Q&A with PERE: An attractive vintage for core and core-plus investing

With return generation now less dependent on market momentum and more focused on selectivity, this dynamic has created an unusually attractive investment vintage for well-capitalized investors, with today’s market offering opportunities to generate alpha through disciplined asset selection, operational expertise and creative deal structuring, even as liquidity constraints and a limited buyer pool continue to extend what could become a compelling vintage for investors. 

What characteristics make the current environment an unusually attractive vintage for core real estate investing?

Marc Feliciano: This phase of the cycle may be slightly different for several reasons. Today, we're seeing the compelling opportunities for a core to core-plus risk strategy because this current environment is a function of the higher rate environment. This has created a longer period of muted returns relative to what you might expect following a typical downturn or contraction.

“Owners and sellers, including those of high-quality core and core-plus investments, are seeking differentiated paths to liquidity.”

This has impacted both the operating cycle – meaning we see a pullback in demand – but also a pullback in the capital market cycle, as evidenced by the total returns of the last three years or so. What makes it interesting is the challenge of generating higher returns when unlevered underwriting is around seven per cent. This challenge can create opportunities for managers who can assess and translate this market dislocation into well-structured investment opportunities, like we’ve been implementing in our core and core-plus strategies in North America.

Coming out of the global financial crisis, we were basically near a zero interest rate policy. The current rate policy is much higher than what many investors have been used to operating in, particularly in the past 15 years or so. It's taken a while for the market to adjust, and that, compounded by supply-related imbalances in industrial and residential, is probably one of the biggest reasons that returns are still muted.

What makes today’s market attractive is the lingering opportunity for enhanced yields for managers that can provide liquidity and deliver differentiated deal structure to ensure that these investments are appropriately de-risked. In short, this cycle is not defined merely by uncertainty but by a fundamental repricing of risk and opportunity across commercial real estate. As traditional sources of capital remain selective, solutions-oriented investors have a greater ability to unlock value through creativity, flexibility and differentiated capital formation, which are now critical drivers of returns rather than leverage or market beta. 

Where are core investors finding opportunities amid current capital market dislocation?

Maggie Coleman: We're spending time on broken capital stacks and where capital market dislocation yields an arbitrage opportunity. We still need to have an advantage, which might mean recognizing when an owner is under pressure to sell and being able to invest at an attractive basis in a top-quality asset that offers both current income and upside potential for strong returns. It also means creating complex structures to solve liquidity challenges for sellers.

As the opportunity set changes, what distinguishes successful core investors in this environment?

MC: Liquidity constraints still impact the broader real estate markets, and the new core and core-plus environment is still unfolding. If you can be selective and identify strong assets and compelling entry points, and structure, this is a very good time to deploy capital. Successful core investors will demonstrate disciplined sourcing and structuring to identify overlooked opportunities that rely less on broad market beta and drive alpha.

Asset selection, sophisticated structuring and execution will all contribute to alpha and are key to outperformance in this environment. With that, you must return to operating real estate and understand what's going to drive embedded value and long-term income growth in the assets you select and operate, what we call an information advantage. We continue to source opportunities that align seller and/or owner incentives with structuring to improve downside protection and create flexibility. That's where we see alpha generation in our recent investments and strategies.

MF: To Maggie’s point, at projected returns of 6.5-7.5 per cent, it really is coming back to fundamentals: selecting the right assets, making the right bets in the right markets that drive the underlying operating performance around rent, leasing velocity, etc. The easy money is no longer there. 

Why is asset selection particularly important in the current market environment?

MC: Given the factors we’ve just described, returns are muted, so broad sector and market selection will not deliver outperformance. We’ve been taking a hyper-local approach, looking at micro-locations, not just submarkets. Market data is much more efficient now, so finding arbitrage is increasingly about micro-locations. We're looking very granularly at assets where we think there is some sort of advantage in this current environment of limited competition.

We have very specific research criteria that we focus on within each of these broad sectors and where we think there will be stronger performance from operating metrics, whether that's income growth, demographics, or supply-and-demand arbitrage opportunities.

As an example, we’ve leaned heavily into alternative sectors as part of our core-plus strategy, where we evaluate long-term income growth using bespoke demand drivers for how real estate is used. As portfolio construction evolves and we focus on consistent outperformance, we continually evaluate how economic sensitivity, operating leverage, capital intensity, and income durability interact across sectors today.

Most recently, we’ve identified investments where seller motivations and an understanding of an asset’s micro-location have translated into strong value enhancement. This is the case in traditional sectors and, increasingly, in alternative sectors we're targeting, such as industrial outdoor storage, cold storage, AI-adjacent industrial and residential alternatives like affordable housing.

“If you can be selective and identify strong assets and compelling entry points and structure, this is a very good time to deploy capital.”

How are redemption queues and liquidity constraints influencing the competitive landscape for core investors?

MF: When you look at when the current owners bought these assets, maybe five or 10 years ago, it comes down to what's happened on the equity side of the capital markets, not just the debt side of the capital markets.

