Despite persistent COVID-19 case counts in the United States, public equities have experienced a “V” shaped recovery. As of September 30, 2020, the S&P 500 has delivered a 52% total return since the COVID-19 induced low on March 23, 2020 to settle at a 5.57% YTD through the close of the third quarter. This can likely be attributed to significant support from the Federal Reserve coupled with modest improvements in employment numbers as American companies try to cope with the impact of the pandemic.
Real estate indices, however, have been flat in 2020. The NCRIEF NPI Index returned 0.71% in the first quarter, -0.99% in the second quarter, and 0.74% in the third quarter. As of September 30, 2020, the index has returned 0.45% YTD and a 2.01% 1-year return on strong 4Q 2019 performance. Through the third quarter, the weakest segments of the NCEIRF NPI have been hotel and retail with trailing 1-year returns of -22.89% and -16.27% respectively. Industrial real estate continues to be the most resilient segment and was the only property type to post positive returns in each quarter this year.
Real Estate in the Private Markets
The negative impact of the pandemic may take longer to flow through to the valuations of privately held assets, and while it may not be to the same degree as in the public markets, it will undoubtedly have an effect on deal and fund performance in the private markets. Deal flow has already slowed significantly as real estate focused GPs work to assess the impact of the pandemic on the asset class.
Fundraising for private real estate funds has also suffered. According to data collected from eVestment’s Market Lens platform, through the first three quarters of 2020 public pension plans reported total commitments of $17.6 billion to the asset class, a 26% drop from the $23.8 billion reported over the corresponding time period in 2019. On a per commitment basis, investors have committed only $80.9 million in 2020 compared to $101.7 million in 2019, a 20% decrease.
Exploring the pandemic’s impact on core real estate sectors
These factors are significant uncertainty for the asset class as we move into 2021. Further, the unprecedented increases in unemployment claims and mandatory retail store closings since the start of the pandemic will eventually put a strain on rent collections in the coming quarters.
At eVestment Private Markets we have access to vast amounts of qualitative and quantitative data on private markets, including data from before, during, and after the 2008 global financial crisis. To understand what the recovery to this crisis might look like, we looked back at that data as well as a range of metrics we’re seeing in today’s market to analyze private real estate deals.
For this analysis we focused on historic private real estate deal activity within industrial, office, multifamily, and retail sectors. Over the past 15 years each of these sectors have experience their own unique, structural shifts and while the impacts of COVID-19 are unprecedented, we may be able to gain insight as to how certain real estate sectors will fare based on their responses to the last major economic downturn.
Prior to the pandemic industrial real estate locations benefitted from strong demand brought on by the rise of e-commerce and improved third-party logistics networks. In the 10-year period from 2006 to 2015, industrial deals exhibited a strong recovery from the global financial crisis attracting more capital and rewarding investors with strong performance. Our survey of roughly 900 industrial private real estate deals from 2006-2015 shows an average gross IRR of 17% with a TVPI 1.7x representing more than $11.1 billion invested.
Early reports show that industrial properties are proving to be resilient due to an increase in demand for e-commerce-based deliveries as social distancing orders continue to be the norm. Industry consultants expect that the sector will continue to ride these tailwinds as we continue to deal with the spread of COVID-19. As NEPC noted in a June real estate review, “Over long-term, demand for industrial [is] likely to remain strong as e-commerce growth continues and some industries may move more manufacturing onshore.”
We’ve seen this demand play out in the fundraising data via reported commitments from public plans to in industrial, and e-commerce (data center) focused real estate funds like Exeter Industrial Value Fund V and IPI Partners II.
While industrial real estate has proven to be somewhat insulated from (if not propped up by) the impacts of the pandemic, the future of office real estate will prove to be significantly more uncertain. Since the global financial crisis, office real estate has trended towards more dense, open concept floor plans with a focus on collaborative working spaces. These shifts in office design have allowed private real estate managers investing in the sector to boost returns in recent years in part by charging more for less square footage. Our data indicates that despite experiencing a significant reduction in performance during the peak of the global financial crisis, office real estate investments provided strong performance throughout the 2010s.
Office vs. Industrial Loss Ratios
However, performance for office real estate has proven to be more sensitive to economic disruptions than industrial properties. It is important to note that although there was a significant rebound in IRR since the 2007 low, the sector has exhibited a substantial loss ratio relative to the industrial cohort from 2006-2015.
Office Loss Ratio
Industrial Loss Ratio
Most large North American corporations remain on lock down with work from home orders staying in place well into 2021. The disruption to traditional working styles will undoubtedly have an impact on future demand for office real estate. The rise of remote working, in some version or another seems here to stay, which will force developers, real estate management firms, and employers to plan and create safe, pandemic-resistant working spaces.
