A Real Economy publication

Real estate investment trends and outlook: Fall 2022

Aug 19, 2022

Real estate investment trends key takeaways

Investors are reevaluating strategies amid interest rate hikes and inflationary pressures.

Financing remains relatively cheap, and cash flow from properties is strong.

Dry powder set for real estate was $215 billion in Q2, and has become risk avoidant.

#
Real estate Economics

Investment may be slowing, but real estate still sees pricing well above pre-pandemic levels.

How will rising inflation and interest rates affect real estate fund investors? Depending on the latest headlines, the answer to this question could vary widely. A holistic view shows that real estate funds appear to be staying the course and factoring in a slight overall cooling of the market. This sentiment is apparent in fundraising, as the volume of sales transactions and related cap rates achieved in those transactions have both eased.

Dry powder is now risk avoidant

During the height of the real estate market in 2021, dry powder that was focused on investment in the United States reached an all-time high of $217 billion, a 22% jump from Dec. 31, 2021, immediately prior to the pandemic, Preqin data shows. Dry powder remained at $215 billion as of the second quarter of this year, suggesting that although fundraising has slowed compared to the record pace in 2021, private capital is still available and ready to be deployed.

At the same time, investors are reevaluating valuations and strategies as interest rate hikes and inflationary pressures point to a potential looming recession. Risk profiles are changing, as capital goes after less risky, value-add, core and core-plus assets, while backing off from opportunistic and debt funds, which can have more unknowns.  

U.S. real estate: dry powder

U.S. Real Estate - Dry Powder chart | real estate investment trends and outlook

Real estate investment funds on a hiatus

The investment landscape of the last two years has been characterized by rising valuations and competitive buying situations in all sectors.

In 2021, after the initial uncertainty of the COVID-19 pandemic eased, transaction volume hit record levels at valuations that far surpassed historic returns. An early pandemic slowdown led by the multifamily and industrial sectors gave way to pent-up demand. Interest in multifamily housing was driven by a need for more space, induced by remote work, adding pressure to a chronic undersupply of housing that began after the financial crisis of 2008−2009.

Meanwhile, rising demand for industrial properties was prompted by consumer spending on goods instead of services during lockdowns. By the end of 2021 and into early 2022, fund managers were challenged with identifying deals that met their return targets at compressed cap rates across various sectors. As a result, transaction volume took a sharp decline in early 2022.

With the Federal Reserve taking action to increase lending rates throughout 2022 and into early 2023, we continue to hear fund managers say they are holding assets off the market to see how pricing is affected by these policy moves. Through July 2022, transaction volume had dropped by 25% compared to the same period last year, and is expected to remain lower through the remainder of the year.

Transaction volume

Transaction Volume chart | real estate investment trends and outlook

However, financing is still relatively cheap, and the cash flow from properties, particularly multifamily and industrial, remains strong. We anticipate transaction volume to pick up in the fourth quarter of 2022 or early 2023 as fund managers reevaluate strategies and their investors’ expectations for returns, looking to deploy capital that remains on the sidelines.

Spurred in part by rising interest rates, much industry commentary has forecast a sustained slowdown in the real estate market. However, data on cap rates over the past five years tell a different story, one of a return to a more normalized ecosystem.

The cap rate (first-year net operating income divided by property price) is a popular measure of valuation in the real estate market and has an inverse relationship to the price paid for a given investment property. Cap rates enjoyed a stable downward trajectory in the years leading up to the pandemic in all real estate sectors. According to CoStar data, from the first quarter of 2017 through the first quarter of 2020, cap rates in all sectors steadily decreased by an average of 3%.

The pandemic then induced a frenzy of transaction activity, resulting in significant acceleration of the drop in cap rates in a condensed period. From the pandemic’s start in the first quarter of 2020 through the third quarter of 2022, the decline in cap rates was more than 15% for all sectors, according to CoStar data.

Cap rate compression

All sectors of real estate saw cap rate compression, including multifamily and industrial—the pandemic darlings—as well as the less certain retail and office. Multifamily cap rates have declined by 0.79% since the second quarter of 2020, compared to an average decline of 0.15% in the three years prior, according to CoStar.

Brick-and-mortar retail, which had already been battling the progressive rise in online shopping, saw cap rates increase by 0.08% from 2017 to 2020, according to CoStar data. Despite the closing of many retail outlets at the onset of the pandemic, cap rates then decreased 0.79% on average from the second quarter of 2020 through the second quarter of 2022. This accelerated decline, along with high transaction volumes, was distinct to the pandemic. The more recent modest slowdowns in cap rate decline and transaction volume represent a return to more normalized activity within the real estate ecosystem.

Competitive buying may ease

Rising valuations and increased competition have made it harder for deals to achieve investment goals. As of the second quarter of 2022, average cap rates for all sectors eased 0.15% on average and remained flat at the beginning of the third quarter, according to CoStar data. If cap rates rise modestly in the near term, they will not represent a downturn in the market. Instead, they will reflect a realignment of values to more historic norms while still allowing for attractive returns. Cap rate increases and rising interest rates are also likely to dampen the increasing competition observed during the last 18 months. This will lead to a more reasonable environment for transaction negotiations.

In addition, modest cap rate increases will not signal another slowdown in real estate transaction activity, but rather a slowdown in the speed of the market. Investors will have more time to analyze the true value of an investment instead of rushing to beat out aggressive and sometimes unreasonable rivals. Investors can take comfort that rising cap rates still denote an accretion of value, just not the sky-high run-up of the last two years, which was unsustainable. 

The takeaway

Real estate investment may be slowing from its unprecedented pace in 2021, but it is still seeing prices well exceeding pre-pandemic levels, and plenty of capital is available for investors to keep spending.

RSM contributors

  • Laura Gerdes
    Lauren Gerdes
    Real Estate Senior Analyst
  • Sarah McKevitt
    Sarah McKevitt
    Real Estate Senior Analyst

Related real estate industry outlooks

Subscribe to Real Estate Insights

Stay in the know with our monthly digest of tax, accounting and business considerations for companies in the real estate industry.