Dry powder for investment

Funds of scale and with higher-yielding strategies will have the advantage

As confidence in real estate markets has wavered, so too has capital raising for real estate funds.

During the first nine months of 2023, $108 billion of real estate capital was raised globally in closed-end real estate funds, 18% below the first nine-months average of the prior five years. The third quarter saw the lowest volume of capital raised in over a decade amid the more difficult market environment.

At the same time, substantial liquidity remains on the side-lines. Dry powder for commercial real estate totalled $402 billion as of October 2023. The question for investors is how and where that pent-up demand will enter the market.

Some capital is already being deployed into higher-yielding strategies, having been accumulated during the previous cycle. Private credit funds, for example, have been especially active in the past 18 months. As of October, 14% of dry powder globally was targeted at debt strategies, down from as much as 21% in 2018.*

This marks a shift from the previous 18 months, when investors had largely been targeting commercial real estate’s lower-risk investments: core and core-plus opportunities. From 2022 onwards, core capital was drawn down as investors focused on more risk-sensitive strategies and benefited from the low-rate environment. But as risk and return expectations shift, investors have become increasingly demanding of higher returns, with risk-free rates rising, in order to compete with fixed income yields. Core capital will, in our view, have to be increasingly creative to compete in an asset class that now demands higher returns.

Here are a handful of the biggest implications for the real estate cycle in the coming months:

1. Higher-yielding strategies will deploy first

Real estate is entering a new normal of higher risk-free rates, which are likely to be in the range of 150-250 basis points above the lows of the pre-2022 cycle, depending on sector and geography. Real estate capital deployment will focus on strategies offering returns that are competitive against the higher cost of capital. This will trigger an increased focus on capital deployment in value add and opportunistic strategies over core and core-plus in the near-term, while favouring strategies that provide opportunities for active asset management to enhance returns.

2. First movers have the advantage

In markets where capital values appear to be bottoming out, higher return requirements will drive capital deployment sooner rather than later. We expect to see this in select growth markets in early 2024. Given the quantum of dry powder, there will be considerable first mover advantage for funds that can deploy efficiently. This will be particularly evident for asset classes and geographies where rental growth forecasts can be underwritten with the greatest confidence. Capital value growth in the medium term is likely to be underestimated, and capital will crowd into strategies where income growth can be confidently underwritten.

3. Interest rates will dictate the pace of dry powder deployment

The interest rate cycle has historically been led by the Federal Reserve, with the European Central Bank lagging between six and 12 months. This cycle is no different. In anticipation of this, capital is already moving to US-focused strategies. Capital deployed to US-focused, closed-end real estate strategies already accelerated 6% year-over-year in 2022 compared to Asia Pacific, where deployment grew just 0.5%. In EMEA, capital deployment fell 7%. And according to Cornell’s 2023 Allocations Monitor Survey, the US remains the preferred destination for capital allocations in 2024; 91% and 71% of institutional investors in Asia-Pacific and EMEA, respectively, expect to allocate capital to North America-focused strategies.

4. Investors will look across the capital stack to debt and hybrid structures

Real estate investors will not only emphasize higher-yielding equity strategies, but also on debt or hybrid structures such as mezzanine or preferred equity positions. The deployment of capital into debt strategies is nuanced across geographies. Since the end of 2021, European debt dry powder has fallen 46% from $17 billion to $9 billion, whereas North American debt dry powder has fallen 22% from $53 billion to $41 billion.

5. Activity will be concentrated around investors with more capital

Investors with larger pools of capital are better positioned to weather future risk and will benefit from their flexibility to deploy across regions and sectors, with allocations being determined by return opportunities. Conversely, investors with limited liquidity will find it hard to deploy capital and may be forced to accept lower yields in an increasingly competitive environment once the market recovers. The interplay between capital raised for real estate and how capital is deployed will remain a crucial question in the coming months.