Is CRE Still a Favored Asset Class?

HAPPY FIRST WEDNESDAY AFTER THANKSGIVING and welcome back to the Riopel Real Estate Round-up! Thank you for continuing to tune in. If you've missed any of my previous editions, please find them here.

Though many of you may have enjoyed some delicious meals last week, it's likely nothing like the plump turkey that Fed Chair Powell fed into the stock market this afternoon. Per CNBC , Reserve Chairman Jerome Powell confirmed earlier today that smaller interest rate increases are likely ahead even as he sees progress in the fight against inflation as largely inadequate. He also cautioned that monetary policy is likely to stay restrictive for some time until real signs of progress emerge on inflation. Nonetheless, immediately following Powell's remarks, the Dow Jones Industrial rallied and closed up over 700 points on the day.

The investment world has been hanging on Powell's every word and I'd like to take a closer look at how commercial real estate investment may fare as a "favored asset" in the coming months. Of course, my opinions contained in this article are purely my own and do not constitute investment advice.

Commercial real estate has been on quite the run, last week Chief Investment Officer reported the size of the professionally managed global real estate investment market surged to a whopping $11.4 trillion in 2021, and investors set a global record by completing real estate transactions totaling $2.1 trillion, this is according to research by MSCI Inc. In comparison, 2022 started out strong, but for the most part, the last several months have seen a severe slowdown as the Fed has deployed its tightening policy to fight inflation.?

So what's going on?

Many investors have long held that commercial real estate provides a valuable inflation hedge and has historically performed well in times of rising inflation. Recently, in the midst of one of the most extreme inflationary periods of record, this adage has been and will be very well tested. Currently, the challenge many investors are facing is a lack of pricing stability in the debt markets, namely it's hard to negotiate leases with economic terms that cover operating costs and debt service when both inflation continues to rise and the cost of debt continues to rise at a breakneck pace. Hopefully, as the Fed shifts its policy to slow down the rate hikes as reflected in Powell's comments today, perhaps that path will bring needed stability and predictability for commercial real estate investors and re-deploy their capital.

Despite the volatility in the short term, many institutions are not backing off their planned allocations to real estate in the future and in fact, according to the Hodes Weill & Associates / 美国康奈尔大学 ?2022 Institutional Real Estate Allocations Monitor (which surveys 173 institutions from 34 countries representing aggregate assets under management of $11.1 trillion and portfolio investments in real estate of roughly $1.1 trillion) target allocations to real estate rose to 10.8% in 2022, an increase of 10 basis points from a year prior. It should be noted that this increase in allocation is not purely reflective of an increase in deploying additional capital, but rather as real estate portfolios benefited from strong performance with high returns and rising valuations, it has led to an increase in portfolio values for the asset class which appears as an increase in the allocation on the books. Though these high returns and valuations usually sound like a great thing, it has presented some challenges for institutional investors in rebalancing their portfolio. These concerns of overallocation, along with declining conviction, has led to the significant slowdown in deployment pacing, which began in the second quarter of 2022.

This challenge is known as the "denominator effect" and it has caused significant challenges for institutional investors as they rebalance their portfolios. The general positive performance of real estate portfolios has occurred while public equities and other asset allocations have declined in value. The denominator effect occurs when the value of one portion of a portfolio decreases drastically and pulls down the overall value of the portfolio. The reported increase in actual allocations towards real estate has been driven by a combination of a denominator (poor performance by other asset classes in the overall portfolio) and a numerator effect (the positive impact from the performance of real estate assets). As a?result,?any?segments?of?portfolio like real estate, which did not?decrease?in value,?now?represent?a large percent of the overall pie.

So what does the future hold? That's anybody's guess, but according to the institutions surveyed making investment decisions on behalf of trillions of dollars, the target allocations to real estate are expected to continue to increase by a further 30 basis points in 2023, as investors anticipate an opportunity to take advantage of potential repricing and dislocation.

We'll see if this wave of dislocation and opportunity comes to fruition but buckle up and thanks for reading!