A promising opportunity lies on the horizon: the private real estate sector. Conversations with managers have revealed a developing potential within this space.
Private real estate, as an asset class, is influenced by various market uncertainties that also impact other sectors. Factors like inflation, rising interest rates and financial challenges affect the broader markets. However, the real estate market also faces unique questions, such as the future of vacant office spaces due to increased remote work resulting from Covid quarantines, and the growing emphasis on environmental, social, and governance trends that direct capital toward sustainable projects, potentially affecting older buildings.
While the current market appears uncertain and complex, the intricacies of real estate investing do not necessarily spell trouble. Complexity often deters less sophisticated investors, leaving opportunities for skilled managers to achieve attractive returns.
Residential and commercial real estate both grapple with the impact of higher interest rates. Mortgage rates and development borrowing costs have risen in line with the Fed target rate, leading to decreased investment and activity in residential markets. Commercial real estate faces similar challenges as a result of higher borrowing costs, further complicated by stress within regional banks. Regional banks play a significant role in financing for commercial real estate developers, as a recent Moody Analytics report suggests, and if credit conditions tighten further, it could affect the corporate real estate sector and developers relying on smaller financing relationships.
Despite the increase in mortgage rates, price drops have not been sufficient to offset the higher borrowing costs for individual buyers. In contrast, large private real estate funds with diverse investment strategies can deploy cash offers and remove more supply from an already constrained residential market. This scarcity of available financing may yield opportunities for private funds that possess scale, established presences, and a wide range of capital and financing options.
There’s general agreement among leading alternative investment providers that it’s wise to refrain from attempting to time the market, as research suggests it is challenging and can lead to poor investment decisions. Instead, the key is to focus on timing in terms of valuation, margin of safety and potential upside. In the case of real estate, these factors excite us about the current opportunity.
For instance, higher borrowing costs and limited financing suggest higher interest generated and potentially more favorable debt terms and covenants for real estate debt investors. On the other hand, higher borrowing costs negatively impact equity stakes, presenting attractive entry points for real estate equity investors. This dynamic opens up various opportunities for opportunistic real estate investors to evaluate distressed equity positions versus the safety and income potential of debt positions in properties. Moreover, preferred equity, mezzanine debt or securitized debt securities could offer even better potential outcomes than traditional debt or equity investments.
As the real estate market experiences potential distress, new entrants are expected to emerge. Many real estate managers have already started raising opportunistic funds alongside their core offerings, and non-real estate managers are also venturing into this sector. However, we believe that managers with established sourcing networks will have a competitive advantage, enabling them to access and conduct due diligence on the most attractive deals in a dynamic and fast-moving market. Quality sourcing ensures that investors can participate in properties with desirable locations, adhering to the well-known cliché in real estate: "Location, location, location."
Stress is likely to linger on the horizon within the real estate sector. Capitalizing on the opportunities that arise is key. Alternative investment providers to wealth managers and family offices that are expanding their suite of products provide advisors and their clients with the means to participate in this promising market.
Steven Brod is CEO of Crystal Capital Partners, an integrated alternative investment platform for advisors.
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