Market Matters: Exploring Real Estate Investment Conditions & Trends

  JUNE 26 EDITION  |  MAY 21 EDITION  |  APRIL 24 EDITION  |  MARCH 28 EDITION

JUNE 26 EDITION  

QUICK BITES  

Disinflationary Trends Are Back on Track

April's PCE and May's CPI reports show renewed cooling.

• In April, core PCE maintained a 2.8% year-over-year pace, while the 3-month moving averages for Core PCE, Core-Ex Shelter PCE, and Super Core PCE (Core Services) each declined to 3.4%, 3.1%, and 3.6% y/y, respectively.
• May’s CPI report also showed positive signs, with some of the stickier portions of core services (including airfare, motor vehicle insurance, and lodging) easing over the month; Core CPI trended at 3.4% y/y in May, with the three-month moving average downshifting to 4.1% y/y, from 4.5% y/y in April.
• Ultimately, both the latest PCE and CPI reports reflect a downward trend in inflation. However, the FOMC still wants to observe more consistent disinflationary progress before pivoting their restrictive policy. Despite the Fed’s patient and data-dependent approach, the acceleration seen in Q1’s inflation data has reversed course and the critical cooling trend desired by the Fed is once again more evident.

Cracks Are Indeed Forming:

While topline macroeconomic figures continue to reflect a resilient economy, underlying data help to provide growing evidence that the weight of restrictive policy is curbing growth: the labor market is rebalancing, employees are feeling less optimistic about their prospects of employment, and the consumer has dialed back their confidence and spending amid dwindling post-pandemic savings and snowballing cost pressures.

• Delving into a few details: job openings were down significantly in March and April, the latter of which registered at 8 million (below forecast expectations of 8.4 million); while still trending higher than pre-pandemic norms, the prevailing figure is now well below the post-pandemic peak of 12 million registered in mid-’22.
• The ratio of job openings to unemployed persons has also returned to near pre-COVID levels, registering around 1.2 versus a peak of 2.0 in ’22.
• The JOLTs diffusion index has also broadened, meaning that the contraction in job openings has been growing more broad-based across all industries (Construction, Health Care and Social Assistance, Manufacturing).
• Meanwhile, the three-month moving average of the Atlanta Fed’s wage growth tracker is now at 4.7% in March, versus June ’22 peak of 6.7% y/y.
• While top-line non-farm payrolls increased in May, job growth has also been concentrated in sectors like Government, Education and Healthcare that generally tend to lag the economy’s broader job formation trends.

Alas, the transmission mechanism of restrictive policy takes time to permeate and flow through interest rate-sensitive segments of the economy, and we’ve seen some pockets of the economy, including manufacturing and CRE, more negatively impacted.

An Uncomfortable Soft-Landing:

While the economy remains resilient (a net positive foundation for CRE fundamentals), growth is still expected to generate what we have been referring to as a “Slow-cession” or an ‘uncomfortable soft-landing’ to distinguish the fact that soft-landing is very different than ‘no-landing’.

• For now, the growing evidence of rebalancing and easing throughout the economy should provide the Fed enough confidence to shift from observation-mode to cutting-mode in Q4, assuming the next several inflation reports show sustained progress.
• The slow and stubborn lag in housing disinflation should also continue to help measures of core inflation retreat closer to target (though elevated wage growth and stubborn services will costs will still keep some core inflation above-target for the immediate horizon).
• For more insights into the outlook, check out our latest U.S. Macro Outlook report, released last week, which features forecasts for both the economy and each CRE sector.

KEY THEMES

Deciphering the Dot Plot, Interest Rates & Capital Markets
 
As part of the FOMC’s June meeting, the committee released their quarterly Summary of Economic Projections, which serves as a valuable lens into the committee’s outlook for monetary policy, both in the immediate term (through year-end), medium term (next year) and longer-term (2026 and thereafter).

