Performance is down, redemptions are up and the market outlook is uncertain. Christopher Walker takes the pulse of US core real estate funds

As inflation escaped from its cage in 2022 and the Federal Reserve struggled to contain the situation with aggressive hikes in interest rates, the core real estate market in the US stalled. According to NCREIF Fund Index - Open End Diversified Core Equity (NFI-ODCE), which covers 26 open-ended core real estate funds in the US worth US$341bn (€309bn) in gross asset value, total returns powered along in the first half of 2022 at 7.37% in Q1 and 4.77% in Q2. But by Q3 they were close to zero (0.52%), before turning negative (-4.97)% in Q4.

As Catherine Marcus, global COO and head of US equity at PGIM Real Estate, observes: “We’ve seen a relatively quick transition from record core returns in 2021 to valuation declines and negative returns in today’s market driven by higher interest rates, tightened lending and broader economic uncertainty.” 

The outlook for this year is not encouraging. “Appraised values have just started to decline because of the lag in private real estate appraisals,” says Marcus. “Transactions activity has dried up and appraisers are reported to have a lack of sales data available to precisely measure the magnitude of revaluation.”

For some, it is no surprise. The direction of travel was clear from declines in the share prices of listed real estate investment trusts (REITs). Rich Hill, head of real estate strategy and research at Cohen & Steers, says: “The slowing in ODCE returns comes exactly as expected due to the lead-lag dynamic of listed and private real estate. Listed real estate has historically been an indicator of where the private market is heading next due to the private market’s slower-moving price discovery and transactions.” 

Last year there was a significant performance disparity between listed and private real estate, with US listed real estate returning -25%, according to the FTSE Nareit All-Equity REITs index, and US private real estate returning 7.47%, according to NFI-ODCE. “Differences in the real-time pricing of listed REITs and private real estate can create significant short-term dislocations,” Hill says.

The US REIT market is currently trading at a 5.7% implied cap rate, while NFI-ODCE was trading at 3.9% at the end of 2022. Based on this variance, Hill anticipates a decline in private real estate property valuations of between 20% and 25%.*

While performance began to drop last year, the weight of money seeking to exit ODCE funds also increased. Marcus says: “Redemption requests ramped up starting in the second half of last year, driven predominantly by the denominator effect of equities and fixed-income value declines occurring well ahead of real estate.”

For the whole of 2022, inflows and outflows among ODCE funds were almost equal, with distribution and redemptions ($22.4bn) slightly higher than contributions ($22.1bn). This resulted in $291m negative cash flow. But in the final quarter of 2022 alone, outflows outstripped inflows, leading to a much bigger $1.1bn negative cash flow.

Earlier this year, IDR Investment Management, which manages an NFI-ODCE index fund, estimated that the redemption queues at ODCE funds had reached $20bn – the biggest waiting line since the global financial crisis. 

Kevin White

Kevin White: “although more employees will likely return to the office as the pandemic fades, the widespread adoption of hybrid working may leave a permanent dent in demand”

According to Marcus, “the majority of core investors redeeming are requesting only a portion of their capital back to rebalance their portfolios”. She says: “Exit queues have grown substantially, but inflows have not completely shut off, as some long-term investors continue to dollar-cost average into the sector. But this has slowed to a trickle.”

What happens next will be tied to the outlook for US core real estate funds, which looks challenging. “A complete repricing of the real estate market will take more time and will likely persist through the next few quarters,” says Marcus.

Kevin White, head of Americas real estate research at DWS Group, adds: “The outlook for US real estate is mixed. Inflation shows few signs of abating. In our view, further interest-rate pressure seems likely, challenging valuations for most asset classes, including real estate. Leading indicators such as the yield curve also signal a potential recession.”

Offices: a peculiarly US malaise

The impact of rising interest rates may appear to be the obvious cause of this crisis of confidence, but employees working from home seems to be causing far more problems in the US than in Europe, let alone Asia. “Traditional office is far and away the most at-risk sector, as tenant demand remains uncertain,” says Marcus.

Many major companies such as Amazon, Meta, Salesforce and Disney are calling for their employees to return to the office, either full or part time. But such appeals have fallen on deaf ears. According to Kastle Systems, which has been tracking occupancy levels through data from its office keycards, fobs and apps, overall national workplace occupancy in the US has remained steady at only 50% occupancy, with the highest usage on Tuesday, Wednesday, and Thursday, and the lowest on Friday across most markets. Pre-pandemic, that figure was 90%.

It varies by function. Marcus says: “Employers with the most collaborative functions, such as architects, scientists and medical offices, have maintained their office presence at pre-COVID levels, while back-office staff such as accountants, call-centre employees and administrative functions are increasingly working from home.”

