Todd Henderson is co-global head of real estate at DWS Group, a leading real estate manager with $36.1 billion private real estate assets under management and four decades of experience in U.S. markets.
How would you describe conditions facing institutional real estate investors today?
The real estate market is in transition resulting from the Federal Reserve’s actions to slow inflation to its target rate. Private real estate performed well in the first half of 2022, with strong returns. However, appreciation stalled in the third quarter and turned negative in the fourth quarter. Despite the poorer relative performance in the second half of the year, private real estate posted a 7.5% total return for the year—significantly better than traditional asset class returns. This has left many institutional real estate investors over allocated to real estate as a result of the denominator effect, and in need to rebalance their portfolios.
In addition to the capital markets response to interest rate increases, demand in the strongest performing sectors has begun to normalize. So, institutional real estate investors are facing a market that is slowing with a need to rebalance their portfolios. While this may sound like a negative outlook for institutional investors, it is not the case.
Market fundamentals are very strong outside of the office sector. While new deliveries are elevated relative to historic levels, the forward construction pipeline is significantly curtailed. We expect the strong fundamentals relative to historic levels to persist despite the slowing economy and believe that the market adjustment to interest rates will be complete by the second half of 2023. This means that institutional investors will be faced with creating capital to invest in the second half of 2023 and throughout 2024 to take advantage of good vintage year opportunities.
To date, the public markets have experienced a more severe repricing than the private markets. The public markets reflect the current interest rate environment and offer attractive yields to investors.
What do you identify as long term structural forces in the economy and how should real estate investors respond?
E-commerce and the demand for housing are strong structural forces in the economy today. E-commerce represents approximately 17% of retail sales today and we expect that it will increase by more than 50% before the end of the decade. This is a good fact for industrial demand and, when you combine it with onshoring required to secure supply chains and overlay historically low vacancies in the industrial sector, we believe it will perform well in 2024 and beyond.
Meanwhile, there is a housing shortage in the U.S. that will not be solved by the amount of rental housing expected to be delivered in 2023. It is a challenge that cannot be solved by delivering 500,000 rental units of new supply in one year. For the market to reach equilibrium in rental units, deliveries need to exceed historical levels by 50% or more for multiple years.
The fact is that the forward pipeline of rental (and for sale) units is shrinking precipitously. This bodes well for residential rental rate growth as the demand for rental housing should exceed levels seen over the last decade due to continued millennial household formation and the elevated cost of homeownership due to interest rates.
What level of activity do you anticipate this year in terms of real estate transactions, development, and M&A?
Transaction activity will be down materially across all sectors and risk types in 2023. And development transactions will likely be down by a greater percentage, resulting from the fact that core real estate is showing signs of pricing below replacement cost. The cost of land will adjust as will the cost of construction materials and labor. However, until that happens, development activity will be muted.
In terms of M&A activity, the public to private trade could present some opportunities in 2023 but currently, large transactions whether public to private or private to private, are virtually illiquid and the discounts to NAV required to transact are not likely palatable to sellers. Public to public mergers may occur in 2023. The expectation, however, is that these mergers will be more strategic in nature and create efficiencies for the merged companies.
Where do you see the biggest opportunities in real estate this year?
In the second half of 2023 and throughout 2024, we believe the industrial and residential sectors will produce some good vintage year buying opportunities. Similarly, the public markets will present good buying opportunities in 2023 given the repricing of the public markets throughout 2022.