Global institutions’ target allocations to real estate are climbing, especially in Europe, the Middle East and Africa (EMEA) and the Asia Pacific (APAC), according to a report published last week by consultancy Hodes Weill & Associates and Cornell University. Yet, despite a rise in institutional confidence in the real estate sector for the first time in five years, institutions are still under-invested in real estate, according to the report.
“Valuations for commercial property are at cyclical highs on a cap-rate and per-square-foot basis, causing some institutions to worry about a potential correction,” said Doug Weill, a managing partner at Hodes Weill. “Confidence increased slightly year-over-year, but still indicates caution,” he added. “On a scale of one to 10, the index is 5.1, which we view as moderately cautious.”
Institutions are awarding some 85% of new investment allocations to third-party real estate managers, according to the report, which is titled 2018 Institutional Real Estate Allocations Monitor. “Institutions typically have staff tasked with making real estate decisions, but they often rely on third-party managers to originate and manage property investments on their behalf,” Weill noted. “As allocations grow, as well as the percent of institutions that are outsourcing investments, commitments to third-party managed products (including open and closed-end funds, separate accounts and joint ventures) should continue to grow,” he predicted.
While cross-border capital flows remain strong, global interest has shifted away from investment in the U.S. and towards EMEA and APAC, the report said. “Europe-, Middle East- and Asia-based institutions have benefitted from strong investment performance from their real estate portfolios, driving up capital for deployment,” Weill said. “Institutions in Europe have the highest allocation to real estate, at 11.1%,” he said. “The U.S. is still the deepest, most liquid market, and should continue to attract interest from global institutions,” he continued. “But the survey indicates that interest in Europe and Asia-focused strategies is growing.”
Endowments and foundations (E&F) tend to be more focused on absolute returns, and thus prioritize value-added investing as opposed to core investing, often through closed-end funds, Weill said. “Institutions are more likely to focus on strategies to improve the real estate—an investment in value-add property can result in less reliance on the exit-cap rate to drive the total return,” he said. “E&Fs tend to aim for internal rates of return (IRR) in the mid- to high-teens.”
The report also stated that more global investors are adopting environmental, social and governance (ESG) policies, while the Americas lag behind. The use of the word ‘global’ is meant to present an average for the market, Weill noted. “The U.S. is lagging, and we did not have enough responses from LatAm to present meaningful conclusions on trends.”
“Europe historically has led the campaign to be more socially-minded in investing,” according to Weill. ESG can mean a combination of factors in the commercial real estate world—ranging from investing in women- and minority-owned businesses to investing in environmentally-friendly ‘green’ buildings that use solar power to achieve net-zero energy status. Also under the ESG umbrella are ‘opportunity zones,’ which entails investing in designated low- and moderate-income neighborhoods to improve the community. “Opportunity zones could include any type of real estate that needs improvement—from residential to office to retail to industrial,” Weill said. “There’s is a tax benefit associated with qualified-investments into opportunity zones that will likely encourage more investment,” Weill said.
The underinvestment in commercial real estate by institutions can be attributed to a few factors, according to Weill. For a visualization of institutions’ actual allocations to real estate versus target allocations, refer to the “All Institutions” bar chart in Exhibit 8 below, from the report.
Most asset classes have performed well over the past few years, including public equities, which has driven up the amount of gross dollars available for investment that institutions have to invest, including in real estate, Weill noted. While global real estate allocations continue to climb, albeit at a slower rate, the report found that institutions remain approximately 90 basis points under-invested relative to target allocations. Of the whole, approximately 60% of institutions are under-invested by an average of 200 basis points. When segmenting by type of institution, insurance companies are, on average, the most under-invested at 7.3%, while endowments and foundations are tracking close to their target allocations, the report said.
Another factor is undrawn capital or dry powder. The amount of capital that institutions have committed to closed-end funds that has yet to be drawn is at record levels, Weill said. “Since 2016, when transactions slowed in the industry, dry powder has grown in excess of $250 billion.” See the chart from Preqin below for visualization:
Below, find a list of the intuitions that were surveyed for the report: