Real estate industry outlook

Uncertainty leads to a shift in investment strategies for managers and investors

Aug 15, 2023

Key takeaways

The stress on liquidity and real estate lending continues amid uncertainty around interest rate hikes. 

Debt funds and open-end structures have been trending with investors seeking lower-risk strategies.  

Fund managers should highlight their asset class specialization to help secure capital commitments.  

Economics Real estate

Persistent inflation and elevated interest rates have disrupted the real estate industry, which likely will take years to enter a new growth cycle. With the timing of a pause in interest rate hikes by the Federal Reserve still unknown, transaction volume has plummeted and investors are refocusing their investment allocations. The race to capture short-term appreciation has ended, with the focus now on stabilizing investment income while the market corrects itself. The emergence of debt funds to capitalize on alternative financing positions and open-end structures aligned to long-term recovery has been trending as investors seek low-risk strategies. 

Transaction volume

The real estate market continues in a holding pattern, unsure where pricing will land. Transaction volume dropped noticeably in the first half of 2023, with a 40% decline in the number of deals and a 65% decline in aggregate sales volume compared to the same period in 2022, signifying investor caution. 

Trends in the asset sectors also indicate that investors are diversifying their capital deployment across various sectors and geographies to further mitigate market risk. Although multifamily properties shined early in the post-pandemic period, they have significantly tapered in demand, as shown by a 74% decline in aggregate sales volume in the first quarter of 2023 compared to the same period in 2022—the largest decline in any real estate sector. Secondary markets, the Sun Belt, and lower-class assets have also begun to follow traditional underwriting trends. Cap rates across the board are rising as 10-year bond yields stay elevated, which will continue to put significant pressure on the recovery of transaction volume in the short term.

While many real estate fund managers and investors hope that deal volume will pick up in the second half of 2023, the economy’s resilience only heightens uncertainty around when Fed rate hikes will pause, keeping stress on liquidity and the lending environment. The market has responded by switching investment strategies. 

TAX TREND: Open-end funds

Open-end funds have tax complexities requiring sophisticated technology to handle. They result from section 704(c), which prevents gain or loss associated with property from being shifted to other partners. Tax technology can reduce risk and increase efficiency in handling these complex computations.

Emerging debt funds

As investors proactively manage their exposure to equity, debt investments continue to show strength. Thirty-eight percent of investors polled by Preqin in the first quarter of 2023 said they will look to invest in debt positions in 2023, compared to 18% a year ago. Increased allocation toward gap financing positions opened up by the lending slowdown, such as mezzanine debt, allows investors to protect against downside risk of equity positions while generating steady income. Preqin data showed that mezzanine funds raised $20.7 billion, making up 64.9% of the private debt capital raised in the first quarter of 2023. Loan-to-value ratios have remained at 55% to 65% on average through the second quarter of 2023 and are not anticipated to increase anytime soon, indicating that fund managers are actively launching debt funds to capitalize on these available high-rate returns.

The total number of funds in the market is at a record level partially due to new debt funds coming online. Debt funds have significantly increased in the market over the last couple of years and represent 13.6% of real estate funds in the market in 2023. 

Mezzanine positions come with higher returns than direct lending, but also carry additional risk due to their subordinate position in the capital stack. With borrowing costs high, recession risk on the horizon and the market unsure how far valuations will fall, the risk of defaults is high. That said, delinquencies remain low, with office, multifamily and industrial delinquency rates sitting below 2%, according to Fitch Ratings as of May 2023.

Open-end funds

As investors seek stability in investment income in place of price appreciation, a trend in long-term investment vehicles has emerged. Global fundraising has taken a major hit, with a 21% drop in capital raised in the first half of 2023 compared to the last two quarters of 2022, along with the worst capital commitments in five years for closed-end funds, including at the height of the pandemic. Conversely, open-end real estate structures have averaged about 30 new funds per year and are on track to hit that level in 2023. 

With no termination date, open-end funds have been particularly attractive for core assets generating strong cash flows over a longer period, providing more consistent returns to managers and investors alike. Investors’ lower risk appetite spurred a 34% increase in core and core plus assets under management as of the end of 2022 compared to 2021—a figure expected to increase throughout 2023 as stabilized assets are held with transaction volume static.

Typically, open-end structures offer investors more readily available liquidity, as these funds can continually raise new capital by offering quarterly subscriptions to settle redemption requests. But as investors pull back from the real estate market and deal volume struggles to recover, liquidity will be a significant risk. Funds that are closing in 2023 are on average taking 18 months to fundraise and just under their target capital raise as of the second quarter of 2023, indicating significant challenges to secure new commitments. Fund managers should ensure that lock-up periods and redemption payout timelines are appropriately structured in new vehicles to mitigate material redemptions and potential declines in portfolio values as the environment remains volatile.

CONSULTING INSIGHT: Financial due diligence

Every M&A transaction presents opportunities and risks that only due diligence can reveal. A failure to uncover this information puts both a potential deal and investors at risk. Learn more about RSM’s financial due diligence services

The takeaway 

For an industry largely focused on total returns generated by price appreciation over the past decade, the rapid change in cash flow strategy has left investors feeling unsettled. Risk premiums will continue to raise terminal cap rates and limit investor returns on future exits. Outside of identifying transactions, competition for fundraising will be a significant hurdle for fund managers. 

Investors continue to stick with established fund managers who have proven track records. Emerging managers will face headwinds to secure capital commitments. Long-term investment vehicles and alternative strategies such as mezzanine financing are trending with both emerging and established fund managers—allowing them to highlight their asset class specialization or deep local market presence as a means to bring investors some stability in an uncertain market.  

RSM contributors

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