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Real Estate

Preqin Special Report: The Future of Alternatives in 2027

In this article

Written by Dave Lowery

October 5, 2022

Headwinds threaten real estate growth 

Investors are pessimistic on the short-term outlook for real estate, as reflected in our new AUM forecasts
While our forecasts are forward-looking, it is important to frame them in the context of what’s happening now. And for real estate markets, uncertainty has become pervasive and 2022 has proven far more turbulent than many expected. We are at the start of what could be a relatively lengthy adjustment – as the previous cycle is well and truly at an end.

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With inflation at, or close to, record levels as we compile this research (September 2022), policymakers have been responding. The Federal Reserve and other central banks around the world have been tightening policy by reining in the excess liquidity they had provided in previous years, and in response to pandemic shocks. Central bankers and policymakers have to tread a fine line, given the scale of debt around the world. Will they prioritize the fight against inflation over the need for growth? Right now, the fight against inflation is taking priority.

Weaker short-term outlook

Real estate was among the worst-hit asset classes during the pandemic and the subsequent recovery. It took several quarters for activity to recover to anything like previous levels. But in another setback, it is looking likely that rising rates could put a halt to that short-lived recovery.

How 2022 is shaping the short-term outlook:

• The negative effects of rising rates are evident in our data. Fundraising markets have weakened significantly.
• Investors generally have shunned higher-risk strategies during 2022, in contrast with the end of 2021, when there was more optimism for the future as economies returned to some level of normality after the pandemic.
• That said, investors do not seem to be universally targeting lower-risk strategies, with fundraising for core strategies weakening over the first half of 2022. Core assets often command premium valuations and can trade at a narrow spread to 10-year government bonds. If the yield on the reference bond increases significantly, the impact on valuations and demand is likely to be negative.
• Office deal activity has yet to recover, with another weak quarter reflecting the ongoing structural issues facing office owners and occupiers. Other sectors are facing increased pressure too, such as retail, which is exposed to consumers with less disposable income as prices rise faster than wages.

Rate rise effects

Rising rates are already causing activity to slow down, with the longer-term effects yet to feed through. The US 10-year yield has broken through the 3% mark five times in 2022[1] but failed to hold above this level. In other key countries for real estate investors, such as the UK and Germany, 10-year yields also remain elevated. These are important economies for real estate markets, and transaction underwriters in them are using the respective 10-year sovereign bond yields as a pricing reference. Yields move inversely to price, so if the reference yield increases, then real estate yields will also increase, leading to price falls.

Rising rates also increase the cost of debt used to finance real estate acquisitions. Given the leverage across some individual deals, many could become too expensive either to buy or to refinance. This will apply further pressure both to valuations and deal activity.

Cyclical shifts in strategy

As the cycle evolves in real estate markets and returns on higher quality assets become harder to generate, many investors move up the risk curve to drive returns. This can mean buying poorer quality (secondary) assets, either physically or outside key submarkets. While this can benefit investors through a higher net initial yield, if the market weakens then the value of these assets is likely to fall faster, and by a greater magnitude than good quality (prime) assets, undermining longer-term returns. Sectors which had looked attractive to investors are also suffering in the current market. Many managers have increased their exposure to residential markets in recent years, driven by solid house price growth in many countries. For residential markets, negative real rates drove higher prices. But rising rates are having an impact here too. The 30-year mortgage rate in the US has doubled[2] since September 2021, rising to 5.2% in August 2022. There has been little movement in delinquency rates[3] yet but this will be watched closely, particularly by those who recently entered the residential market.

Real estate was among the hardest hit of all asset classes by the pandemic. But the outlook had begun to brighten. Unfortunately, this is no longer the case. Despite some real estate assets offering some protection against the effects of inflation, if prices are weakening, investors are likely to stay away. This broader context is important, given the weakening outlook at the start of our new forecast horizon.

Real estate forecasts in context

While AUM growth in some asset classes looks set to significantly decelerate, real estate could be relatively well protected. AUM hit $1.3tn at the end of 2021 and is expected to increase by a CAGR of 8.4% between the end of 2021 and the end of 2027, to reach $2.1tn (Fig. 5.1). This slowdown from the 9.4% annual AUM growth between 2015 and 2021 reflects the changing market conditions. Preqin forecasts suggest that annual performance across the global asset class will be relatively flat at 9.2% per year throughout the forecast horizon, compared with the 2015 to 2021 period when it was 9.5% (Fig. 5.6). Some within the asset class may question the ability to deliver these returns when borrowing costs are rising and valuations are falling, but weakness early in the forecast horizon could provide opportunities for solid returns into the medium term as the cycle evolves.

Value added strategies are forecast to outperform opportunistic on a global level (9.2% per year, compared with 8.1%, Fig. 5.6). Forecast AUM growth reflects this, with opportunistic strategies set to grow by 5.9% per year, compared with 7.6% per year for value added strategies (Fig. 5.2). In comparison, 'Other' strategies should perform best, with annual returns of 11.0%. This bucket contains core and core plus strategies, among others, for which, while they are exposed to rising yields, a floor to valuations could emerge as investors and managers focus on quality. Clearly, the short-term weakening outlook is likely to hit the higher-risk strategies harder than those towards the lower end of the risk spectrum.

