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Private CRE Returns Sag in Q4. More to Come?

Private CRE Returns Sag in Q4
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REITs Rebound

Private real estate values are dropping just as REITs are rebounding from 2022 losses. The difference in performance illustrates the disparity between public and private commercial real estate investment styles, but also begets the question of how much further prices will drop.

Newly released returns reveal private fund values sagged in the fourth quarter of 2022 while REITs staged a fourth-quarter rally in what was still a year of huge price declines. Private real estate funds that comprise major industry indexes fell by roughly 5% in the fourth quarter, their worst performance in decades.

The National Council of Real Estate Investment Fiduciaries’ (NCREIF) ODCE index of core real estate funds fell by 5.0% in the fourth quarter, including a -5.8% appreciation return and 0.8% dividend yield. For the year, the ODCE produced a 7.5% gain, consisting of a 3.9% appreciation return and a 3.5% dividend.

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The Pension Real Estate Association’s (PREA) U.S. AFOE Quarterly Property Fund Index likewise dropped 4.8% in the fourth quarter of 2022, with -5.5% appreciation and 0.5% dividend gains. The net fund return was 7.7% for the full year in 2022, consisting of 5.2% appreciation and 2.5% income gains.

Meanwhile, the NAREIT All-Equity REIT Index returned 4.1% in the fourth quarter but produced total returns of -24.4% during 2022. The REIT index returns during the year included -27.5% appreciation return and a 4.2% dividend yield.

Uncertainty Remains

Commercial property prices hit record highs in the first quarter of 2022, but rising interest and mortgage rates prompted valuations to fall. Investors quickly penalized public REITs, worried about the impact of rising rates and the prospect of an economic downturn that would reduce demand for commercial properties. The equity REIT index returned -17.0% in the second quarter of 2022 and -9.4% in the third quarter before stabilizing. The equity REIT index produced total returns of 5.2% in 4Q 2022 and 9.3% in 1Q 2023.

While REIT shares were dropping starting in the second quarter of 2022, it took several quarters for private fund indexes to record similar price declines. Private real estate funds are appraised only occasionally, so the changes in value are recorded much more slowly. Returns of public and private real estate tend to even out over time, but during periods of market disruption they perform much differently.

The question now for private funds such as those covered by NCREIF and PREA is how much more they will decline before hitting bottom and rebounding. Mortgage rates are now higher than the average early-2022 capitalization rates for most property types. That has prompted a 15% to 25% increase in cap rates, depending on property type, location and property-level income stability.

If cap rates stay at their new level—which is no sure thing, given the unexpected strong performance of the economy—further valuation declines are likely in the offing for private real estate funds, and possibly for some REITs.

About the author

Paul Fiorilla

Paul Fiorilla has more than 25 years of experience as a researcher and writer in the commercial real estate markets. He previously served as a vice president of research at Prudential Real Estate Investors in Madison, N.J., where he oversaw publishing of outlooks and thought leadership research. Before that, he covered real estate capital markets and CMBS at Commercial Mortgage Alert.

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