After A Decade Of Dominance, Sovereign Wealth Funds Are Forced To Evolve

Flush with cash and carrying little baggage from existing portfolios, sovereign wealth funds have dominated in the years following the Lehman Brothers crash, striking the biggest deals and reaping stellar returns from real estate. 

But the higher-for-longer interest rate environment has ushered in a period of soul-searching for these big beasts and their feelings about real estate. As a whole, sovereign wealth funds are allocating less to the sector. And many are shaking up their real estate divisions to ensure that big 2023 losses are not repeated. 

Even those sticking with the sector are mixing up their strategies, moving into new sectors or becoming lenders as well as investors to cut risk. 

“There are pressures on allocations, and on the whole, they’re coming down with more frequency than they’re going up,” Oxford Properties Chief Investment Officer Chad Remis told Bisnow.

Sovereign wealth funds, those owned by governments or regional superannuation funds like those of Canada or Australia, are expecting to cut their average allocations to real estate in 2024, according to data from real estate capital advisory business Hodes Weill, which conducts an annual survey of big global institutional investors and their investment intentions. 

Sovereign funds have a target of allocating 7.5% of their assets to real estate but expect to cut that to 7.2% next year. The average institution, including pension funds, expects to keep allocations the same, at 10.8%. 

That runs counter to the last decade when sovereign funds ramped up their allocations to the sector. Some, such as the Abu Dhabi Investment Authority, GIC and large Canadian funds, had been investing for decades, but many global funds pushed into real estate for the first time in the years after the financial crisis. 

Competition was scarce, prices were cheap, and as interest rates fell and bond rates moved close to zero, the income provided by real estate proved vital in having money to pay out to government backers or state pension holders. 

Some of the biggest deals of the past 15 years were undertaken by sovereign funds, like China Investment Corporation’s €12B (£10B, $13B) purchase of Blackstone’s European logistics business, Logicor, or ADIA and the Canada Pension Plan Investment Board’s $3.2B purchase of a portfolio of U.S. warehouses from Exeter Group in 2015.

As prices rose as the market recovered, sovereign funds remained active buyers, and even those with already mature businesses saw their real estate holdings expand dramatically. Oxford’s assets under management rose from about $20B to more than $80B in the past 12 years, which led to Remis' appointment as the fund’s first CIO.

But the interest rate hikes of 2022 and 2023 changed all that.

Returns have plummeted. Norway’s Norges Bank fund, the world’s largest sovereign wealth fund, with more than $1T of assets, saw its direct property holdings produce a negative return of 12% in 2023. At Canada’s Public Sector Pension Investment Board, the figure was negative 16%, primarily due to a drop in the value of its Canadian office portfolio. 

But as real estate returns dropped, other asset classes performed well. As interest rates have risen across the globe, so have the yields on government bonds. Two years ago, U.S. industrial property or good London offices yielded 4%. Now, investors can get the same return from U.S. or UK government debt and at a lot less risk. 

The result has been a mixed picture when it comes to new deals for sovereign funds. The amount they spent on real estate fell 40% in 2023 to $32B, according to data from research firm Global SWF. But that is a smaller drop than the 47% overall drop in global real estate volumes in 2023. The 26% of the funds' overall spending made up by real estate is higher than the 20% figure the previous year, according to Global SWF. 

For many of these funds, the challenge now is to work out how to invest in a very different macroeconomic environment. Several are restructuring their real estate divisions.  

Caisse de Depot et Placement du Quebec said it was merging its real estate division, Ivanhoé Cambridge, with a lending division called Otéra Capital and bringing the two previously external divisions in-house. The Ontario Teachers’ Pension Plan is bringing its external manager, Cadillac Fairview, in-house and changing its investment remit to focus only on the domestic market. Ontario will now undertake overseas investments. 

Norges brought its real estate investment team in-house in 2019, before the current turmoil in the market. It had said it wouldn’t be making many new investments in direct property because its previous investments underperformed return targets. It has since rowed back on the second part of that plan, but its target allocation for real estate was lowered from 7% to between 3% and 5%. 

For several years, ADIA, one of the world’s biggest funds and largest real estate owners, operated without an overall head of real estate or regional heads. In 2022, it appointed Drew Goldman, former Deutsche Bank global head of investment banking coverage and M&A, its global head of real estate. 

Oxford, the real estate investment arm of the Ontario Municipal Employees Retirement System, has not made any major changes to its structure or roles. OMERS said it was cutting its target allocation for real estate from 22.5% to 18%, with the current allocation at 15%. 

What is evolving is the way Oxford invests and how it finds its returns. In 2022 and 2023, it sold $3.5B of mature industrial assets, as well as a number of large office buildings, and it is reinvesting the proceeds, Remis said.

“[OMERS] has an understanding that in the last few years, the broad macro metrics have worked against us, but the operational performance has been amazing,” he said. 

The fund has made a significant move into real estate credit in the past five years, and that now represents about 15% of its portfolio.

At the start of the current turmoil, it was providing floating-rate loans, with the interest paid by borrowers increasing as rates rose. It is providing credit to borrowers with good assets that need to be recapitalised in a tough banking market, Remis said. The fund likes credit investments because 90% of the return on such deals comes from income rather than valuation shifts. 

In the industrial sector, the fund is using capital from assets it sold to build new schemes.

“If you can sell at a 5% cap rate and deploy that at a 10% cap rate for the next 10 years, that is beneficial for the portfolio,” Remis said.

Remis added that the fund is still a big believer in the value of good-quality offices. Residential and and healthcare are favoured sectors given the demographic tailwinds. 

Overall, Remis is backing real estate as a significant player in the portfolios of global investors going forward. Even as rates remain higher than they have been for the past 15 years, real estate has a job to do, he said. 

“Once you have reset your values, inflation and real estate tend to go hand in hand,” he said. “So real estate is one of the best places, in our opinion, you can invest and protect against inflation.”