For the core and core-plus fund world, which are largely open-end vehicles as opposed to closed-end vehicles, there are still significant redemption queues for several of the open-end funds. This factor, coupled with higher debt costs, creates capital market dislocations that lead to, at times, higher returns than typically associated with core and core-plus risk.

If you find the right deal profile that might not quite meet the parameters of the value-add or opportunistic fund space, but it's above the core and core-plus return profiles, then that leads to those attractive opportunities. In our U.S. core-plus and Canadian core strategies, our focus has been a balance of creating liquidity that has both addressed queues and redeployed into this vintage of investments. For our platform, this has been a priority, even three years ago. 

How have market valuation and transaction pricing created opportunities for core investors?

MF: Because of the structure of the market today, we initially thought it was going to be a higher volume of transactions in this vintage period to acquire new assets or tie up new opportunities. It’s probably getting elongated because the bid/ask spread between appraisal value, valuation methodology, and fair market value – as evidenced through the transaction market and in redemption queues – complicates things. This elongation has been amplified by the geopolitical backdrop.

Everything in separate accounts is typically independently appraised at a point throughout a cycle. In the contraction phase, appraisals tend to lag, meaning that they tend to be higher than the transaction pricing market is supporting, leading to misaligned seller expectations.

Then, in the growth phase, particularly near the end of it, appraisals also tend to lag, but they tend to be below where transaction pricing is. This isn't unusual. What is unusual, as mentioned earlier, is the confluence of factors, including the extended period of high interest rates and liquidity constraints, that are lasting a lot longer than our experiences over the past three to eight cycles. Owners and sellers, including those of high-quality core and core-plus investments, are seeking differentiated paths to liquidity.

That's also what creates a great vintage period. It isn't just the opportunity to find these higher returns relative to the risk profile, but it's also going a little bit longer, which may be the good and the bad. I think that people will look back and say, “Wow, what a great five-year period of buying,” because the opportunities are out there if you have the money. 

What role are capital structure challenges playing in today’s opportunity set across core investment strategies?

MF: There's a part of the story that goes beyond real estate and what the intent or motivation of the seller is, and that's related to the capital structure, or what might be a broken capital stack, or needing a refi or recap.

What's limiting the buyer pool and the competition for that type of asset today is this narrative beyond the real estate story, in other words, deeply understanding what's driving a transaction beyond the underlying real estate. When you couple that solution with the real estate asset, that's what leads to that alpha of higher returns relative to the commensurate risk profile. 

If the opportunity is so compelling, what’s preventing more investors from deploying capital?

MC: Institutional investors are focused on capital deployment, particularly as allocations reset, but there have been challenges with liquidity that they are managing, and some lack of clarity because of the low transaction volumes. These two factors present challenges to deployment. Buyers and sellers are having a difficult time coming together as to where market pricing really might be for each asset. Again, discernment of the motivations driving a seller and the strength of the underlying real estate can guide investment decisions for better outperformance when liquidity is available.

Investors in the core and core-plus space are focusing on ways to invest in this current environment because, if you can find the right asset and fully understand a seller’s motivations, as Marc noted, there is outperformance or alpha generation opportunities in core and core plus today without elevated risk. In short, managers that can leverage information advantages can create solutions for sellers and owners of high-quality assets, offering them liquidity flexibility, aligning incentives, and potentially enhancing income and total returns. 

Which geographic markets offer the strongest opportunities for core investors today and in the years ahead?

MC: Many of the themes we’ve talked about relative to liquidity constraints, higher interest rates, and leveraging information advantages in sourcing and structuring hold true for the U.S. market, certainly, as well as in Canada and Asia. Our thesis transcends across all our global strategies because these markets are having similar challenges today. That said, we have leaned heavily into the immediate opportunity in North America.

MF: We're highly active in our U.S. and Canada strategies across the risk spectrum, but particularly in our core and core-plus product. We do believe the U.S. is still the biggest in terms of depth, and the largest market share in terms of the institutional global real estate market. Despite the volatility, the investment market in the U.S. and Canada offers deep capital markets, strong legal protections and transparent governance. Those attributes help reduce investment risk and enable global capital to deploy at scale, even during periods of heightened uncertainty.

“Asset selection, sophisticated structuring and execution will all contribute to alpha and are key to outperformance in this environment.”

The U.S. offers those outsized returns simply because it's the most liquid, or what we joke is “liquidity at a price.” That's the good news and bad news of what you're observing around the bid/ask spread between appraisal-based valuations and spot transaction pricing. You get some very wide spreads simply because there's liquidity.

Since the U.S. market structure has evolved, it allows for that liquidity. But again, it's liquidity at a price – good or bad, depending on where you are in the cycle. We do think the U.S. offers a more attractive risk-reward, putting aside the currency effect, and then you have different cycles in Canada. Canada’s return projections are improving and closing in on the U.S. As our investment platform scales, we continue to be excited about the current environment across regions. 

This material originally appeared on the PEI PERE website, and is repurposed with permission. The views expressed are subject to change. Manulife Investment Management is not responsible for the comments by or views of anyone not affiliated with Manulife Investment Management.