The latest on commercial real estate investment? 5 Lessons from PREA
The recent conference of the Pension Real Estate Association (PREA) took place in Boston, and if the record attendance of some 1,200 pension funds and investment managers is any indication, there is no sign that high interest rates are yet decreasing investor interest in real estate. Here are 5 takeaways from the conference.
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Interest rates -- Higher for longer
Christina Romer (UC Berkeley) gave a great talk on the state of the economy. Economic growth and job growth seem to hold up quite nicely in the face of the steep rate hikes of the past 18 months, and inflation seems to come down, albeit slowly. A soft landing may happen after all (but as always…there are plenty of wildcards). While financial markets happily forecast that rates can come down again in 2024, it’s unlikely that we will go back to the loose monetary policy we saw over the past decade. The neutral interest rate (r* in jargon) is not 0.5%, but rather 3-4%. That means real estate investors should be prepared for “higher for longer” (as opposed to the “lower for longer” we heard until not too long ago). Cap rates have been slow to adjust, as liquidity in the market is low, and pricing of commercial real estate will have to come down some more for most property types to reflect the reality of a risk-free rate that is now at a level at which industrial and prime office traded in the recent past…
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ESG – Escape Stressed Geography
Michael Ferrari (Climate Alpha) kicked off the main day of the conference with a warning note on the implications of climate risk for commercial real estate investors (with not just downside risk, but also some perspectives on “upside”). During the “investor-only” day, Derk Welling (APG Asset Management) and I already covered the notion of how to measure climate risk, and how to further integrate climate metrics into underwriting. My strong feeling is that the narrative on climate risk needs to change – every presentation starts with showing a chart on the increase in damage from storms and flooding events (and plotting an arbitrary, upward sloping line). But that’s too superficial, too macro. For the average investor, actual damage from climate shocks is very small, and that damage is typically covered by insurance (even though insurance is ever more expensive). It all feels “too far away.” Can we bring measures of climate risk to the asset, including a VaR measure, and the cost of mitigation? Current climate risk data is often inconsistent (as per Derk, the correlation between different climate risk datasets is basically zero), and risk does not necessarily imply damage. As with transition risk, climate risk becomes more tangible if investors can incorporate (future) capex, adjust the discount rate, and perhaps let mitigation measures be reflected in rents and occupancy rates.
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Debt is where the opportunity is
If senior loans yield 6-8%, and junior/mezzanine debt yield north of 10%, who wants equity anyway? There is currently a very strong case for investment in real estate debt. With traditional lenders perhaps not fully closed, but certainly much more careful in providing debt, there is also a strong market need for alternative lenders. With developers taking longer to sell their product, and some investors having refinancing coming up on assets that have lost some of their value (but not necessarily cash flow), “rescue financing” will be an interesting product to provide, with equity-like returns. Of course, such financing is often much shorter term, leading to the need for reinvestment in 2-3 years, at potentially lower yields, and perhaps missing out on the “golden vintage” years that are supposed to come in 2024 and 2025. Another question for institutional investors is where real estate debt sits in the portfolio, and whether they can up their allocation quickly enough – this could be in real estate, or in alternative credit, and is often benchmark-dependent. One thing is for sure: for core real estate, returns of 5-6% are no longer enough, and most equity investors will remain on the sideline until sufficient repricing has taken place. Until that time, real estate debt may be an attractive place to be in.
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Power is the biggest limiting factor for growth
Did you know that a search on ChatGPT consumes 10x the amount of power of a regular Google search? As large-language models (LLMs) such as ChatGPT evolve (and those AI models are just the beginning), the demand for digital infrastructure is slated to further grow. “Digital infrastructure” includes, of course, data centers, from small local centers to so-called hyperscalers. But another important component is power. And at a time when conventional power plants (nuclear, coal, gas) are phased out and renewable power is phased in, simply connecting a new data center (or a new building for that matter) to the grid is no longer simple. Power grids are overburdened, and it can take more than 5 years to get connected in Europe and typically more than 1 year to get connected in the US. That will put a cap on development, keeping supply in check (or too low), which bodes well for Blackstone, Digital Realty, and other data center investors, but not so well for that ChatGPT search!
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Ozempic is the new AI
“The two things everybody wants to talk about are AI and weight-loss drugs.” Indeed, looking at the stock price of Nordisk, the maker of Ozempic (medication for diabetes, but better known for its effects on weight-loss), it has been a good ride this year, with a stock return of almost 50%. The interest in pharma is also reflected in the commercial real estate market, with life science as the “hot” property type (even though high interest rates have cooled off the market for VC-driven biomedical companies). Especially in cities that have medical universities (e.g. Boston and San Francisco in the US), investors are not just developing new life science space, but also actively converting existing (office) space to better cater to the needs of biomedical companies – both small and large. A great example is the Innovation and Design Building in Boston (owned by Jamestown), a massive refurbished warehouse that initially catered to designers, retail and some office tenants. I toured the building, located in the Seaport area, and over the past years, quite a few
