Real estate is going through a period of deleveraging and most owners with expiring debt will have to either re-equitize assets to refinance, extend their debt or accept less proceeds on a sale. This may lead to underperformance for the sector, loss of capital, and many managers losing promotions earned over the last several years. Investors may face longer hold periods and lower internal rates of return (IRRs). All of this will be sector dependent with strong growth sectors such as industrial and apartments likely faring better than office and shopping centres.

Real estate is a highly levered sector where prices are driven in large part by the cost and amount of debt one can borrow. Over the past 30 years real estate investors have been operating in a declining interest rate environment and for the last decade in an era of record low interest rates. Over this period there was strong economic growth which drove strong net operating income (NOI) growth. These factors led to a long bull market for real estate.

The strong NOI growth was coupled with the prevalence of IRR driven investment funds with shorter hold periods and a preference for short-term floating rate debt. These investors borrowed short term as they could grow NOI quickly and then sell or refinance at a higher value without any pre-payment penalty typically associated with longer term debt. There as some market reports which indicate that over the last 5 year 80% of the loans originated were floating rate debt which generally has a shorter term[1].

With higher interest rates more recently, the borrowing cost and in turn cap rates resulted in an immediate decline creating an issue for borrowers with short term debt. If the loan matures when rates are high, borrowers may have to invest additional equity to rebalance the loan to new loan to value ratios, or default on the loan if value is less than the loan amount. One of the biggest issues is the speed and size of increases on loan values, coupled with the possibility that rates will stay higher for longer in which case it may be difficult for owners to wait it out.

We believe the revaluation process is going to play out over the next 12-18 months as the bid-ask spread between buyers and sellers narrows and some owners are forced sellers. During this period of price discovery banks may be reluctant to lend and owners with equity to protect may recapitalise their investment mostly with mezzanine debt.

The extent of the capital required is unknown but will be significant, in our view. In the past investors looked to the amount of dry powder as a floor to price decline. The amount of dry powder has ranged between $250-300b[2] over the last several years. This must be viewed in context of the total real estate market which is estimated to be close to $10 Trillion[3]. It also needs to be considered that office and shopping centres, still the dominant sectors in terms of market share, are facing the largest potential repricing. 

While equity availability is an issue, a larger concern is how the value declines will impact the banks and their willingness to lend. In the US, credit for office assets is difficult to source but appears to be still available for other sectors (but only for higher quality assets). If banks experience losses on their real estate loans this could lead to tighten credit standards and potentially only extending credit to their best customers. If this occurs many new and smaller managers may not be able to access credit, impacting their ability to continue operations.

For pension managers it will be important to understand their portfolio issues and their managers’ plans for addressing them. It is likely managers will ask for additional capital and pension managers will need to determine if it makes economic sense. If pension managers are committed to the asset class, they may wish to capitalise on the repricing and consider new allocations. However, if rates stay higher for longer the recovery may take longer than previous recoveries.