Falling CRE valuations have been a thorny problem for the industry during the last few years as professionals know. It can affect the ability to refinance properties and possibly undermine mortgage covenants.
There is also an entirely different effect they can have, which is on the U.S. private equity real estate model, wrote Jim Costello, executive director, of MSCI Research. Specifically, he noted that gated withdrawals at some open-end CRE funds are adding risk to the model. “The heart of the problem is uncertainty around asset valuation and the ability of limited partners (LPs) to get at their capital,” he wrote.
As GlobeSt.com has previously reported, monetary strategy during the pandemic created ultra-low interest rates and enormous amounts of liquidity injected into financial systems with high leverage. The desire for return resulted in many investors pouring money into the CRE asset class, driving up prices. Rapidly growing inflation eventually led to high interest rates from the Fed. That tanked transactions and drove valuations down.
PE firms often have expansive latitude in how they handle their activities and, as Costello pointed out, every fund manager saw negative impacts on asset values that started in 2022. It created an opacity in the real estate fund realm, similar to how a lack of price discovery was disruptive in CRE markets. Costello mentioned that many MSCI clients were asking whether the degree of asset value cuts they had made were similar in size to those of other companies.
PE companies and their executives regularly use sophisticated math to evaluate investment opportunities, estimate future cash flows, and compare companies to industry baselines. And yet, there was great variation in volumes and timing, rather than the immediate response of public markets. Costello asked: "How objective are these appraisal-based values when timing can be chosen selectively?”
MSCI also looked at data on the weighted average differences between appraised values and sale prices. Globally, the figure was -2%. Switzerland was +8.8%. Italy and Japan, +4.9% and +4.6% respectively. The UK came in at -0.7% and France, -2.5%. Canada, -4.0%. Meanwhile, the U.S. was -6.8% — the worst performance of any global region in MSCI’s annual review of the topic.
The question of why this happened brought up memories of earlier times. Costello pointed to a story in The New York Times story from the early 1990s about inflated valuations in real estate funds at Prudential Insurance. Some internally appraised values were “wildly inflated,” raising “the cost of investing in the funds beyond their actual worth” and increasing the fees Prudential received.
To be clear, neither Costello nor anyone else at the company accused any private equity real estate fund of acting inappropriately. However, the point is that at a time when property valuations are falling, there might be “perverse motivations” and “skewed incentives” for managers to try hiding that asset values were falling until, possibly, markets could rally and the values recovered.
Another data point is that appraisals for central business district offices fell by 43% from peak values to midyear 2024. Yet, the RCA commercial-property price index (CPPI), shows transaction prices were off 51% from the peak values. It helps illuminate the suggestion that managers should use multiple forms of validation like third-party datasets and other measures of performance for greater transparency for limited partners.