Little change expected for North American real estate

Real estate AUM in North America is forecast to hit $1.3tn in 2027, up from $777bn at the end of 2021 – growth of 9.1% per year (Fig. 5.1). This represents a slight slowdown from the 9.8% compound annual growth between the end of 2015 and 2021, and can be considered a positive outcome given the challenges the market is facing. Arguably, the US (which dominates the North America region) is furthest along in its macro cycle (as is often the case), so while significant short-term uncertainty still persists around the path, and magnitude, of interest rate increases, when rates do begin to fall, it’s likely to happen in the US first.
Still, as uncertainty remains, this real estate cycle has some time to run until it becomes established. Looking further back to between the end of 2010 and the end of 2015, North American real estate AUM growth reached 14.4% per year. Before this period, we saw large-scale falls in asset valuations, and the resulting recovery was a period of what could be described as excess returns. Quality assets were in demand, and this could be the case in future – although with so much uncertainty and the fact that we appear to be at the start of a correction, these excess returns could come either toward the end of, or after, our forecast horizon.

The strategy composition of the forecast AUM growth suggests a similar pattern will play out over the next few years. Higher-risk strategies are likely to be hit hard in North America, with opportunistic AUM growth expected to fall to 5.1% per year – down from 7.2% between 2015 and 2021 (Fig. 5.3). Value added is expected to grow slightly faster, at an annual rate of 7.1%, while “Other” strategies are forecast to grow by 14.1% per year. This should reflect demand for core assets as the repricing cycle evolves, but also potential demand for real estate debt funds. Many investors still need security of income or lower-risk exposure to the North American market, and the asset-backed nature of core and debt strategies in real estate is where they are likely to find it.

Europe the laggard

In a reversal of previous fortunes, Europe looks set to lag behind other regions over the forecast horizon. After seeing AUM grow from $188bn in 2015 to $341bn at the end of 2021 (Fig. 5.4), Europe led the way for AUM growth (10.4% per year, compared with 9.8% in North America, and 6.7% in APAC). This is likely because the interest rate outlook for Europe was for low or negative rates for longer than other regions, boosting both valuations and demand for assets. But the interest rate outlook has shifted due to record inflation across the continent, mainly as a result of higher energy prices following the Russian invasion of Ukraine. Previous forecasts for lower rates have been torn up, with forecasts now far higher than in the past. There has been a significant increase in the German 10-year Bund yield, and even greater increases in its counterparts across Southern Europe – particularly Italy.
The low (negative) rates over recent years acted as a significant boost to valuations. With assets often priced against a reference 10-year bond yield, while they were low there was ample reason to invest in real estate. But the spike in 10-year bond yields means hits to valuations are expected for some European assets, particularly prime assets. This all feeds into weaker AUM growth over the forecast horizon. European real estate AUM is forecast to rise from $341bn at the end of 2021 to $506bn at the end of 2027 (Fig. 5.4), which equals annual growth of 6.8%.
The European private equity real estate market is structured differently to that of North America, with dominant strategies being value added and core. Delving deeper into our forecasts shows value added as the strategy with the strongest AUM growth: 8.2% over the forecast horizon, compared with 9.4% between 2015 and 2021. 'Other' strategies look set to experience a slightly tougher market over the next few years, for reasons we partly describe above. Annual AUM growth for this category is forecast to slow from 12.4% to 7.2%. Performance is forecast to stay largely the same, at >10% per year. Opportunistic strategies in Europe fare even worse, with AUM growth of 4.6% expected between the end of 2021 and end of 2027.

The European market is set to be challenging for real estate managers, and in such a market, experience and disciplined underwriting will be vital to the successful delivery of returns – regardless of the strategy being targeted.

APAC growth continues – from a low base

Whereas the European market is set to face challenges and for growth to slow, APAC is expected to see an acceleration in AUM growth over the forecast horizon. During the 2015 to 2021 period, APAC AUM growth reached a CAGR of 6.7%. Preqin forecasts suggest this should increase to a CAGR of 9.7% between the end of 2021 and end of 2027, with AUM rising from $168bn to $293bn (Fig. 5.5). Performance is expected to weaken for opportunistic strategies. During the 2015 to 2021 period, opportunistic funds delivered an annual return of 10.6%, while Preqin forecasts suggest this will fall to 8.6% between 2021 and 2027 (Fig. 5.7). Both value added and 'other' strategies should see performance increase from 7.4% and 9.8%, to 8.3% and 10.6%, respectively.
 Within the APAC region, many differing headwinds and drivers are evident. In China, the real estate market is in a state of flux. Rising defaults on US dollar-denominated debt are adding pressure to overseas investment in China’s domestic market. It has been a difficult market for overseas investors to enter at scale, and the current market instability is likely to deter further foreign activity. 

Meanwhile, significant falls in the USD/JPY exchange rate are making the Japanese market more attractive to US dollar-denominated investors. Put simply, a 20% exchange rate ‘discount’, if unwound over a period of 10 years, could, in theory, lead to 200bps of annual performance gains. It’s unlikely to be as simple as this, but the scale of the devaluation could lead to far more activity in Japan. As we saw in our recent investor survey, interest is rising in Japanese real estate.

Uncertain short-term outlook for real estate

Clearly, the global real estate market is subject to many headwinds. This is not lost on investors. In our most recent survey, 41% of respondents suggested that performance will worsen over the next 12 months, compared with the last 12 months. Only private equity and venture capital investors had a more pessimistic outlook. In addition to immediate interest rate changes, structural issues add to the uncertainty.

Will offices return to pre-pandemic levels of occupancy? Doubtful, given current views.
Will retailers face further margin pressure, weakening the outlook for retail assets, which had started to recover? A real possibility.
Will rising mortgage rates dampen house purchase activity, leading to additional rent growth in the private rented sector? Also possible, exacerbating existing issues.

We are in the early stages of the adjustment process. Additional volatility and uncertainty may lie ahead. But there are also some opportunities, and those managers who have been through previous cycles and navigated them with success should be well-placed to benefit. The real estate asset class may not be expected to grow as fast as others within private capital markets, but that does not mean there are no opportunities.