Developments in the real estate sector
January 2014 | COVER STORY | SECTOR ANALYSIS
Financier Worldwide Magazine
Having emerged from the global recession and its aftermath, the real estate sector showed signs of recovery in 2013 and is expected to build on this momentum in the year ahead. The sector’s low-gear recovery has been boosted by a number of key trends. Private equity has shown an increased interest in recent months, and positioned itself for further involvement in 2014. Similarly, sovereign wealth funds are becoming increasingly involved in the asset class. But challenges remain. The impact of regulation is still uncertain, and capital availability for construction activity and non-prime properties remains tight. Going forward, successful investors will need to navigate these issues among others and capitalise on new drivers of growth.
Despite its reputation as a stable asset class, the financial crisis had a profound effect on the real estate sector. Indeed, property was, in the eyes of many, a key factor in the downturn itself – the crisis revealed the damage caused by subprime lending on residential properties and the sale of these loans to investors. In the commercial market, values quickly dropped as businesses, particularly retailers, failed, and a lack of liquidity was exposed in the market.
In the years since, the recovery of the real estate sector has been slow, although it is gaining momentum. The sector entered 2013 on a broadly positive note. Capital real estate values had remained stable throughout 2012. In terms of leasing activity, rated real estate investment trusts (REITs) were on track, and rated developers were largely seeing improved profitability. The funding environment saw great improvement in 2010-11 and real estate debt grew in popularity. This appetite grew throughout 2013, as real estate firms shifted toward debt issuance and non-bank funding rather than bank debt.
The real estate market continues to move through a phase of extended recovery. It is hoped that 2014 will see the market progress further, with recent trends having the momentum to finally make a real impact. Indeed, real estate assets have remained an attractive asset class. Alternative investors have recognised their worth throughout the crisis, with no major shift in investor allocations over recent years. According to EY’s ‘Trends in real estate private equity’ report, there are currently estimated to be 436 funds raising target capital of $150bn. In recent years there has been a marked increase in transactions in moderately leveraged core assets, says the report, overseen by managers who have maintained the confidence of investors through the economic downturn.
Within the industry, there is a feeling that 2014 may well be the year that the real estate market ‘recovers from the recovery’. According to PwC’s ‘Emerging trends in real estate’, real estate professionals believe that growth is at a tipping point – the sector’s slow burning recovery has hidden signs of improvement which will improve greatly once growth is back in full swing.
But while the trends identified suggest opportunities for investors and developers alike in 2014, the landscape remains a challenging one, and economic and demographic changes will leave players confronted by familiar hurdles, as well as some that will force the industry to adapt.
Real estate teams have always faced myriad challenges in maintaining their portfolios. Mergers and acquisitions, and corporate dissolutions, confront real estate teams with portfolios that can change overnight. But despite this instability, portfolio managers are paid to demonstrate strong value in sustainability, speed-to-market, cost reduction and operational efficiency.
Today’s heavily scrutinised regulatory environment has thrown up countless challenges. Government regulations have had a widespread effect on the real estate sector and the global recovery as a whole. Though the crisis showed that change was essential, today’s increasing volume of rules and conditions for lenders, appraisers, agents and developers only adds pressure, especially in conjunction with market conditions. “The impact of the AIFMD and the tightening of national private placement regimes in Europe means many managers, particularly those from outside the EU, are having to reconfigure their fund management platforms and marketing strategies to continue to access target investors. Unlike the start of previous economic cycles, managers are putting a lot more emphasis on due diligence and understanding better the risk profile of target assets in the context of individual geographical and property dynamics,”explains Michael Hornsby, a partner at EY. “There is significant investor demand for greater levels of oversight, transparency, and a closer examination of the efficiency of operating platforms. This is partially driven by more sophisticated asset-liability models and changes in capital allocation frameworks for pension funds and insurance companies.” During the boom, many outside of the real estate sector would argue that the industry was far too deregulated. However, those inside now contend that the pendulum has swung too far the other way, making the work of real estate professionals unnecessarily challenging.
With tighter regulations in place, many lenders are cautious. Restrictive investment guidelines and a lack of financing for investors have prolonged the sector’s woes. With many independent brokers shuttering their businesses, borrowers have fewer options when it comes to accessing finance. According to Deloitte’s ‘Development Funding in a Cold Climate’ report, this is particularly true for UK borrowers seeking funds for development projects. Lenders have been increasingly unwilling to take development risks, and as such commercial development funding has been restricted largely by region, and to projects possessing a host of sought after characteristics, including prime location, proof of strong demand and relatively modest loan to cost ratios.
The real estate sector, by its nature a social business, is reliant on strong business relationships and partnerships. Joint ventures have therefore long been a feature of many deals. With this in mind, it is surprising that operational due diligence is only now becoming a prominent feature of partnership negotiations. The downturn, however, exposed such failings, forcing businesses and investors to address lapses in due diligence and documentation, and putting in place more stringent measures for transparency. Especially in an era of increasing cross-border deals, real estate managers must put in place sound anti-corruption measures, particularly when doing business in high-risk markets. A key feature of such programs is an understanding of how third-parties and intermediaries do business on your behalf.
