Joe Azelby, head of real estate and private markets, UBS Asset Management, believes the commercial real estate markets are making incremental steps toward recovery as more clarity emerges over the Federal Reserve’s outlook on interest rates and price discovery starts to take hold.
“Real estate as an asset class follows the broader capital markets. We were obviously following the stock and bond markets down over the past year, and it usually takes us a year to adjust even as they recover,” Azelby says. “Interest rates seem to be leveling off and inflation is better behaved than it was. In a way, we are seeing this all happening as we speak. The question remains if things will stay on a positive track.”
There has been a slight thawing of the transaction market, which has allowed price discovery to start. The real estate appraisal markets, however, can take a long time to move prices directionally even as transaction volume picks up, Azelby adds.
“Until now, the bid-ask spread on most real estate transactions is quite wide where sellers are longing for yesterday’s prices and buyers want tomorrow’s prices. The appraisal community watches that activity closely and uses and incorporates those data points into real estate values,” Azelby says.
What has been going on in the public equity and debt markets has had a significant impact on the private markets, with Azelby noting stock market declines have caused portfolios to fall out of balance.
“Institutional capital has been the dominant source of real estate investing and it is actually a good time for pockets of capital to get busy. Institutions struggling with the denominator effect, whereby the market decline in stock and bond prices has backed portfolios into an overallocation to real estate and perhaps other private market positions. It is an interesting position for wealth management and for other sources of capital that are underinvested or beholden to a specific allocation,” he adds.
Generally speaking, there is less capital in the market than there was a year ago and investors are in some cases seeking redemptions from open-end commingled funds.
“The current rally in the equity markets, if it persists, will alleviate some of the denominator effect but we certainly felt that in the second half of last year in a big way. But we have seen in the past that flows can change on a dime and they sometimes do,” he adds.
Return to normalcy
Like many of his peers, Azelby does not see a return to activity until later in the year. “The markets are going to be relatively quiet until at least the end of the first quarter and I suspect there will be more activity in the second quarter and beyond,” Azelby says. “I suspect we will see normalcy over the course of the year, whatever that means in this cycle.”
While there is growing interest in debt as an investment, Azelby noted the equity and the debt sides of the business remain distinct.
“You would think that there would be huge synergies between an equity and debt platform and [we] haven’t really seen that,” he says. “We have seen highly successful real estate debt shops grow up and develop but I’ve always been surprised at how few synergies there are. People have great success on the debt side and others have great success on the equity side.”
From where Azelby sits, it is better to own an asset and participate in its growth. “If you’re doing high yield debt, then that capital has a lot of velocity.When you lend some money at a high interest rate, it tends to come back home very, very quickly, and you’ve got to create another opportunity to redeploy that capital. So people do it but I do think that it’s a highly specialized, high turnover business that people have adapted to,” he adds.
One factor that will become important across markets is ESG.
“European investors are highly focused on it. US investors are getting more focused on it. I would say Asia is somewhere in between overall but varies significantly between countries,” he says.
“We’re seeing a convergence of asset classes because decarbonization requires an orchestra of sustainable activities in order to achieve goals. It’s almost like ESG is forcing the convergence of real estate, infrastructure [and] private equity, because these are multi-dimensional solutions that require input from many different traditionally separate pockets of expertise.”
While the sentiment in the market may be marginally better than it was at the start of the year, the situation is evolving and nuanced.
“The current trouble we are seeing now didn’t start when Russia invaded Ukraine, that just shone a brighter light on issues like interest rates, inflation, supply chain problems and underemployment,” he says. “All the signals are saying, ‘Things are going to get better.’ We will see if it’s sustainable.”