• The immediate-term policy view continues to shift and dial-back given stickier than expected inflation and resilient macroeconomic growth. As a result of this backdrop, FOMC officials raised their projections for the year-end ’24 policy rate from 4.625% to 5.125%, which implies that members of the committee expect only one 25 bps rate cut, as opposed to the few cuts assumed within the March ‘24 SEP. While expectations for cuts this year were dialed back, none of the participants signaled an expectation that rates would need to rise this year.
• For those looking for green shoots, there was a slight improvement in median rate cut expectations for 2025, as the median came in at 4.125% for 2025, indicating that participants expect 100 bps of cuts for ’25, versus 75 bps projected during the March ’24 SEP.
• While GDP projections remained steady, near-term inflation projections notched up slightly higher, the latter of which likely contributes to the noteworthy upward shift in longer-run policy rate projections. This latest SEP now shows the median long-run policy rate is projected at 2.75%, which is the highest long-run rate noted by the committee since 2019.
   

With increasing acceptance and recalibration towards a more normalized interest rate environment, CRE buyers and sellers are growing increasingly more open to act, though both sides remain cautious and selective in the near term.

• As participants increasingly recognize that longer-dated rates are not likely to resume their prior decades-long compression trend, investors will remain income-focused for the foreseeable future as existing debt slowly re-prices into the higher-rate environment.
• Fortunately for most asset classes, the NOI outlook is decent, if not robust, growing by 1.5% to 2% this year and next (in a diversified portfolio) before accelerating to the 4.5% to 7.5% range in the following years.
• Even though some measured cap rates will march upwards as credit spreads normalize off higher base rates, we forecast that total unlevered returns will again reach double-digits and high-single-digits in 2026 and beyond.
• Polarization from a cross-sector appreciation-returns-standpoint has narrowed over the last five quarters (see more on this in Deeper Dive section and Chart 1 below). Looking ahead, market- and property-level selection will play a more pronounced role in attribution as performance converges across sectors and managers (i.e. allocation effects grow relatively more measured amid narrowing appreciation returns). This underscores the relative value that manager-expertise, track record and asset management will bring to portfolio management in the future. Allocation strategies of simply riding sectoral tailwinds will only be a piece of the puzzle in the next chapter.

Diving Deeper
 
Generating Alpha in the Chapters Ahead (with a Lens into Employment Growth)

Tracking institutional returns (and appreciation returns in particular) provides a distilled view into the themes that will shape both this downcycle and the recovery ahead.

The NCREIF NPI recently recorded its 5th consecutive quarter of negative unlevered appreciation returns. Yet, there’s a lot more to unpack as to what it can tell us about performance looking ahead.

Chart 1 illustrates an important point on past polarization and recent convergence: notice that the Retail, Industrial and Apartment sectors' appreciation returns have converged more recently, while Office continues to pull back as an outlier. Prior polarization underscores the benefits of portfolio diversification, both from a downside protection and upside alpha-generation perspective. Yet, downturns tend to bring a convergence in performance, which is exactly what we’re witnessing right now.

Taking a historic view of such polarization demonstrates just how significant and unique the last 3 years have been. At the height of this last cycle, we were seeing double-digit spreads between Appreciation Returns across sectors. The divergence in appreciation returns contributed to significant alpha-generation in the prior chapter for investment managers that were proportionally weighted to Industrial or Multifamily, for example, before the post-pandemic upswing in values unfolded.

Importantly, polarization has narrowed over the last several quarters as the combination of ongoing macroeconomic uncertainty, together with the ongoing acceptance of the longer-term costs of capital, is causing a more broad-based pullback in appreciation returns and performance across even the most resilient of sectors.

As higher costs of capital cause a broad-based rightsizing in yield effects, cross-sector divergence in appreciation returns is not likely to be nearly as pronounced as it was over the last 3 years. The more that the current uncertain environment collectively places pressure on NOI growth assumptions and key valuation metrics (going-in yields and exit-caps), the more convergence we will likely see in ODCE investment manager performance. Looking ahead, selection-effects (i.e. market and property level selection) are set to impact returns in a more pronounced way as allocation effects converge.

