Investors are just beginning to process the long-term implications of the global pandemic on real estate assets and on their portfolios. Juniper Square brought together Chris Ebersole, real estate investment officer at Oregon State Treasury, Christy Gahr, principal at Meketa Investment Group and Alisa Mall, managing director of investments at Carnegie Corporation of New York to discuss these issues as part of The Institutional Investors’ Perspective In the Time of COVID-19, a live broadcast held May 11th. The event was moderated by Mary Kate Heck, director of investor programs for Juniper Square.
First quarter reports don’t show much change in real estate value. “The story will be in the second quarter,” Gahr said. “Most of our clients have been hyper-focused on rebalancing and revisiting their asset allocation. I think this comes through just based on simply how low equity markets can go and how much change can be made or needs to be made because of some of the depreciations they’re seeing elsewhere in their portfolios.” There is a wide range of reactions among Meketa clients, from sitting on the sidelines citing significant dry powder, to focusing more aggressively on new opportunities.
The impact on first quarter returns was limited to a modest drop in NOI. The latest data from NCREIF’s ODCE index through the first quarter was a total net return of 98 basis points with income at 102bps and appreciation essentially flat. Income is below the 10-year and 20-year quarterly averages of 121 basis points and 143 basis points. There were no significant revisions of value in the first quarter results. “Appraisers do not see enough evidence to support informed changes in the discount rate,” said Gahr. While private funds have generally delayed their reporting, she expects the same outcome as ODCE.
Gahr pointed to the experiences of prior downturns for insight. In both the early 1990s downturn and the financial crisis, real estate saw a decline in value of more than 30 percent, although NOI drops were only 7 percent and 4 percent, respectively. The public market peak to trough drop in value was 25-35% depending on property type. Overall, public real estate is down 40% during this present crisis.
The negative impacts to the real estate market are still unfolding and it will likely be several quarters before the true extent of the decline becomes clear. Based on what’s unfolded so far with public REITs, Gahr said that cap rates have expanded by 56 basis points amid the COVID crisis. The numbers vary by property type, with office cap rates blowing out by 130 basis points to date vs 56 basis points for the industrial sector. Cap rates on mall assets, meanwhile, have grown by 250 basis points and expanded 100 basis points on multifamily properties.
“The only exception where we’re seeing more positive performance and cap rate compression is in digital real estate, which includes data centers and towers,” Gahr said.
Ebersole explained that Oregon State Treasury’s strategy to shift its real estate portfolio from a focus on total returns to one on income has helped insulate it from some of the risk in the market.
“This is largely a testament to our head of real estate and our former [chief investment officer] who really saw not just real estate, but our other private asset classes taking too much equity type risk,” Ebersole said. “Essentially, everybody was swinging for the fences. So the overall plan was restructured in such a way that every asset class has its role…. As a result of that, we find ourselves in a much better position than where we were back in 2008.”
At Carnegie Corporation of New York, Mall oversees the foundation’s real assets program. “We are hyper-focused on the liquidity needs of the portfolio. We do not want to sell equities at any point during this and we want to make sure that we can rebalance effectively and be opportunistic on the margins where we can. That likely will not be in our real estate portfolio. We, in contrast to Chris, have primarily a value-add portfolio. So, we are waiting to see where things shake out. We are overweight to retail, so I expect it will be pretty ugly. But one thing that I will say in contrast to the financial crisis that gives me comfort is that our portfolio is in a much better position today than it was then.”
Mall added that in 2008 the foundation’s portfolio had a lot of near-term debt maturities at high loan-to-value ratios. Working through that proved to be a good lesson for the real estate team. “We’re very on top of monitoring what the debt levels are, what kinds of debt we have across the board in our real estate portfolio,” she said.
Another lesson from the past cycle is the importance of diversification within a real estate portfolio.
“The financial crisis served as a reminder about the importance of setting a foundation with traditional core real estate and making sure that was the bones to your program,” Gahr added. “So, I’m happy to report that with many of our clients right now, yes, there will be pains throughout their real estate programs, but overall they positioned themselves differently this time than they had been 12 years ago.”
The current strains throughout the economy are expected to produce distressed debt and equity investment opportunities, although panelists said it might take some time for that to bubble up into the market.
“We have some clients that are talking to us about what it would look like to shift core dollars into tactical non-core opportunities right now,” Gahr said. “Our viewpoint is that if you’re at your allocation, you should not necessarily be thinking about this too tactically just yet. The distress isn’t there yet. What we’re hearing from most managers, especially on the opportunistic side of things, is to expect the distressed transactions three to four quarters from now.”
Mall added, “Something that I’ve been spending a lot of time thinking about is, on a go forward basis, do we want to shift that balance so that we have more exposure over time to groups that can play up and down the capital stack, that can inhabit and take advantage of different things opportunistically when they think the time is right?”
