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Late-Cycle Investing Through Private Real Estate

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Qualifying Real Estate Investment Strategies1

The short and long view

Across assets, the investment horizon looks cloudy. Economies have been recovering for an unprecedented amount of time and the U.S. economy is showing signs of a mature business cycle, the Fed is raising interest rates and many assets, including real estate, exhibit stretched valuations where the only support is coming from low bond yields. Real estate as an asset class is not immune from these challenges, and this can be seen from near-term return expectations being revised lower, and real estate not being expected to emulate its performance in recent years. That being said, we continue to see fundamental tailwinds supporting resilient real estate values across many core markets5.

In general, we believe the supply and demand balance remains healthy, and leverage levels remain controlled relative to the previous cycle6. In fact, we have seen many investors stay committed because of their focus on enduring characteristics of real estate as a portfolio diversifier and a historically reliable source of income (as shown by bar chart insert).

Notably for non-profit investors with perpetual asset pools that aim to maintain purchasing power, real estate values have historically exhibited significant, positive correlation to inflation7. With its role as a partial inflation hedge and its long-term growth prospects, we continue to see non-profit investors actively evaluating how best to place new capital or recycle existing capital in the asset class to benefit from near-term dynamics.

Many investors stay committed because of their focus on enduring characteristics of real estate.

Current Real Estate Opportunities

For portfolios with an established core real estate allocation and the appropriate risk appetite, we continue to see attractive non-core opportunities across developed markets with a focus on managing downside risk. The liquidity risk premium also continues to exhibit value relative to public markets; therefore, implementation via closed-end funds or other long-term lock-up structures remains appealing to allow flexible deployment of capital. For investors that prefer lower leverage and quarterly liquidity features offered by core strategies, core-plus strategies tend to have greater value-add potential.

These strategies generally provide managers greater flexibility to enhance total return, such as through asset renovations and other capital expenditure programs, and/or to utilize slightly higher but still reasonable leverage levels of 40%-50% LTV (loan-to-value) relative to traditional core strategies. In addition to equity investments, commercial real estate debt has seen growing demand, benefiting from structural dislocations created by bank lending retrenchment to comply with Basel III and Dodd-Frank regulations.

While debt strategies exhibit lower return expectations than equity relative to marketable debt, we believe they present a compelling and growing opportunity set for investors with the appropriate liquidity risk budget. For portfolios with an established equity-based real estate benchmark, the incorporation of debt would require a benchmark adjustment, or a review of the role private debt broadly plays in the total portfolio and where to best place a strategic allocation that includes real estate debt.

While debt strategies exhibit lower return expectations than equity relative to marketable debt, we believe they present a compelling and growing opportunity set for investors with the appropriate liquidity risk budget.

Aon Capabilities

With the recent acquisition of The Townsend Group, a global real estate investment firm, Aon continues to expand our real estate investment expertise and resources globally. We welcome you to engage with us to learn how we have been partnering with managers on asset repositioning, driving operational performance and acquiring assets at discounts from market pricing, as well as negotiating favorable deal terms, fee economics and structures.

1 Real estate as discussed in this article refers to commercial property assets that generally offer both income and capital appreciation return components, accessed through various investment vehicles, such as commingled open-end funds, secondary funds, co-investments, and other closed-end fund structures.
2 5.5% is AHIC’s 10-year capital market assumption for core real estate, 1Q2018; actual realized return depends on how the strategy is implemented.
3 6.4% is AHIC’s 10-year capital market assumption for non-core real estate, 1Q2018; actual realized return depends on how the strategy is implemented. Based on rental yield plus real rental growth, adjusted for management costs and inflation.
4 Relative to core strategies; some non-core assets may generate core-like higher current income.
5 “Impact of Rising Interest Rate Environment on Real Estate Values,” February 22, 2018, Aon Retirement and Investment Blog.
6 Nearly $900 billion has been returned to institutions from fund investments since 2013; 84% of investors surveyed expect to commit the same, or more, capital to real estate in the next 12 months; source: Preqin Investor Outlook Alternative Assets, H1 2018.

7 Real estate as proxied by the NCREIF Property Index, inflation as proxied by CPI (Consumer Price Index), as of 12/31/2017. The NCREIF Property Index (NPI) is a quarterly, unleveraged composite total return for private commercial real estate properties held for investment purposes only.

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