Market-level returns were also polarized during the post-pandemic years, and they too have converged as the broader capital markets correction unfolds. Chart 2 depicts the average standard deviations of cross-market rolling four-quarter total returns for each sector over time.

While dispersion on a cross-market basis is not likely to return to the historically wide ranges witnessed post-pandemic, a reversion to a more typical distribution is emerging. Much of this expectation can be linked to the recognition that demand-side growth will not follow a uniform path across the country, as underscored by cross-market employment growth forecasts. Chart 3 ranks the top employment markets according to the cumulative growth rate projected between ’24-’28, and the nominal level of new employment is featured in the data labels. Just the top 28 of 102 MSAs with over 300K in employment as of Q1 ‘24 were included to give a glimpse of regional dispersion.

Indeed, most of the employment and population growth is going to occur in Sunbelt markets, throughout the West, Southeast and Southwest regions of the country. However, it’s also important to note that these are not just small markets experiencing strong growth due to smaller base effects. Several larger markets will arise as top-ranking employment growth markets in the near-term, including Las Vegas, Orlando, Phoenix, Austin, Houston, Miami and Dallas. Such market-level dispersion offers investors another avenue towards outperformance, apart from operational efficiency and income-optimization strategies that will help drive returns in the chapters ahead.

MAY 21 EDITION  

QUICK BITES  

• Moment of Truth: While it is fair to say that every moment could be characterized as that proverbial “moment of truth,” the juncture we are at now is undeniably critical to the outlook. Coming into this year, inflation was trending steadily lower all as the economy was posting resilient growth, and the Fed made a clear dovish shift in messaging. The financial markets responded with eager anticipation, which allowed for some stability and momentum to form throughout the financial and treasury markets. Such optimism spread through the CRE capital markets, as risk spreads trended in.  
  
  
• Soft-Landing Is Different from No-Landing: Unfortunately, over the past few months, we’ve seen some of that progress unwind as the broader economy remains remarkably resilient. In some respects, more “bad” news in the macroeconomy counteractively spells good news for inflation and monetary policy. Indeed, there are signs that we’re on the path to reaching target inflation, but until inflation shows consistent and measurable progress towards slowing, we believe the Fed is unlikely to cut rates, perhaps only doing so once or twice this year. 
  
  
• It’s Called Restrictive for a Reason: The markets are actively recalibrating their expectations not only to a more gradual, delayed rate cutting cycle, but also to a more accepted view of what it means to normalize to higher interest rates. Quite simply, the stubbornness in inflation is a powerful reminder that a shift in the timing and magnitude of Fed rate cuts, on the margin, will not make or break the larger narrative that will unfold over the medium and longer-term. Restrictive monetary policy is intended to weigh on growth, and we continue to expect a slowdown; yet the foundations of both households and businesses remain solid, which will help CRE fundamentals weather a downturn relatively well. 
  
  
• Volatility --> Acceptance: Ultimately, the CRE market really doesn’t need to wait for the Fed to cut rates to accept the normalized interest rate regime. Fortunately, we’re seeing that acceptance process unfold even as inflation remains choppy and as the Fed remains patient. Such acceptance will continue to usher in more price discovery and transaction activity, all as property fundamentals outside of commodity office remain on healthy footing, poised for inflection in the coming years. 
  
  
• For more insights into the macro-picture, check out Cushman & Wakefield’s U.S. Macro Outlook update written by our Global Chief Economist, Kevin Thorpe. 

KEY THEMES

Key Capital Flows Themes 
 
After persevering through two years of a rate hiking cycle, both buyers and sellers are adjusting their business plans to the new environment, which doesn't necessarily mean sitting on the sidelines. While many sellers became holders throughout 2022 and 2023, they are now recognizing 2024 as a time to transact. Many owners are exhibiting a clear interest to trade some of their assets for various liquidity reasons, primarily driven from redemption needs from pension accounts or other LPs in their accounts. Other sellers are simply behind on their sales and portfolio management/rebalancing goals, and recognize they need to move product. 
 
