Finding value in dislocated real estate markets

March 29, 2023
By James Maydew

While challenging to navigate, cyclical downturns can present potential opportunities for investors with the liquidity and capital to take advantage of current market disruptions.

2022 was characterised as a year of heightened macroeconomic uncertainty spurred by geopolitics, rising interest rates, and growing inflation. These factors, combined with the rising cost of capital, have driven dislocation and mispricing in the global real estate market.

As highlighted in our recent insight, Unprecedented: The compelling opportunity in global listed real estate, this market dislocation and volatility are creating opportunities for investors to acquire portfolios of existing assets at discounted pricing, particularly in public markets.

Here’s a summary of what we think is driving the current dislocation, how the current period compares to past periods of dispersion, and where we are seeing opportunity as part of our long-term investment approach.past periods of dispersion, and where we are seeing opportunity as part of our long-term investment approach.

Factors at play: What is causing the current dispersion?

2022 brought heightened inflation and a continuing period of aggressive monetary tightening. These factors prompted investors to exercise caution about the global economic outlook and seek to reduce their risk exposures.

This has resulted in liquid risk assets in all forms selling off at historically low prices compared to both underlying net asset values (NAV), and less liquid, unlisted real estate assets. Some key factors at play include:

• The clear relationship between debt serviceability and the size of the discounts. For the capital-intensive asset class of real estate, the market has considered higher interest burden to be a clear headwind as rates have started to rise.
• Rising rates and the impact they have had on the economics/valuations of risk assets as the cost of capital shifts higher.
• Risk appetite as investors seek to reduce risk exposure and use liquidity immediately, which ultimately has an impact on the public markets. Historical data from Refinitiv and The New York Stock Exchange as at December 2020, shows that the average holding period of US equities has fallen since the mid-1960s, when it was at an average of five years, to less than six months in the 2020s.
• The investment time horizon between listed market investors and patient private capital investors – this creates an arbitrage between listed and unlisted real estate due to the time horizon of these investors.

The history of dispersions: How does the current period compare?

Listed markets are currently seeing some of the steepest discounts to NAV experienced over the past two decades. As highlighted in Figure 1, Region discounts to NAV, these discounts vary by region. Discounts were largest at maximum bearishness on inflation and rates in 2022. They have started to reduce a little in 2023 but it remains early days.

The current period of dispersion can be put into context if we look back at past periods of dispersion and what defined them over those time frames. The size of the discounts that we are currently seeing is similar to major past dislocations including the crash of technology stocks (“tech wreck”), global financial crisis (GFC), COVID-19 pandemic and European debt crisis. These events, which had material impacts on underlying real estate fundamentals that were either long lasting in the case of the GFC, or short and sharp as with COVID-19. As it currently stands, when you look across the majority of real estate sectors, we have yet to see any material changes in real estate fundamentals.

In the case of the GFC, this event tends to invoke a lot of scar tissue for investors whenever the economic environment deteriorates. However, as highlighted in Figure 2, REIT Debt serviceability as assessed by Net Debt to earnings before interest, taxes, depreciation, and amortisation (EBITDA) in core markets such as US, UK and Australia, is very different from what we experienced at the peak of the GFC. There are pockets of concern that warrant caution, such as some countries within Europe (see Figure 3) that took advantage of cheap and freely available debt prior to the 2022 interest rate acceleration.

Therefore, the size of the debt burden relative to earnings before interest, taxes, depreciation, and amortisation (EBITDA) is thus a more accurate assessment of the risks at play, in our view. There appears to us to be a clear relationship between debt serviceability and the size of the discounts. As highlighted in Figure 3, Sector debt to EBITDA versus NAV, the lower the debt serviceability, the greater the discount tends to be.

The GFC unveiled a whole host of investment practices that were not truly sustainable. Capital was allocated for the exuberance of the time and was not balanced nor for the long term. This period featured poor risk management, including excessive leverage, short debt tenor, limited diversification of capital sources, excessive development, and assumptions that we believe were simply baked in for too much growth.

With any macroeconomic headwinds, that GFC scar tissue arises, often leading the market to question whether the next recession will have GFC-style implications.

While we don’t anticipate a similar scenario, we believe that an economic pause could be a positive for real estate markets, helping to identify weaker participants, and for maintaining confidence in high-quality, well-managed balance sheets with sustainable cash flow growth. The pricing differential between primary and secondary real estate needed to be reinstated and that appears to be underway globally.

Many of the poor or weak practices of the GFC period are no longer a feature of the listed real estate market, as management teams and board of directors either learned their lessons or were ousted/taken over for poor investment practices.

Where to from here? Bigger discounts to come?

We believe the discounts we have seen will start to shrink as we move past maximum bearishness on inflation and get closer to a central bank pause.

History suggests that pricing is likely to start firming ahead of the low points for both global growth and real estate fundamentals, as investors take advantage of cheaper entry points.

We expect to see more deals take place through 2023 as pricing adjusts further and investors take advantage of more attractive capitalisation rates.

All eyes will be on the economic environment and what that does to real estate fundamentals and access to capital as markets navigate a challenging period of liquidity, with near-term difficulties currently present in certain banking channels.

We have yet to see a material fallout in real estate growth fundamentals in 2022-2023 however, and for our preferred sectors, we believe it will not materialise as solid competitive growth is still being delivered.

Opportunities over the long term

Over the long term, our preference is in sectors that we believe are structural and essential in nature and not aligned to the short-term economic cycle or discretionary needs.

We are less focused on particular regions and more focused on the sectors and their fundamental drivers.

For industries that are expanding, the real estate sectors supporting them are, in general, also growing. Digital real estate is a key sector where we see long-term opportunity driven by a generational shift in digital demand and exponential, continued growth in mobile data usage.

As part of our investment approach, we remain focused on these sectors. We think these are the sectors with well capitalised quality real estate portfolios and the potential for sustainable long-term growth to navigate and offset a higher cost environment.

Author

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