Among alternative asset investors, private equity real estate funds occupy a unique place in the financial web being affected by the credit crunch. One the one hand they are subject to the same credit tightening that all private equity funds are now subject to, and on the other their investment target is the area that spurred the current troubles in the first place.
For this reason PERE.com decided to take a look at how investors anticipate real estate and private equity is perform in the context of all alternative assets. As the year draws to a close and there continues to be fears of a crash similar to that of the early 1990s, how confident are investors about real estate’s place in their overall investment strategy? Going down the line from a macro to micro perspective, the outlook for real estate seems promising.
Globally, alternative assets have continued to see an increase in interest in 2007, although this has seemed to vary based on whether investors were already experienced in this area. A survey of leading European institutional investors released last month by JPMorgan found that 13 percent of the average respondent’s portfolio continues to be made up of alternatives, a number that has remained relatively unchanged for the past few years. The survey found that there was a marked division between investors and non-investors, with those who had already invested keen to increase their allocations significantly, while the majority of institutions without any prior exposure seemed to have little interest in gaining any now.
The good news was that very few institutional investors who are already alternatives investors plan to decrease their allocation. This should be promising news to GPs, particularly for those managing real estate funds. The survey showed that institutions investing in alternatives plan to invest more in real estate over the next two to four years than in hedge funds, private equity or infrastructure.
Out of the €103.6 billion these institutions plan to invest in alternatives over the coming years, €27.2 billion is expected to go toward real estate and €14.5 billion toward infrastructure – twice as much as private equity and hedge funds combined. Private equity real estate firms can also be encouraged by the fact that 39 percent of investors plan on restructuring their investments toward more indirect real estate rather than direct, according to the report.
The survey’s authors speculate that the reason for this is defensive. 61 percent of respondents said that low correlation with other asset classes was the chief reason for their real estate preference, while just 28 percent cited the potential for higher returns. This is perhaps not surprising considering that realized annual return from real estate investment since inception is expected to decline from an average of 12.2 percent to 8.1 percent over the coming year.
Coller Capital’s Global Private Equity Barometer, released earlier this month, showed some similar sentiment about where investors should turn in light of the global credit crunch. Over half of private equity investors and three quarters of North American investors surveyed said they believe the credit market’s recent difficulties signal the end of the global buyout boom. Half of the LPs surveyed said they think North America will be the hardest hit by the crunch globally.
LPs generally expressed pessimism for the short-term. Half of the investors surveyed said they believe the pace of GP investment will slow over the coming year, compared with fewer than 10 percent of LPs in the winters of 2005 and 2006. However in the medium-term investors private equity return expectations remain strong. 39 percent of LPs expect net returns of 16 percent plus, over the next three to five years. Significantly, 73 percent expect to see returns above this amount for Asia-Pacific funds.
This result probably explains why the negative short-term expectations of LPs don’t seem to be diminishing investor enthusiasm at the moment. Almost all of the LP respondents – 96 percent – said they plan to increase their private equity commitments over the next three years, and 78 percent plan to increase their number of GP relationships.
As the credit crunch continues and markets globally face increasing uncertainty, investors are expressing confidence in real estate as a safe haven. A report released this month by LaSalle Investment Management concluded that despite the disruption in European and North American credit markets, the overall outlook for investment in real estate will remain solid. Study author Jacques Gordon says that the fundamentals of the real estate sector are capable of weathering a slowing global economy, and that tighter lending requirements in North America and Europe will actually put moderate-level investors in a better position to secure deals at improved pricing.
While some have expressed fear that the market may be heading toward a crash similar to that experienced in the early 1990s, LaSalle’s analysts conclude that such an event is unlikely. “We don’t believe that markets are heading for an early 1990s-style hard landing as there is little risk of over supply,” says report co-author Robin Goodchild. “There is no shortage of capital available to invest in real estate, as allocations continue to be increased and funds have unspent equity, so prices are not likely to fall significantly.”
Other basic factors make a repeat of the early 1990s hard landing unlikely. Interest rates were drastically higher then than they are today, and Western economies were in the midst of a general recession.
However, LaSalle concludes that risk must be more carefully priced in 2008, as nervous capital markets and inflationary pressures create a more uncertain environment. For instance residential real estate, LaSalle points out, has become overheated in many markets around the world and this could put underlying economies at risk as this bubble deflates. Fully leased commercial real estate, LaSalle concludes, has the best defensive characteristics to weather a slowdown.
However in the short term, year-end studies showed that Western property is likely to produce negative returns in 2008. UK property firm Forsyth Partners, for instance, concluded in a statement issued at the end of the year that returns from UK physical property may now only just beat cash this year and will be negative in 2008. Predictions for the US have been downbeat as well. In September, the US suffered its first month to month drop in seven years as prices fell an average 1.2 percent, according to the Moody’s/REAL Commercial Property Index. The problems have been recognized by the performance of property equities, which are now down 25 percent from their early February peak as measured by the S&P Real Estate sector index, underperforming the S&P500 by some 27 percent. In November alone the sector fell ten percent.
Lasalle says a full-blown recession in the US is unlikely and that it is looking increasingly probable that a severe slowdown will occur and will be accompanied by a pullback in consumer spending. For this reason, LaSalle is recommending a greater tilt to low-risk core investments and recession-resistant property types such as healthcare facilities and senior and student housing.
In Europe predictions have not been quite so dire. While the credit crunch is starting to impact global finance centers like London and Frankfurt, markets are generally in a solid position to absorb the shocks. The UK still remains the most vulnerable to economic turbulence, according to LaSalle. Markets in the UK experienced the most yield compression prior to the credit crunch, which will dampen short-term returns. On the other hand in the rest of Europe yield compression is likely over, and cap rates are unlikely to rise for prime assets because capital flows continue to be strong and the cost of euro debt is much lower than for pound sterling.
But it is Asia that everyone seems to be looking toward as 2007 draws to a close. With economic growth predicted to remain explosive over the coming year, and with India and China remaining largely immune from the global credit crunch – the East will no doubt be the hottest destination for capital in 2008.
Fundamentals in the Asian real estate markets remain attractive and the strong demand from occupiers, modest levels of new supply in the near term and low vacancies mean that opportunities in Asia continue to be big. LaSalle points out that uncertainties in the global debt markets should instigate more prudent lending in Asia even though there is still a plentiful supply of debt and equity throughout the region. This, LaSalle concludes, will be healthy for Asia’s real estate markets and should produce more stable, sustainable growth.
No matter what happens in 2008: it is guaranteed to be a year of much apprehension as the uncertainties in the capital markets continue. However, the fact that investors are still viewing real estate as an attractive, vibrant asset class capable of weathering the storm and making good returns by looking at the medium-term and turning to opportunities in Asia should be reassuring news for real estate investors. Though the talk may be gloomy, there are still good reasons to believe that 2008 will not be a repeat of 1993.