An on-the-ground pulse continues to show a significant imbalance between the supply of quality offerings for sale relative to investor demand in 2024. And, value-add and opportunistic buyers hungry for blood-in-the water are still sitting on significant amounts of dry powder that ultimately needs to be deployed. Both sides, also recognize that timing a bottom is unrealistic, garnering this period before the elections and ahead of a Fed pivot as a unique window of opportunity to act. 
 
For more insights into how we see capital markets unfolding even amid this period of dislocation and volatility, check out our latest short report, “Following the Flows,” which features perspectives on the capital flow sources that are expected to drive the market.

Key Global Inflation and Monetary Policy Themes 
 
April’s CPI print provides the Fed (and financial markets) with some encouragement that inflation is downshifting from the pace registered in Q1. 

• Core CPI is trending at 3.6% y/y, while the 3-month annualized pace is still elevated at 4.1% y/y. Core Goods inflation continues to ease (trending at 1.2% y/y in April) and has returned to its pre-pandemic pace, however, some of the disinflationary influences of healing supply chains have nevertheless dissipated more recently. Ultimately, much of the focus on inflation still lies in the service sector, which continues to ease, but at a stubbornly slow pace. 
  
  
• Housing services (both OER and rent of primary residences) inflation continues to downshift, but also slowly.  

With housing inflation arising not only as influential to inflation, but also to CRE more broadly, a few reflections on multifamily rent growth help to frame the outlook. Oftentimes, when analyzing the progress towards reaching the Fed’s core inflation target, it may feel tempting to point to the well-known lag in shelter inflation as justification for saying that we’ve effectively reached target by stripping out Shelter inflation from Core (which in some sense is correct and is certainly not lost on the Fed). However, writing off Shelter from the inflation outlook altogether (such as looking at Core CPI ex-shelter) and concluding that the Fed has achieved its 2% inflation mandate would ignore a few important considerations. 

• First off, rent of primary residence (which draws in theory from multifamily rent growth, and which is recognized as filtering through with a lag) has indeed cooled from its 2021-2022 peak, however the pace is still trending at 1.5% y/y (which is certainly not 0%). In addition, Cushman & Wakefield manages 180,000 units across the country, which provide us a unique lens into rent growth trends. A recent deep dive into this data by our Head of Multifamily Insights, Sam Tenenbaum, highlights that new lease trade-outs are showing resilience, which naturally places upward pressure on overall trade-outs as well. 
  
  
• In addition to multifamily rent growth, the Owner’s Equivalent Rent component of shelter inflation also (indirectly) takes into account home prices and even hotel room costs, which are up 6.5% and 3% y/y, respectively. 

Shelter inflation is still expected to ease as the lag effect of the private rental market filters through, but its overall influence on inflation unlikely to drop to zero, as looking at CPI ex-shelter would imply. The Fed is no-doubt aware of this, which underscores their patient stance in wanting to see other elements of inflation consistently trend down before cutting. 
 
Meanwhile, taking a more global perspective, inflation throughout the U.S. has cooled more slowly than throughout Europe and the UK, a dynamic which positions both the ECB and the BOE to potentially cut their policy rates ahead of a pivot from the U.S. Federal Reserve Open Market Committee (“Fed”). 

• While global monetary policy has historically moved in coordination and largely followed the Fed’s tack, regional disparities in macroeconomic fundamentals and inflation dynamics are now initiating a divergence in those paths. 
  
  
• The U.S. macroeconomy has posted remarkable resilience against the weight of restrictive policy, whereas Europe and the UK have experienced economic stagnation with nearly non-existent consumer spending trends, sluggish investment, a softening labor market and slowing wage growth, which collectively contribute to more deflationary pressures. As a result, the ECB and BOE are now widely expected to cut before the Fed. 
  
  
• Improved liquidity and conviction among investors arises as a direct implication of an earlier potential cut (and even of the dovish positioning on part of the BOE and ECB). The window of relative opportunity before oncoming rate cuts also arises as a unique period of dislocation where many European investors will be keen to capitalize on both buy-and sell-side opportunities ahead of a full-swing capital markets recovery. 
  
