentiments on the impact of higher mortgage rates.

Q. How do you see the rise of interest rates rippling through and causing stress in the real estate market?

Kyle Jeffers, ACORE Capital: “The rapid rise of interest rates (upwards of 500 bps) has caused an exponential increase in debt service for borrowers and has forced large banks (who make up most of the lending market) to pull back or fully pause new lending. We are seeing borrowers across all sectors struggle with this new dynamic. For example, borrowers in the multifamily sector that originated deals in 2019-21 with loans coming due are forced to either refinance at rates that are higher than the implied cap rate the existing loan was originated (making them negatively levered) or work out a solution with their existing borrower (extension, foreclosure, etc.). In addition, the rise in rates had caused cap rates to rise and also provided uncertainty as to what actual cap rates are. The widening of cap rates and lack of liquidity has caused a large gap between borrowers and sellers, leading to minimal transactions taking place.”

GROWTH OF ALTERNATIVE ASSET CLASSES AS AN INVESTABLE INSTITUTIONAL PRODUCT

Alternative real estate sectors garnered increasing attention throughout 2023 as investable institutional products. In the face of underperforming traditional sectors, such as office, there has been a shift in investor focus. Although industrial and multifamily assets remain key focal points for institutional investors, the market has witnessed a surge in popularity for alternative sectors, including but not limited to data centers, cold storage, self-storage, medical office, life sciences, student housing, senior housing and single-family rentals.

According to CBRE's Unlocking Alternatives 2023 report, highlighted in the chart below, despite representing a fraction of the overall transaction volume, alternative sectors that demonstrate resilience or stand to benefit from evolving work and demographic trends are strategically positioned for substantial growth.

*Source: CBRE Unlocking Alternatives Report Through Q2 2023, RCA, CoStar, Preqin, Cushman & Wakefield Research*

The National Council of Real Estate Investment Fiduciaries (NCREIF) is also accommodating the expansion of these specialty sectors, as seen with the NCREIF NPI-Plus. As defined by NCREIF, the objective of the National Property Index (NPI) is to provide a historical measurement of property-level returns to increase the understanding of, and lend credibility to, real estate as an institutional investment asset class. Beginning in the first quarter of 2024, NCREIF is starting to transition to the NPI-Plus, which incorporates additional property types and new subtypes in addition to those traditionally included.

THE OFFICE SECTOR: WILL OFFICE RECOVER? WHAT WILL A POSSIBLE OFFICE RECOVERY LOOK LIKE?

Earlier this year, Alliance analyzed the office sector, conducting a research piece on navigating the office sector in a hybrid work era. The office sector has been an integral part of investment portfolios for decades, but recent trends and market conditions have resulted in industry-wide negative investment sentiment toward the asset class. There has been a steady reduction in office exposure in portfolios over the last 5-10 years. The COVID-19 pandemic exacerbated the office sector’s decline, and despite the waning of the pandemic, the desire among employees for hybrid/remote work remains strong.

In 2023, the market continued to react and change in response to the decline in demand for office. The office sector has seen a divergence in the last three years as there has been a flight to quality where B- and C-Class offices are less in favor as a result. Hybrid and remote work are in full bloom, and employers continue to grapple with ways to attract their employees back into the office by offering newer, amenity-laden workspaces.

What are B- and C-Class office owners and managers doing to combat the flight to quality? According to JLL, leasing volume in the first quarter of 2023 experienced a decline of 10.7%, marking the third consecutive quarter of decelerating demand. Managers are taking note of the slowing demand and recognizing that tenants now hold the upper hand. Therefore, managers are proactively providing concessions to their tenants, such as implementing new lease structures, deferring rent collections or offering tenant improvement allowances. 2023 ended with the Los Angeles office market office reaching a record-high availability of 26.7%[1], and heightened office vacancy rates throughout the San Francisco Bay Area.

As we embark on a new year, the question remains. Will offices recover? And if so, what will an office recovery look like? Despite the challenges faced by the office sector, there are still pockets of opportunity for investors in select markets.

RISING INSURANCE COSTS

The past year saw rising insurance costs taking center stage for multifamily investors as premiums increased materially. In an already challenging investment environment, the uncertainty of future insurance costs in select markets, along with higher debt costs and property taxes, is another variable for investors to contemplate in transaction pricing. Additionally, the increasing insurance costs raise more significant concerns for multifamily relative to other property types because the increases cannot be passed directly through to tenants without impacting the ongoing housing affordability issue.

Managers should pursue a comprehensive approach to address insurance needs, including working in partnership with their carriers to mitigate risk, leveraging the resources of their insurance broker and considering working with a third-party insurance or risk consultant. Environmental, Social and Governance (ESG) factors play a role here, requiring organizations to increase awareness of physical climate risks. An insurance broker can provide valuable guidance for understanding and designing an insurance strategy, offering the optimal cost and risk mitigation combination. Managers must evaluate a broker's experience and resources to access a breadth of policy options, particularly in challenging market environments. A third-party insurance or risk consultant can provide an independent assessment of whether the insurance coverage is appropriate and the right price and guidance on trends in the insurance industry.

There appears to be a growing likelihood that the increase in insurance costs for commercial properties will persist into the upcoming year. In the latter part of 2023, Willis Towers Watson forecasted a potential growth of 10% to 25% in insurance rates for properties exposed to catastrophes. Furthermore, the firm suggested that even properties not exposed to catastrophes might experience a 10% rate increase.[2]

CONCLUSION

In 2023, the institutional real estate space bore witness to a transformative landscape defined by overarching themes. The surge in debt investment opportunities and the concurrent slowdown in institutional allocations were notable facets, influenced by concerns over rising interest rates impacting pricing and creating distress in certain markets. Additionally, the growth of alternative asset classes, the evolving dynamics of office spaces amidst remote work trends, and the significant impact of rising insurance costs emerged as pivotal factors, collectively shaping the narrative of the institutional real estate sector throughout the year.

ABOUT ALLIANCE GLOBAL ADVISORS

Alliance Global Advisors is a women-owned consulting firm focused on empowering the institutional investment community to elevate best practices. Advising clients with over $520 billion in assets under management, Alliance partners with organizations to provide an independent perspective and innovative approach to critical strategic initiatives. Our partnerships allow senior management teams to focus on what matters most: diligently managing client capital, creating value and delivering exceptional returns in a performance-driven market.

Disclaimer: This blog was originally published in January 2024 and will be updated periodically to reflect changes in the industry. The content may contain or cite personal and/or professional opinions that differ from the views of Alliance Global Advisors.

[1] https://www.bisnow.com/los-angeles/news/office/los-angeles-office-leasing-year-end-2023-122259#:~:text=Office%20availability%20reached%20a%20record,a%20new%20report%20from%20Savills

[2] https://www.wtwco.com/en-us/insights/2023/11/insurance-marketplace-realities-2024