The panelists also explored how behavioral changes like social distancing could ultimately shape the outlook for various commercial real estate subsectors. Some parts of the retail world—like independent restaurants—face a tough slog and many may not survive. Others have been able to innovate and adapt by facilitating the use of curbside pickup, for example.
“I don’t know what that’s going to look like yet, but I have to believe (recovery) is going to come because people like shopping,” Mall said. “I went to Best Buy the other day. My six-year-old needed a new device, and the line for Best Buy curbside pickup was 18 cars long. I think there’s going to be a lot of blood in the streets, so to speak. It’s going to be really ugly. but I think you’re clearly going to have some winners and losers emerge.”
The hospitality sector may also be in for a rough stretch, both in terms of a slow resumption of demand and in terms of what changes are needed to help travelers feel safe. Gahr pointed to the experience in the Asian market, which is further ahead in the post-pandemic economic cycle. Asian hotels are open, but occupancies remain low—around 30 percent.
“I think that the U.S. is going to have a long battle upwards,” Gahr said. “It will take time for the consumer population to come back. It’s going to take time for business travel to pick back up. Most of the events that we’ve all seen in our own calendars are canceled at least through the third quarter now. I think most are probably thinking about bumping those back into even 2021. So I think there’s going to be quarters of pain, not months of pain for hospitality.”
On the bright side, all three panelists agreed that the multifamily sector has weathered the pandemic better than expected. Class A assets, with many tenants still employed in the tech industry and elsewhere are holding up the best. Class B and Class C properties have managed to hold up better than expected despite having more tenants affected by the more than 30 million layoffs recorded in recent weeks.
“Collections and leasing activity aren’t too far off where they were pre-crisis,” Ebersole said. “On the value-add side, we’ve also seen some of these projects perform well. The workforce housing subsector is another story, but we like it long term. So, we’re in the process of completing diligence on some multifamily investments that have been in process for the last six to nine months. We’ll probably look to add more in the future.” He noted similar outperformance of A assets in Senior Housing, where health and safety procedures are better.
The office sector also could be facing a shakeout. Emerging from a period of forced remote work, some companies have signaled a willingness to keep bigger portions of their workforce offsite than they had before the crisis. Meanwhile, some companies bringing workers back will have to revisit layouts to reduce density and ensure worker safety. The question is whether these are just short-term adaptations or if they mark an overall paradigm shift for the office sector.
“I expect that there will be some changes to how we come in and out of our offices in the near to medium term,” Mall said. “There will clearly be some kind of screening, and testing, and maybe contact tracing, but over time, things are going to revert to some form of normalcy.”
Another point of discussion is how much general partners and limited partners have been communicating amid the crisis. Mall, Ebersole and Gahr all agreed that they had seen good levels across the board.
“We tell everybody more is better,” Ebersole said. “That certainly has been the approach that people have taken in terms of monitoring updates. But I think one thing we would like to see is a little more emphasis on asset management. It’s certainly the least exciting, but we’re at the point now where that’s what matters. Just knowing that asset management teams are properly resourced and properly aligned and well positioned to deal with this.”
With respect to making new investments, Gahr said that the appeal of having seeded assets has suddenly flipped. The concern is portfolios put together right before the pandemic hit may be overvalued. Before, “nearly every consultant and every institutional investor was telling the GP community, ‘I want to see a seeded portfolio. I want to know what I’m getting myself into. Come to me once you’ve had your first close and you have some seed assets.’” Gahr said. “And then overnight it was, ‘I don’t want your seeded portfolio. It can’t possibly be worth what it was when you purchased it. Why would I buy into a pool of existing assets?’”
To address that, Gahr said Meketa has had some conversations with GPs about carving out seed assets. “They need permission from their existing LP base to create a sidecar for any new investors that are to come in to protect them from that seeded portfolio,” she said. “If you’re 20 percent or below as it relates to your seeded portfolio, your investors may not hold you to the same level of conversation around restructuring, but 20 percent and above might require some sort of creative solution. So it’s been interesting.”
From Ebersole’s and Mall’s perspectives, another aspect that’s been affected by the current climate has been a slowdown on creating relationships with new fund managers.
“We’ve more or less put a soft hold on new manager relationships at this point,” Ebersole said. “We’ve seen through the investments that were in diligence prior to this, and we have a number of opportunities to allocate more capital to existing relationships, but at the end of the day, if it’s a new manager for the commitments that we’re talking about making, it’s just tough to get to the finish line without being able to sit in a room with somebody. I don’t see that changing.”
View the entire broadcast on-demand: The Institutional Investors’ Perspective In The Time Of COVID-19