Navigating the Juxtaposition | Challenges and Opportunities in Today's Real Estate Market
The current market juxtaposition – with low vacancies and double-digit rent growth in certain sectors versus market volatility and reduced liquidity – creates a few challenges when it comes to determining the value of a real estate property in today’s rapidly shifting environment. In terms of property valuations, today’s market is feeling a bit like the gameshow, “The Price is Right.” With price discovery happening in real time, we are all determining our own estimates for what we think is “fair market value.”
Cap Rate Spreads vs. 10-Year Treasury Yield
Effective Rent Growth
What Role Have Interest Rates Played?
Due to the pace and quantum of recent U.S. interest rate hikes, real estate yields (i.e., “cap rates”) have failed to keep up with this expansion, resulting in narrow spreads over U.S. treasury yields. Will real estate spreads revert to their historical averages in the near term through an increase in cap rates? Or will sellers refuse to transact at higher yields (i.e., lower values), resulting in real estate maintaining narrow, or even negative, debt spreads?
This valuation uncertainty, in combination with a pullback in lending, has reduced liquidity in the U.S. real estate market. Further, overall increased borrowing costs and perceptions of value diminution have created pockets of distress within commercial real estate. While some owners who are facing upcoming debt maturities won’t have a choice other than to sell at higher cap rates, the current market uncertainty may lead to attractive buying opportunities.
Across real estate sectors, the highest levels of distress are observed in commodity office and shopping malls, with vacancies rising and rents flattening or even decreasing. Despite these challenges, fundamentals in other sectors such as multifamily, industrial, hotels, Class A office and necessity-based retail have widely remained strong, with continued demand and positive rent growth.
How is the Office Sector Faring?
When looking at the contrast within the commercial real estate sectors, office and industrial are on two different ends of the spectrum in terms of fundamentals and overall investor sentiment. Industrial has been a strong performer, supported by e-commerce tailwinds, while office has been challenged. There is no doubt that the pandemic has forever shifted the way we work, creating less overall demand for office; however, even within that sector, we are seeing a great amount of variance in performance based on the individual property type. Class A office continues to hold up much better than the dislocation we have seen in traditional commodity office. In contrast to older vintage office product, we have actually observed positive demand for Class A office space. The chart below shows that high-quality office product has seen positive net absorption, while older vintage commodity office has faced severe challenges with negative net absorption overall.
Net Absorption Since COVID-19 by Building Vintage
Industrial Outdoor Storage: The Next Big Thing?
A segment where we have seen an increased interest from private and institutional investors is the industrial outdoor storage (“IOS”) space. IOS is an industrial subsector that is a critical component of the supply chain for retailers and logistics operators. The sector benefits from similar structural demand drivers (e-commerce and onshoring) as traditional industrial; however, due to land scarcity and zoning, and entitlement challenges, limited new supply is coming online. This supply and demand imbalance in the U.S. IOS space has led rents to advance by nearly 30% on average since the end of 2019 and vacancy to fall to less than 3% in mid-2022.1 In addition, given the fragmented nature of current IOS ownership and the nascency of the sector from an institutional perspective, IOS assets can be acquired at capitalization rates (i.e., initial yields) that are typically 100bps to 250bps higher than traditional industrial assets. With the potential for strong income growth over the near-term and higher entry cap rates, will IOS be the next hot real estate subsector to which institutional capital will flock?
IOS vs. Industrial Vacancy
IOS Rent Trends
The current real estate market environment is unlike anything we have seen before; a gameshow-esque, true juxtaposition across sectors. We find it hard to paint any one sector with a broad brush, so we continue to monitor each sector closely as we believe dislocations may also bring great investment opportunities.
We cover more on this and other compelling areas within private infrastructure in our 2023 Real Assets Market Overview. Fill out the form below for an instant download of the deck.
2023 Real Assets Market Overview
This presentation has been prepared solely for informational purposes and contains confidential and proprietary information, the disclosure of which could be harmful to Hamilton Lane. Accordingly, the recipients of this presentation are requested to maintain the confidentiality of the information contained herein. This presentation may not be copied or distributed, in whole or in part, without the prior written consent of Hamilton Lane.
