Investors Withdrawing $20 Billion From Core Real Estate Funds

Some of the biggest investors in US commercial real estate are looking to sell before property values slide further.

A group of property funds for institutional investors ended last year with a record $20 billion in withdrawal requests, according to IDR Investment Management. The firm's index of open-end diversified core equity funds showed the largest waiting line for redemptions since the Great Recession.

John Murray, head of global private commercial real estate at Pacific Investment Management Co., said in an interview that it's like the nightclub where everybody lines up to get in and then lines up to leave when it closes.

Some institutional investors are looking to reduce their exposure to some of the largest funds at firms like JPMorgan Chase & Co., Morgan Stanley, and Prudential Financial Inc., according to sources familiar with the matter who spoke on condition of anonymity.

As of the third quarter of 2022, the UBS Trumbull Property Fund had a queue of $7.2 billion for withdrawals, representing 40% of its value, according to a December presentation by Callan, a pension consultant.

The pressure on institutional fund managers is increasing as capital outflows increase and interest rates rise. This is especially hard on the commercial real estate market. At the same time, managers such as Blackstone Inc. are seeing retail investors pull their money out of real estate investments due to the volatile markets.

In December, Blackstone made a big push into retail with its Blackstone Real Estate Income Trust. This trust limited how much money investors could withdraw each quarter. In contrast, the ODCE funds (pronounced like "odyssey") do not have any quarterly limits on withdrawals.

Commercial property prices fell 13% last year, according to an index by Green Street. A Bloomberg gauge of publicly traded real estate investment trusts tumbled 29%.

But funds from the Office of the Director of Corporate Enforcement (ODCE) move more slowly, valuing properties based on comparable sales. However, with few sellers willing or forced to take a loss recently, comparable sales have become scarce. That's why the ODCE index posted a 7.5% gain for all of 2022, according to preliminary data released Jan. 13 by the National Council of Real Estate Investment Fiduciaries. The first sign of a pullback came in the fourth quarter, when the index dropped 5%.

Cathy Marcus, global chief operating officer and head of US equity at Prudential’s PGIM real estate, which manages $204 billion in property globally, including the oldest ODCE fund, believes that the potential valuation decline from the coronavirus pandemic will not be severe.

“Do the math,” said Marcus. “This is not calculus. We’re going to end up with some valuation decline, but it’s not going to be earth shattering.”

Capital outflows are both a symptom and a cause of problems ahead for commercial real estate. As capital leaves the sector, investment and development activity is likely to slow, leading to further outflows. This vicious cycle could put significant downward pressure on prices and exacerbate the sector's problems.

Many core funds are selling their most liquid assets, like industrial and multifamily assets, in response to redemptions. This is likely to create headwinds for even the most relatively resilient sectors of commercial real estate, Murray wrote in a December note.

The denominator effect is one reason why institutional investors are queuing up to exit the market. Investment managers often have targets for how much they want to have invested in stocks, bonds, real estate and other assets. However, as markets slumped last year, their stock and bond holdings shrank in size while real estate held up better. This often meant that real estate constituted a bigger slice of their portfolios than they initially intended.

According to a survey by Hodes Weill & Associates and Cornell University’s Baker Program in Real Estate, about 32% of institutional investors with $11 trillion in total assets considered their portfolio overallocated to real estate in 2022, up from 8.7% in 2021.

"Real estate values have appreciated to the point where some investors are looking to take profits off the table," said Marcus from PGIM.

Many investors are reducing their exposure to ODCE funds, but they are not abandoning their stakes entirely. According to Garrett Zdolshek, chief investment officer of IDR Investments, which manages about $5 billion, the exit line may be inflated by investors who assume they will only receive a fraction of their request. IDR runs a fund tracking the $350 billion of gross assets in the NCREIF Open-End Diversified Core Equity Index.

The outflow of investors can quickly turn into a waiting line for those wanting to get back in, as happened briefly in 2020 and more dramatically after the 2008 global financial crisis when stocks recovered and the investing pie grew.

"In 2009, we saw a 15% redemption queue, which reversed to a 14% entrance queue at the end of 2010," Zdolshek said.

The ODCE funds are still outperforming the broader stock market, due to the lag in revaluing assets. According to Callan, the PGIM Prisa fund had a total return of 19% in the 12 months through September, when the S&P 500 posted a 15% loss. Other returns during that period include 21% for the Morgan Stanley Prime Property Fund, 19% for Invesco Core Real Estate USA, 18% for the JPMorgan Strategic Property Fund and almost 17% for the UBS Trumbull fund.

The UBS fund paid out $1.85 billion to clients who requested redemptions last year, according to Callan. This fund has seen an increase in redemption requests in recent months, likely due to the pandemic.

The representatives for PGIM, Morgan Stanley, JPMorgan, Invesco, and UBS refused to give any comments regarding the performance or redemptions of their respective funds.

The ODCE funds have historically been less volatile than REITs, but their slower reaction to revaluing assets may now make them susceptible to an arbitrage trade as public REITs appear to have more upside.

According to Morgan Stanley research analyst Tony Charles, investors are taking advantage of the arbitrage opportunity between public and private markets, and funds in need of liquidity. Charles wrote about this in a December note.