William Pattison, head of the real estate research and strategy team within the risk, research and analytics group at MetLife Investment Management.
Historically, commercial real estate has had some of the strongest risk-adjusted returns of all the major institutional investment asset classes, based on a MetLife Investment Management analysis of returns in recent decades. Right now, we are coming off a period of high inflation, which has historically been when real estate returns are stronger, says William Pattison, head of the real estate research and strategy team within the risk, research and analytics group of MIM. Chief Investment Officer spoke with Pattison about the factors creating opportunities for institutional investors in real estate.
CIO: How have rising interest rates and inflation affected the real estate investment outlook?
Pattison: Real asset sectors such as commercial real estate benefit from high inflation. But the reason they benefit is not well understood, in my opinion. And it’s potentially especially confusing today, given that commercial real estate prices have been declining during the high inflationary period of [this] past year.
To explain, the reason inflation benefits real estate is because it increases construction costs, which in turn causes the supply-and-demand balance of real estate to favor investors. So, during 2022 and 2023, when inflation and construction costs were rising, new project starts began declining. Since commercial real estate projects typically take three or four years to get the land entitled and build the building, real estate investors may not start benefiting from the high inflation of 2022 and 2023 until around 2025. In the meantime, the rising interest-rate environment has been causing property price declines.
CIO: Have rising insurance costs affected real estate investing?
Pattison: Yes, property insurance costs have gone up materially over the past three years, and especially in the past year. That’s been partially related to higher natural disaster frequency, but equally important have been the high inflation and rising labor costs that are causing property repair costs to grow.
One important factor to keep in mind is that insurance costs affect real estate investment returns, which can vary materially by property type. Investors in property types such as apartments, hotels and self-storage directly realize property insurance costs. This contrasts with office, industrial, retail and other property types where leases typically pass insurance cost increases on to tenants.
CIO: Which real estate investment sectors look most promising over the short term? Over the long term?
Pattison: In the short term, infill warehouses[—i.e., warehouse assets located in dense urban areas—]continue to look the most promising. I’ve been saying that for about 10 years, so feel a bit like a broken record, but I believe that is the segment that has the greatest demand tailwinds, and asset pricing remains attractive.
Those tailwinds are coming from consumers buying more goods online, and, equally as important, those goods are getting delivered faster. Companies such as Amazon need a lot more warehouse space to deliver the same number of goods in one day as they did 20 years ago, when most of their deliveries sold under the banner of “7-to-10-day super-saver shipping.” Within the next 10 years, we believe that most goods ordered online will be delivered on the same day, and there is not nearly enough infill warehouse space to meet that need today.
Outside of warehouses, single-family rentals are likely to benefit from the demographic picture in the U.S. We expect that the Millennial generation will be effectively aging out of apartments through the remainder of the decade, and they often don’t have the down payment necessary to purchase a single-family home. As a result, I believe demand for single family rentals is likely to rise into the 2030s.
CIO: What economic factors will have the biggest influence on real estate investment performance in the next 12 to 18 months?
Pattison: Many traditional commercial real estate investors stopped making new allocations in 2021 and 2022 because of what is known as the denominator effect. Essentially what happened was commercial real estate prices appreciated faster than the stock and bond markets, and that left many investors overallocated to real estate.
That denominator effect is decreasing, as real estate prices have been falling in 2023, and many investors who were on the sidelines are now starting to consider new allocations. I think transaction volume is likely to remain low over the next several quarters, but a couple of capital market leading indicators suggest transaction volume will be growing over the next year.
CIO: Are certain geographies performing better than others?
Pattison: Most investors categorize growth markets, such as Dallas, Phoenix or Nashville, and slow-growth markets, such as Chicago and New York. Growth markets have been outperforming for the past decade—and that’s where we’ve been most active with new investments—although starting about a year ago, we began to be more cautious with apartment investments in most growth markets due to the construction pipelines. It’s still too soon to say if we were correct in that strategy shift.
One other geographic factor that I think is often overlooked is the outperformance of smaller markets in recent decades, and especially during the peak pandemic years. Core investors who have the lowest cost of capital available generally want assets that are above $50 million, which leaves them looking only in the largest 20 or 30 metropolitan statistical areas. This has historically contributed to slightly better investment returns in smaller, tertiary markets.
CIO: What challenges are institutional investors facing with real estate investments right now?
Pattison: Liquidity is certainly a challenge today. Banks have pulled back from lending or underwriting new commercial mortgages, and transaction volume is materially down this year compared with averages over the past decade. That makes creating accurate mark-to-markets difficult for managers and real estate appraisers.Within the office sector, it’s still unclear exactly how work-from-home will play out, though forecast ranges from our team are much tighter today than they were even just a year ago. Our view is that national average vacancy rates will be rising through the end of 2024 before beginning to recover.
CIO: What factors should institutional investors consider when investing in real estate?
Pattison: There are many, but one important factor is diversification within a real estate portfolio.
As an example, assets in Houston are correlated with assets in Denver because both of those markets are sensitive to energy prices. Diversification also includes consideration of property types, and I think some level of allocation to even the out-of-favor segments such as office is appropriate. I don’t think a zero percent allocation to office is appropriate, just as a 100% allocation to infill warehouses would not be appropriate.
One other factor ties back to the inflation concept we talked about earlier. Over time, the price of a building generally converges on the cost to build the building. When prices get above this level, new construction grows, and there is a self-correcting mechanism to bring prices back. With the sharp rise in interest rates over the past two years, most assets can now be purchased for less than the cost to build, and I think that will be creating attractive entry points for investors over the next year or two.