The information contained in this presentation may include forward-looking statements regarding returns, performance, opinions, the fund presented or its portfolio companies, or other events contained herein. Forward-looking statements include a number of risks, uncertainties and other factors beyond our control, or the control of the fund or the portfolio companies, which may result in material differences in actual results, performance or other expectations. The opinions, estimates and analyses reflect our current judgment, which may change in the future.
All opinions, estimates and forecasts of future performance or other events contained herein are based on information available to Hamilton Lane as of the date of this presentation and are subject to change. Past performance of the investments described herein is not indicative of future results. In addition, nothing contained herein shall be deemed to be a prediction of future performance. The information included in this presentation has not been reviewed or audited by independent public accountants. Certain information included herein has been obtained from sources that Hamilton Lane believes to be reliable, but the accuracy of such information cannot be guaranteed.
This presentation is not an offer to sell, or a solicitation of any offer to buy, any security or to enter into any agreement with Hamilton Lane or any of its affiliates. Any such offering will be made only at your request. We do not intend that any public offering will be made by us at any time with respect to any potential transaction discussed in this presentation. Any offering or potential transaction will be made pursuant to separate documentation negotiated between us, which will supersede entirely the information contained herein.
Certain of the performance results included herein do not reflect the deduction of any applicable advisory or management fees, since it is not possible to allocate such fees accurately in a vintage year presentation or in a composite measured at different points in time. A client’s rate of return will be reduced by any applicable advisory or management fees, carried interest and any expenses incurred. Hamilton Lane’s fees are described in Part 2 of our Form ADV, a copy of which is available upon request.
The following hypothetical example illustrates the effect of fees on earned returns for both separate accounts and fund-of-funds investment vehicles. The example is solely for illustration purposes and is not intended as a guarantee or prediction of the actual returns that would be earned by similar investment vehicles having comparable features. The example is as follows: The hypothetical separate account or fund-of-funds consisted of $100 million in commitments with a fee structure of 1.0% on committed capital during the first four years of the term of the investment and then declining by 10% per year thereafter for the 12-year life of the account. The commitments were made during the first three years in relatively equal increments and the assumption of returns was based on cash flow assumptions derived from a historical database of actual private equity cash flows. Hamilton Lane modeled the impact of fees on four different return streams over a 12-year time period. In these examples, the effect of the fees reduced returns by approximately 2%. This does not include performance fees, since the performance of the account would determine the effect such fees would have on returns. Expenses also vary based on the particular investment vehicle and, therefore, were not included in this hypothetical example. Both performance fees and expenses would further decrease the return.
Hamilton Lane (Germany) GmbH is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C. Hamilton Lane (Germany) GmbH is authorised and regulated by the Federal Financial Supervisory Authority (BaFin). In the European Economic Area this communication is directed solely at persons who would be classified as professional investors within the meaning of Directive 2011/61/EU (AIFMD). Its contents are not directed at, may not be suitable for and should not be relied upon by retail clients.
Hamilton Lane (UK) Limited is a wholly-owned subsidiary of Hamilton Lane Advisors, L.L.C. Hamilton Lane (UK) Limited is authorised and regulated by the Financial Conduct Authority (FCA). In the United Kingdom this communication is directed solely at persons who would be classified as a professional client or eligible counterparty under the FCA Handbook of Rules and Guidance. Its contents are not directed at, may not be suitable for and should not be relied upon by retail clients.
Hamilton Lane Advisors, L.L.C. is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 in respect of the financial services by operation of ASIC Class Order 03/1100: U.S. SEC regulated financial service providers. Hamilton Lane Advisors, L.L.C. is regulated by the SEC under U.S. laws, which differ from Australian laws.
Any tables, graphs or charts relating to past performance included in this presentation are intended only to illustrate the performance of the indices, composites, specific accounts or funds referred to for the historical periods shown. Such tables, graphs and charts are not intended to predict future performance and should not be used as the basis for an investment decision.
The information herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice, or investment recommendations. You should consult your accounting, legal, tax or other advisors about the matters discussed herein.
The calculations contained in this document are made by Hamilton Lane based on information provided by the general partner (e.g. cash flows and valuations), and have not been prepared, reviewed or approved by the general partners.
As of June 7, 2023