Some companies are requesting short-term lease extensions as they continue to navigate the hybrid work environment. And there are also differences in physical occupancy that vary by geographic region in the US, with reports of better attendance in areas with shorter commutes, such as Texas, and less in congested cities like San Francisco and New York.

A leading headhunter, speaking under anonymity, says: “Recruiting in New York is increasingly a remote-first assignment. Even hybrid is a struggle and recruiting for ‘in office’ is almost a non-starter.”

Marcus says: “Some tenants are reducing their footprint upon renewal but very few are vacating offices altogether.”

Adriana de Alcantara

Adriana de Alcantara: “we believe that the disruption in US property values presents an opportunity for investment and that having dry powder in this market will be advantageous as we continue to navigate the rest of 2023”

Rather than the death of the office, these trends point to a bifurcation. Adriana de Alcantara, senior managing director and fund manager for Hines US Property Partners, an open-ended core real estate fund, says: “The office is not going anywhere, because it serves a need – our craving for connection and collaboration are met by the office.”

“Flight to quality remains the trend through widespread adoption of hybrid work. Office occupiers and investors favour high-quality offices as a strategy for encouraging employees to work from the office and equipping them to be their most productive when they are there.”

But, de Alcantara admits, the “office is in a state of transition”, which she likens to the disruption affecting retail property in the years leading up to COVID-19. 

White says: “Prospects for the office sector are challenged. Although more employees will likely return to the office as the pandemic fades, the widespread adoption of hybrid working may leave a permanent dent in demand.

“Over time, this slack may be absorbed through population and job growth, particularly as construction shuts down and some existing buildings are converted to alternative uses – net deliveries are poised to plummet after next year, based on current pipelines. However, this adjustment could take several years.” 

But ODCE funds are less exposed to offices than they were a decade ago. At the end of 2012, office was the largest sector constituent of the index, representing 36.9%. By the end of 2022, this had fallen to 21.6%. Retail, too, has shrunk from 18.9% to 10% over that time. Apartments have stayed fairly steady, climbing from 26.2% to 29.2%, and it is industrial that has seen the biggest growth, from 13.2% to 31.2%, becoming the largest segment. (See figure.) 

De Alcantara says: “The ODCE allocation is witnessing a significant shift across all sectors. Looking at ODCE historical property type weightings, the industrial sector has increased by 15%, apartments by 3%, niche sectors by 4%, while office and retail sectors have decreased by 13% and 8%, respectively, since 2019.”

Some areas of retail are benefitting from employees working from home. White notes that vacancies in the neighbourhood and community (N&C) segment have “fallen to their lowest level in at least 17 years”. N&C assets are typically located in or near residential areas and so “may capture more sales as people move to suburbs and spend more of their work week at home”. N&C centres are also relatively insulated from e-commerce threats, being service-oriented and with significant grocery content. 

Sector weightings after 10 years

Marcus continues to “be bullish on the housing sectors that are fuelled by structural and demographic trends that support long-term demand. That includes senior housing and other strategies that provide attainably priced housing, including manufactured housing and single-family rentals.”

White also believes that Millennial household formation will provide enduring support, while rising mortgage rates will skew demand towards rental properties. “A dearth of construction since the [2008] global financial crisis [GFC] has also created a structural housing deficit: rental vacancy rates – across both single and multifamily units – are near their lowest level since 1984,” he says. 

In the industrial sector, rental income jumped 12% in 2022 as vacancies slipped to a record low (since 1988) of 1.5%, according to White. “A post-COVID normalisation of spending patterns dampened absorption in 2022, but we estimate that this correction is largely complete,” he says. “It seems likely that a shortage of available space has created a backlog of pent-up demand.” 

Meanwhile, he believes several longer-term growth drivers remain intact. “In our view, e-commerce penetration is poised to increase from 18% to nearly 30% by the end of the decade.”

Notwithstanding anecdotal reports of bloated stocks at some retailers, White argues that overall business inventories remain well below 2019 levels and efforts to protect supply chains from geopolitical, pandemic and other disruptions “will accelerate the pre-COVID trend towards increased inventory accumulation”.

He adds: “While the development pipeline is active, warehouse construction spending (inflation-adjusted) is down 8% from last year’s peak, signalling that supply will ebb in the next few quarters.”

De Alcantara concludes that there is “potential for some bright spots and opportunities during the second half of the year. We believe that the disruption in US property values presents an opportunity for investment and that having dry powder in this market will be advantageous as we continue to navigate the rest of 2023.”

Once an equilibrium is reached on pricing, however, “core real estate will perform well”, says Marcus. “Fundamentals are healthy and we are targeting property types that benefit from long-term demand driven by demographic trends.”

* A previous version of this article said Hill anticipated a decline in private real estate property valuations of between 15% and 20%. Hill has since updated his forecast.