Another notable challenge for the sector has been the shift in demand for office and retail space – a result of changing business practices and emerging technologies. Today’s employees are beginning to embrace remote working, reducing the overall need for office space – a trend that is only going to intensify as the workforce gets younger and more comfortable with the technology of working remotely. Online retailers have also changed the market for physical outlets. Online sales volume has been on the rise for years, and companies are trying to reorganise their physical stores to adapt to this reality. “The increase in online retail shopping will have an impact on the way in which consumers use physical retail outlets,” says Mr Hornsby. “This is having a significant impact on the way retailers balance their physical and online presence. Another related impact of increasing online sales is the growing expectation of next day delivery times. This is driving changes in the way logistics networks are configured, needing not only large regional hubs, but also a high number of smaller facilities that are close to customers.”
With traditional lenders having retreated from the real estate space in recent years, new sources of finance are emerging. Much of today’s activity is driven by hedge funds, private equity firms and foreign investors. And, as a result of yield compression in the US and prime European locations, much of this is targeting secondary markets such as gateway cities with growth potential.
A recent survey of foreign investors by the Association of Foreign Investors in Real Estate (AFIRE) – made up of nearly 200 ‘investing organisations’ in 21 countries – found that 81 percent of a sample of its members intend to increase their portfolio of assets in the US. They cited the country’s “stable environment” and position as the “best market for capital appreciation” as reasons for this outlook. Certainly, foreign investors are on a shopping spree. According to Real Capital Analytics, from January to August 2013, such investors acquired $22.8bn worth of US real estate, accounting for 13 percent of all real estate transactions in the country. Over the past three years, the biggest investors into the US have been Canada and China, followed by countries in the Middle East. This influx of foreign capital is expected to increase over the next 10 years, despite expected amendments to the US Foreign Investment in Real Property Tax Act (FIRPTA).
Foreign capital has entered the market through a number of sources, though sovereign wealth funds made headline news in 2013 due to their large assets and increasing influence. According to Preqin’s ‘2014 Sovereign Wealth Fund Review’, as of October 2013 the assets of sovereign wealth funds topped $5 trillion; of this, more than $180bn was allocated to real estate investment. A significant proportion of sovereign wealth funds invest in private real estate, including Qatar Investment Authority, Abu Dhabi Investment Authority and China Investment Corporation, which all have over $25bn allocated to the asset class. This is often invested across the real estate spectrum through listed securities and private funds. MENA, North America and Asia are the regions in which the largest proportions of sovereign wealth funds are based, with 33 percent, 19 percent and 28 percent of these investors based in these regions respectively, according to the report.
North America is the favoured region for sovereign wealth funds, says Preqin, with Europe and Asia taking second and third place respectively. Fewer sovereign wealth funds, meanwhile, concentrate on Australia and MENA. Regarding investment behaviour, 57 percent of sovereign wealth funds that invest in private real estate currently show a preference for core real estate, though they are showing an increased appetite for distressed debt vehicles. And while sovereign wealth funds are often seen as focusing on trophy assets, there is growing demand for non-core exposure.
Along with foreign investors, private equity has made a renewed appearance on the real estate scene in recent years. EY estimates that $340bn is globally available for investment into real estate. But with approximately 425 funds in the market on a regular basis, and the top 10 managers attracting 50 percent of the available capital, fundraising is still extremely competitive. “Large opportunistic real estate funds with significant amounts of capital to place are increasingly diversifying their strategies to help them invest at scale,” Mr Hornsby says. “Investment strategies such as student and young professional housing, single-family residential and senior and mezzanine debt funds continue to proliferate. New entrants, such as private equity groups and hedge funds, are looking at opportunities in distressed markets such as Southern Europe – they are trying to call the bottom of the market as opportunities for repositioning and turnaround are increasing.”
The real estate market appears to be on a solid path towards growth, having pulled clear of the recovery phase that has mired it since the downturn. Despite this, real estate professionals do not have an easy road ahead. Success in 2014 is by no means guaranteed, and returns will only come to those who can display exception management and operating skills.
On the development side, financing for development projects is gradually becoming easier to obtain, according to Deloitte’s report. Although funding is relatively scarce, it is available for the right opportunities. However, when putting together a funding package for major developments, parties must consider a number of points. Equity investors need to accept lower returns, or accept more risk relative to the returns projected. They need to gain a greater understanding of the different components of risk in development projects. Developers, for their part, need to be aware of the changing demands from funding providers and must be able to segregate and apportion project risks accordingly.
Although private equity has been lauded for its role in real estate’s recovery, the industry will have to work hard to capitalise on its gains. With further yield compression expected, along with modest economic growth predictions and higher interest rates, fund managers will be under considerable pressure to maximise cash flow from assets. “This will mean a focus on efficiency and reduction in cost leakage in their asset and property management functions,” stresses Mr Hornsby. “Fund managers have invested a significant amount of time and money to meet their initial objective to secure continued access to investors under the AIFMD. In doing so, many have recognised opportunities to shape more homogeneous and efficient middle and back office operating models. There is evidence that this will involve more outsourcing as well as M&A activity in the sector with a push towards economies of scale. In conclusion, it feels like the beginning of a new economic cycle in many ways. Investors remain cautious, but appear to have learnt a lot during the last economic downturn.”
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