  
• With monetary policy conditions slightly farther ahead in the ECB and the UK, yields in certain markets have already stabilized, particularly markets that have witnessed swifter yield adjustments offering attractive entry points. A potentially earlier ECB or BOE policy shift would also act as an example of the response that U.S. capital markets participants might have as the cutting cycle ensues. 
  
  
• For more insights into European and UK monetary policy, inflation and investment implications, check out our latest report The Opening Gambit for Central Banks: Unravelling the ‘Who Cuts First’ written by Sukhdeep Dillon, our Head of EMEA Forecasting. 

DIVING DEEPER

Cushman & Wakefield’s Investment Strategy Framework “CPR”

Over the last several months, we have finished building out an Investment Strategy framework that draws from several of the models I created while working for and/or consulting for several institutional private equity investment managers.  
 
The framework created for Cushman & Wakefield is aptly named the Cushman Pulse Report, or “CPR”, and it is aimed to serve as a tactical and strategic tool for the full spectrum of CRE capital markets participants (owners, portfolio managers, investors, lenders, brokers, developers etc.). 

The CPR is structured with the recognition that forward-looking investment strategy requires a systematic cross-sector and cross-market perspective of fundamentals and capital markets conditions and performance both currently, in the medium-term as well as in the longer-term. 

Chart 1 provides a perspective of each of the CPR’s four prongs, including Cyclical Positioning, Near-Term Growth Trajectory, Winds (i.e. Mega Trends), and Target-Market Matrices.

• The first prong, Cyclical Positioning, can be thought of as the foundation to the investment strategy pyramid, as it captures a view of cross-sector cyclicality and utilizes a full spectrum of fundamentals and capital markets indicators to identify key inflections within each sector’s respective indicators and unique cycles. Each of the cyclical phases align with key execution points for investment, and the positions allow for flexibility of interpretation given the wide audience: depending on the philosophy and risk appetite of a given investor, the current and future cyclical positioning can inform timing of execution (to either acquire, develop, hold or monetize/exit).  
  
  
• The second prong, i.e. Trajectory, accounts for the fact that two sectors may be in similar Cyclical Positions, but offer entirely unique growth trajectories. Therefore, we utilize our propriety forecasts to project near-term growth prospects for each sector. 
  
  
• The third prong, i.e. Winds, encompasses a comprehensive rubric to evaluate the influence that longer-term mega trends such as aging demographics, climate change, technology innovation, and geopolitical trends will have on each sector. By evaluating each sector against a consistent set of Winds, we are able to arrive at relative cross-sector Winds attractiveness scores that reflect the degree to which the collective Winds will either positively or negatively influence a sector over the longer-term. 
  
  
• We synthesize the first, second and third prongs into a “confluence view” of cross-sector conditions, which allows a comprehensive, consistent and data driven perspective of how the sectors’ compare for investment currently, in the near-term and across longer-term horizons. 
  
  
• In addition to the quantitative frameworks that comprise the sector-level prongs, we also provide thematic investment recommendations for each sector, which originate from our pulse of performance and investment trends. 
  
  
• The fourth prong, i.e. Target-Market Matrices, applies a similar conceptual and quantitative approach taken at the sector level, but at the market-level for each sector. Each investor holds unique philosophies, strategy and firm infrastructure that naturally provide for firm-level proprietary target-markets, however we sought to create a framework that allows for a quantitative, rigorous and consistent approach towards contextualizing how the markets stack up against one another, utilizing a spectrum of strategy profiles. 
   
• We share this investment strategy framework with key strategic clients. Please reach out to us to request access.
  
