Money is pouring into U.S. real estate funds as the nation recovers from the coronavirus pandemic, but the investment strategies they are pursuing look different than they did two years ago.
Historically, downtown office towers would be the prime target for the largest real estate investors, as the size of the assets allows them to deploy hundreds of millions of dollars at once. But now, the long-term stability of office assets has come into question as many office buildings remain less than half-filled, and investors are shifting their attention to new types of real estate.
Multifamily and industrial have been two of the hottest targets, as the property types have performed well during the pandemic, but as those sectors become flush with cash, investors are looking toward alternative sectors such as life sciences, medical office and data centers.
"There’s a flood of capital worldwide looking for some sort of yield, so there has been capital going into alternative CRE just as a way to find opportunities, because it’s so crowded elsewhere in the market," Real Capital Analytics Senior Vice President Jim Costello said.
Industrial and apartment deal volume from January through May were 18% and 8% higher than their 2015 to 2019 averages, respectively, RCA's latest U.S. Capital Trends report found, while all other major property sectors were below their pre-pandemic norms.
The total deal volume of U.S. real estate transactions in Q2 was $68.3B, according to Preqin, more than double the total from Q2 2020. Between January and June, Preqin reported a 16% increase in the number of real estate funds in the market and a 15% increase in the amount of capital targeted.
"There's a lot of money out there," Avison Young President of U.S. Capital Markets John Kevill said. "Unlike in 2009 and 2010, there hasn't been a massive degradation of the capital base. People have made more money so they have more to put in. And the world is a volatile place, and real estate has always been a good spot for investment in times of volatility."
This increase in fundraising targets hasn't yet translated into more funds closing; 59 funds closed in Q2 totaling $19B, according to Preqin, the weakest quarter in the past five years. There have been some high-profile closings so far this year, including a $4.7B fund from Oaktree Capital Management, a $2.8B fund from Cerberus Capital Management and a $1.7B fund from Ares Management.
"There's an appetite for real estate right now," Nuveen Real Estate Managing Director Nadir Settles said. "We're raising money where there's a lot of demand, and we're raising money at a high volume."
Settles leads New York office real estate investments for Nuveen, a subsidiary of financial services giant TIAA, with $133B in assets under management. Where he said he sees the most demand is the multifamily and industrial sectors, plus newer emerging sectors like life sciences.
"In others, it's more of a struggle because that's the investor appetite," Settles said. "They have trepidation on retail. They have trepidation on office, so where there's demand for Nuveen in multifamily and alternative investments, that's where other investors, as well as ourselves, are probably seeing a lion's share of flows come into."
The concern around downtown office investment has continued because workers have still yet to return in large numbers, now 17 months after the pandemic began. Building security firm Kastle Systems reported an average building occupancy of 31% across the 10 largest markets during the week of July 7, down from 32.7% the week before.
Settles said the market for investing in traditional downtown office still hasn't recovered, but he expects it will after Labor Day when more people return to the office. In the meantime, he has seen a surge in demand for a property type that Nuveen considers a subsector of office: life sciences.
Nuveen and several partners in March closed a $600M financing deal to redevelop a former ABC/Walt Disney office building in Manhattan into a life sciences building including wet and dry labs. Settles said this project had been in the works since 2019, but the pandemic only increased the demand for life sciences.
"The subsector that really grew during the pandemic was life science," Settles said. "We already had a foothold in life sciences and are looking to go deeper there, and there's a lot of investor interest in life sciences."
Ares Management's $1.7B fund represents its largest to date, and it attracted over 35 investors from across the world, Ares Head of U.S. Real Estate Private Equity David Roth said in an email. He said the strong fundraising haul, which was above its $1.5B target, shows that there is a large appetite for U.S. real estate in today's market.
"The industrial sector continues to experience strong investor demand, with the secular trend toward e-commerce further accelerated by COVID," Roth wrote. "Additionally, we are seeing that over the last decade, 'niche' or 'adjacent' sectors like life sciences, data centers and student housing have been rapidly institutionalizing and institutional investors have become more familiar, active and comfortable investing in these sectors."
Kevill, who brokered the sale of a workforce housing complex near Atlanta in April for $45M, said he has seen large investors look to reduce the amount of office in their portfolios and add in other property types that they hadn't previously owned.
"Particularly institutional investors are taking a look at the pie chart everybody throws together of asset allocation and adding new slices to the pie," Kevill said. "Now you're seeing a slice for senior living, medical office, self-storage, last-mile industrial, data center. Even the larger core and core-plus funds are looking to distribute risk in many cases away from office and into other asset classes."
Kevill said the stability of the stock market and the financial system during the Covid crisis, compared to the previous recession, has given investors large stockpiles of money to invest in real estate, and they are increasingly looking at the fundamentals of each sector and seeing how much more growth potential other property types have than office.
"That strategy is essentially a reset," Kevill said. "This [pandemic] has been such a massive shock to the system, many investors have had to take a step back and looked at their strategy."
Beyond the market fundamentals, Kevill said the shift has also been driven by the amount of information that is available on emerging property sectors.
"There has been a massive increase in the data available for investors to underwrite asset classes that were previously not as institutional," Kevill said, citing medical office, data centers, industrial, flex-office and multifamily in secondary markets as examples.
In addition to the equity markets having billions of dollars to invest in real estate, the debt markets are also flush with cash, CBRE Vice Chairman David Webb said.
"On the financing side, the banks are now as strong as ever," Webb said. "Banks drive bank lending, and they also drive the debt fund lending, so both of those areas are going to continue to improve. They're both very strong. Life companies have been strong all year, and Fannie and Freddie are strong as well and very competitive."
Webb said the amount of debt and equity looking for deals is tightening cap rates in many sectors, lowering the potential return on investment for acquisitions.
"The breadth of the cash that's out there to be invested globally, everyone has so much cash," Webb said. "So that's just supply and demand, it drives cap rates down and drives prices up ... and buyers seem willing to accept lower going-in returns."
Costello said investors are especially willing to accept lower returns in the multifamily and industrial, the sectors that have had the most demand driving up pricing. National price growth for apartments in May was up 10.1% year-over-year, the highest increase, followed by industrial at 9.5%, according to RCA.
"The apartment and industrial sectors tend to be a little bit more stable and have more predictable income flows," Costello said. "That is an element that they’re willing to accept that lower yield, plus the fact that they do see some growth opportunities ahead."
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