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Institutional investors have trimmed target allocations to real estate for the first time in 13 years as they unload property fund stakes at steep discounts.
A survey of 166 institutional investors, ranging from pension funds to university endowments, released by Cornell University and capital advisory firm Hodes Weill & Associates found target allocation for the asset class dropped to 10.7 per cent this year, the first decline since the study began in 2013.
A previous survey by financial advisory group Campbell Lutyens found that institutional investors sold real estate fund stakes at an average discount of 34 per cent to net asset value in the first half of this year, up from 19 per cent a year earlier.
The retreat and widening discounts in the secondary market come as sluggish property transactions and high interest rates weigh on cash flows from real estate portfolios, leaving the sector among the worst-performing asset classes for institutional investors.
“Institutions are not abandoning their allocation to real estate,” said Doug Weill, co-managing partner of advisory firm Hodes Weill, at a webinar on Tuesday, “but there is clearly a little bit of a pullback”.
While real estate has historically served as a stable source of income and a hedge against inflation in institutional portfolios, the asset class has in recent years struggled with muted deal activity, softening valuations and higher office vacancy rates.
The higher for longer interest rate environment has damped residential and commercial property sales, while remote and hybrid working has driven office vacancies to record highs, squeezing deal activity and rental income.
Grant Walker, managing director for real estate at the $200bn Teacher Retirement System of Texas, which has 14 per cent of its portfolio in the asset class, told a board meeting last month that the fund’s property holdings lost 2.6 per cent in the second quarter — a big drag on overall returns — as the sector “continues to be challenged by higher interest rates and lower valuations”.
The Hodes Weill study found that respondents gained 1.4 per cent on their real estate investments last year after losing 1.4 per cent in 2023, well below their target return of 8.4 per cent. Two-fifths of respondents said they were under-allocated to the sector relative to their targets this year.
Real estate funds have been struggling to generate the cash flow needed to pay investors. Their distribution rate — cash returned to investors as a share of assets — has steadily declined over the past decade, reaching a record low of 6.6 per cent in the second quarter of this year, according to MSCI.
“The bottom line is [that] closed real estate fund distributions are at a 10-year low,” said Jamie Sunday, co-head of real estate secondaries at Ares Management. “That is creating pressure across a whole host of investor types.”
With little hope of a quick turnaround, institutional investors have been tapping the secondary market to raise liquidity for new investments. An executive at a university endowment, who spoke on condition of anonymity to discuss a private transaction, said the fund sold real estate stakes this year and redeployed the capital into data centres.
“There is a big need to rebalance our portfolio and create liquidity,” the person said.
A significant obstacle for asset managers looking to sell real estate stakes on the secondary market is the widening discount they must accept.
Asset managers said they agreed to steep price cuts amid fading confidence in a near-term market rebound, particularly in the office sector, which has been hit hardest by the downturn.
“The market is telling me that these values are not coming back in the short term,” said an executive at a public pension plan that sold real estate stakes at a “significant” discount this year, who did not want to be publicly identified discussing a loss for the fund. “It’s time to cut my losses and exit the investment as quickly as I can.”
Sunday of Ares said a growing number of limited partners were “getting comfortable with the higher pricing discounts as an increasing number of investors are transacting in the secondary market”.