  

APRIL 24 EDITION  

QUICK BITES  

• Consistency is still key (re: inflation) Inflation is still running too hot, particularly on trailing 3- and 6-month annualized bases, and particularly across certain segments of core and super core measures i.e. both core services and housing inflation remain stubbornly high and are fueling reacceleration (across both CPI and PCE). The Fed wants to see consistent improvement.
• Data dependency & credibility are also key: The Fed is not going to shift stance prematurely without ample evidence (i.e. consistent reports that inflation is trending lower). A premature stance not only adds risk towards loosening financial market and consumer conditions too soon, thereby allowing inflation to reaccelerate, but it also risks undermining the stance and credibility that it has worked so hard to maintain thus far. Case in point, inflation expectations remain anchored, and the markets are gradually realigning their expectations with more gradual rate cuts, akin to what the Fed wanted the market to adopt as the year kicked off.
• First rate cut expectations have shifted back: While upside risk to short-term rates has grown on the back of hotter-than desired inflation, the Fed recognizes real rates are still in restrictive territory (relative to neutral rates), which, given the recognition that monetary policy works in long and variable lags, continues to support the case for a rough-September first rate cut of approximately 25bps.

KEY THEMES

Green Shoots Throughout the Capital Markets

• Believe it or not, we can find a few “Green-shoots” in all of this financial market volatility: : The stability throughout the treasury and financial markets that unfolded as ’24 progressed was welcome for capital markets overall (and remains key to the recovery story overall), however, it was also somewhat unrealistic to expect a complete lack of volatility ahead. This recent market volatility really just reflects the fact that market expectations have realigned towards delayed and more gradual cuts (spiking the 10Y 20 bps in the week following the most recent CPI print); this very upswing underscores the broader market’s recalibration and acceptance of higher-for-truly longer (we knew the acceptance process is just that, a process).
• Counterintuitively, choppiness can actually lead to traction in liquidity: Volatility is a net negative for broader (i.e. not just CRE) credit and equity deal flow in the immediate term, however, recent volatility has acted as a powerful reminder of the reality and recalibration process the market faces. Investors cannot necessarily wait for the Fed’s cutting cycle to come to the rescue. Though counterintuitive, the more that the financial markets recognize that Fed rate cuts will influence the short-end and that other growth- and inflationary- forces will influence the longer-end, the more liquidity and momentum the markets will gain as all sides align their views towards interest rate normalization.
• Financial conditions were arguably too loose relative to what the Fed wanted anyhow: While the Fed doesn’t want to see volatility unfold as it has, recent CPI reports have helped to reign-in market expectations to thresholds and levels arguably more consistent with where they should really be (considering where real policy interest rates still are). To contextualize this point, take a look at the chart below, which features both financial market conditions and real policy rates. On the back of the Fed’s dovish shift (and improving inflationary conditions) back in late-‘23, the financial markets turned overly exuberant to start the ‘24 year, which led to a significant loosening in financial market conditions. The sheer power of expectations moved the market significantly, and likely more than what the economy and the Fed wants/needs to keep credit flows, consumer spending, hiring and capital expenditures in-check. These recent inflation reports are helping to reverse some of that loosening, bringing conditions back towards levels that are more conducive to reigning in growth and inflation.

• Yields are up, but spreads to benchmark rates are still relatively contained; this is true in both Corporate and CMBS landscapes: Despite that the markets have taken a few steps backward in terms of stability and tightening in base rates, spreads for both corporate bonds and CMBS debt spreads are much improved relative to 2023 highs. Such spread compression has helped make debt costs more competitive, and for CMBS, has helped generate some momentum for issuance. Securitized issuance bounced back to $17.8 billion in the first quarter, up from $12.8 billion in Q4. More CMBS issuance means more diversification of, and competition among, CRE lender sources, which points to more traction for CRE volumes ahead.
• Lending standards have turned slightly less stringent: a condition which acts as a leading-indicator towards transaction volume in the quarter(s) to come. Word on the street confirms that some banks are on the precipice of rotating strategy: Chris Gorman, KeyCorp CEO, said on their recent earnings call that they were ready to begin playing offense. After focusing on reducing risk, the bank is angling for growth. External Link
• Yield spreads growing more enticing: Cap rates, in aggregate, and across sectors also continue to rise, helping to restore some yield spread, which is likely to entice buyers off the sidelines and spur more transaction activity looking ahead.
• For CRE, the conditioning process is key: regardless of whether a Fed rate cut happens in the immediate/near-future, the CRE capital markets are progressing through (an arguably more difficult) process of accepting that costs of capital are normalizing higher following a decades-long period of accommodative monetary policy that allowed for widespread rate compression.