At this time, it is difficult to say with any certainty that video calls and instant messaging will replace the conference rooms and open floor plans of the last decade; but, as the saying goes, “change is the only constant”.
With increased stress placed on the office sector, public plan investors are turning to real estate debt funds focused on commercial real estate to find value. One example is Ohio School ERS. In their fiscal year 2021 objectives, the pension plan notes that staff will, “Evaluate specific opportunities arising from the impacts of coronavirus and economic slowdown, including opportunistic strategies involving real estate recapitalizations.”
Consequently, funds like Torchlight Debt Opportunity VII and Kayne Anderson RE Opportunistic Debt II have attracted funding from pension investors like Alaska Permanent, Connecticut Retirement, and Wisconsin Investment Board to take advantage of these opportunities.
Multifamily real estate has experienced explosive growth since the global financial crisis. Much of this growth has come from the development and completion of new urban apartment complexes across the major markets in the United States. In the early 2010s the sector benefitted from millennials’ rejection of the suburbs in favor of “in-town” city neighborhoods. In addition to more traditional urban apartments complexes, the sector has delivered strong gains from niche categories like student housing and senior care facilities. Our data reflects the robust rebound from the lows of the financial crisis to strong performance over the observed period.
Multifamily Loss Ratio
In our sample, multifamily real estate has an observed loss ratio 9.4%. Despite having a higher loss ratio than industrial real estate, the sector is commonly seen as the most defensive sector within real estate and historically has stood up to economic cycles very well. That said, low interest rates have caused asset prices, including home prices to increase, especially the largest cities in the US.
Multifamily Loss Ratio
As a result, consumers who would prefer buying over leasing are unable to afford single-family home prices and must continue to rent. Some of the fastest growing markets in the country are in the Sunbelt – Atlanta, Dallas, Houston, Miami and Phoenix – underscoring the rental demand in more affordable cities. These factors should continue to provide support for multifamily real estate.
As the millennial population continues to age and pursue home ownership there are indications that the demographic has begun to move out of cities and seek better value in the suburbs or smaller satellite cities. Further, the flexibility of work from home has allowed families to relocate to entirely different states to live close to their extended families or seek out more affordable single-family homes outside of major metropolitan areas.
The combination of millennial relocations and the unprecedented levels of unemployment in the United States that continue to jeopardize many Americans’ ability to pay rent poses a significant threat to rental income for multifamily operators. Lockdown protocols and uncertainty regarding future income will likely lead many renters to renew lease agreements they are comfortable with or renegotiate leases at reduced rates due to excess supply and reduced demand.
The near-term headwinds for the multifamily sector will be centered around rent abatements and deferrals as well as reductions in government stimulus. Institutional investors are responding to these headwinds by taking a “wait and see” approach, writing smaller checks, or focusing on debt related opportunities.
Over the past decade, the United States has seen a reduction in occupied retail space. This trend has been supported by the closure of large shopping malls and downsizing of big box retailers. These changes are likely to continue as consumers continue to embrace e-commerce as their primary method of shopping. The concentrated retail formats of the past are giving way to mixed use locations that provide shoppers with more options and utility. Overall retailers are focused on reducing brick-and-mortar footprint.
Retail Loss Ratio
As expected, performance for the sector struggled through the Great Recession and delivered the second highest loss ratio of the four key real estate sectors. Despite the higher loss ratios, improvements in consumer confidence and consumer spending lead to a substantial rebound in performance after 2008.
Retail Loss Ratio
The impacts of COVID-19 have put an incredible amount of pressure on retailers as non-essentials businesses are forced to remain closed as a result of lock down procedures. Small businesses, gyms and restaurants are most at risk to not meet rent obligations during this time.
There is a near universal consensus across public plan investors to underweight retail investments for the near future as the sector continues to struggle with the impact of lockdowns. However, there are always investors willing to take on risk for the right opportunity. One example is Oregon PERF, who notes, “Given the considerable transformation that retail is undergoing, research on viable, long-term strategies that could complement current holdings will be pursued. Extensive diligence on separate account and open-ended structures with partners who have proven operational expertise will be conducted.”
Other investors are taking a more diversified approach, accessing the sector via the opportunistic investments of larger diversified funds Oaktree Real Estate Opportunities VIII which expects to allocate 30% of its capital to debt and equity “Rescue Capital” in the commercial sector.
While there are bright spots in the sector, it is clear that challenges remain for real estate. The overall fundraising figures from public plan investors suggest that many LPs are simply passing on the sector in the near term. With news of a promising vaccine just now breaking, it will be interesting to see if investors flock back to the asset class in 2021 or if the declines seen in 2020 are simply an acceleration of real estate trends that were already in motion before the pandemic took hold.