Some of the biggest investors in US commercial real estate are looking to cash in before property values slide further.
A group of property funds for institutional investors ended last year with US$20 billion in withdrawal requests, the biggest waiting line since the Great Recession, according to IDR Investment Management, which tracks an index of the open-end diversified core equity funds.
“It’s like the nightclub where everybody lines up to get in and then lines up to leave when it closes,” John Murray, head of global private commercial real estate at Pacific Investment Management Co., said in an interview.
Institutional investors sought to cut their exposure to some of the biggest funds at managers including JPMorgan Chase & Co., Morgan Stanley and Prudential Financial Inc., according to people familiar with the matter who asked not to be identified citing private information.
The UBS Trumbull Property Fund had a US$7.2 billion queue for withdrawals — 40% of its value — as of the third quarter of 2022, according to a December presentation by Callan, a pension consultant.
The capital outflows are ratcheting up the pressure on institutional fund managers as higher interest rates batter the commercial real estate market. At the same time, managers such as Blackstone Inc. are seeing retail investors — wealthy individuals in particular — pulling money from real estate bets amid volatile markets.
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One of Blackstone’s biggest retail pushes, its Blackstone Real Estate Income Trust, limited how much money investors could take out in December 2022. The ODCE funds — pronounced like “odyssey” — don’t specify quarterly limits on withdrawals.
Soaring borrowing costs pushed commercial property prices down 13% last year, an index by Green Street shows, while a Bloomberg gauge of publicly traded real estate investment trusts tumbled 29%.
But ODCE funds move more slowly, valuing properties based on comparable sales — and those have become scarce recently, with few sellers willing or forced to take a loss. That’s why the ODCE index posted a 7.5% gain for all of 2022, according to preliminary data released Jan. 13 by the National Council of Real Estate Investment Fiduciaries. The first sign of a pullback came in the fourth quarter, when the index dropped 5%.
“Do the math,” said Cathy Marcus, global chief operating officer and head of US equity at Prudential’s PGIM real estate, which manages US$204 billion in property globally, including the oldest ODCE fund. “This is not calculus. We’re going to end up with some valuation decline, but it’s not going to be earth shattering.”
The capital outflows are both a symptom and a cause of problems ahead for commercial real estate.
Redemptions are “prompting many core funds to attempt to sell their most liquid assets, like industrial and multifamily assets, which implies a headwind for even the most relatively resilient sectors” of commercial real estate, Murray wrote in a December note.
For institutional investors, the exit queue is at least partly a response to what’s known as the denominator effect. Investment managers often have certain targets for how much they want to have invested in stocks, bonds, real estate and other assets. As markets slumped last year, their stock and bond holdings shrunk in size while real estate held up better, meaning it often constituted a bigger slice of their portfolios than they initially intended.
About 32% of institutional investors with US$11 trillion in total assets considered their portfolio overallocated to real estate in 2022, up from 8.7% in 2021, according to a survey by Hodes Weill & Associates and Cornell University’s Baker Program in Real Estate.
“Real estate appreciated itself into having a denominator issue,” PGIM’s Marcus said. “Some investors are looking to take money off the table.”
Exit queue
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Most investors are reducing exposure to ODCE funds, not abandoning their stakes. And the exit line may be inflated by investors who assume they’ll only receive a fraction of their request, so they ask for more than they expect to get, according to Garrett Zdolshek, chief investment officer of IDR Investments, which manages about US$5 billion. IDR runs a fund tracking the US$350 billion of gross assets in the NCREIF Open-End Diversified Core Equity Index.
The outflow backlog can quickly flip to a waiting line for investors wanting to get back in, as happened briefly in 2020 and more dramatically after the 2008 global financial crisis when stocks recovered and the investing pie grew.
“We saw a 15% redemption queue in 2009 reverse to a 14% entrance queue at the end of 2010,” Zdolshek said.
Because of the lag in revaluing the assets, the ODCE funds are still outperforming the broader stock market. The PGIM Prisa fund had a total return of 19% in the 12 months through September, when the S&P 500 posted a 15% loss, Callan reported. Other returns during that period include 21% for the Morgan Stanley Prime Property Fund, 19% for Invesco Core Real Estate USA, 18% for the JPMorgan Strategic Property Fund and almost 17% for the UBS Trumbull fund, according to Callan.
The UBS fund, where the redemption line began building before the pandemic, paid US$1.85 billion last year through October to clients who wanted their money back, according to Callan.
Spokespeople for PGIM, Morgan Stanley, JPMorgan, Invesco and UBS declined to comment on their funds’ performance or redemptions.
A historic benefit of the ODCE funds is their returns are less volatile than REITs. But their slower reaction to revaluing assets may now leave them susceptible to an arbitrage trade as public REITS appear to have more upside.
“We are taking advantage of the arbitrage between public and private markets and funds in need of liquidity,” Morgan Stanley research analyst Tony Charles wrote in a December note.