DIVING DEEPER

What Happens If The Fed Doesn’t Pivot At All In 2024? How Much Does Your Outlook For The Capital Markets Change Under That Scenario?

Assuming we skirt a recession and/or face a no-landing sort of situation, the lack of rate cuts in 2024 might not alter the course of the capital markets recovery as much as one would initially think because the market is still going to be recalibrating to a higher cost-of-capital paradigm, and sellers might even start to acquiesce more quickly, helping to bridge the bid-ask spread divide more quickly.

This does however arguably put the macro economy at risk of a policy error by the Fed. They were late with rate hikes as inflation ramped up, which was a mistake, but holding higher-for-longer also poses potentially a greater risk as the cumulative weight of restrictive policy weighs on interest rate-sensitive pockets of the economy (i.e. banks).

Regardless of rate-cut timing, the more that the debt and capital markets acclimate and condition to a higher-cost-of-capital regime, the more quickly that alignment can come between buyers and sellers, increasing liquidity, and providing appraisal-based valuations more transaction-based evidence to write-down assets to levels that are appealing and satisfaction to fund-level investors for entry.

The Equities Markets Have Improved (Notwithstanding Recent Blip Post CPI Report); Is The Denominator Effect Dissipating Or Is It Still Prompting Institutions To Seek To Rebalance Their Portfolios?

The denominator effect has been at the forefront of portfolio management conversations between investors, investment managers and consultants over the course of the last year and a half as public equities fell amid the market volatility that followed the Fed’s rate hiking cycle. While still very much on the radar and a part of portfolio management conversations today, the overall effect is moderating for many institutions as the public equity markets have rebounded, and as private real estate valuation write downs are collectively bringing broader portfolio allocations into better balance. Capital is cautiously shifting back into real estate as the pendulum for the denominator effect has shifted, and as institutions are once again either appropriately weighted or even under-allocated to CRE.

Keep in mind, however, that the denominator effect isn’t the only consideration to portfolio management; conviction in strategy and rebalancing of portfolios across sectors is also still required as valuations adjust. Uncertainty in the broader market has acted as a considerable deterrent towards investors ultimately making new capital commitments. Even absent the Denominator Effect, institutions needed to take pause to assess the broader macroeconomic landscape, to consider the implications of higher rates on their existing portfolios and evaluate their appetites for risk and return in the next chapter.

What Is Your Outlook For Redemption Queues As We Head Through 2024?

Open-End Fund redemption queues tend to inflect sharply as valuations adjust and as uncertainties subside. Indeed, redemption queues remain elevated among ODCE funds (and those indexed to ODCE) given heightened uncertainty and a lack of liquidity throughout the property markets; however, NCREIF’s ODCE Index has logged five consecutive quarters of valuation write-downs (through year-end 2023), garnering valuations increasingly attractive as an entry point.

Assuming capital flows and investor behavior mirrors historic patterns, another few quarters of valuation write-downs will lead to a reversal in fund flows whereby Entrance Queues tick-up as investors seek to allocate new capital. Many investors still recognize that the 2024 and 2025 vintage years will be attractive entry-points for forward-looking returns, which means that there is a palpable desire not to miss the window of opportunity that dislocation offers entirely.

Ultimately, it’s important to recognize that elevated redemption requests arise not only because investors are skittish about the market (which characterized past cycles), but more so because investors this time around were anticipating the downward adjustment to values and wanted to get ahead of the repricing event. Given the lack of the liquidity for redemptions and the delays in being able to withdraw funds, the more that valuations adjust towards a potential inflection, the more likely that those requests will be rescinded by investors. Indeed, many private REITs have mentioned satisfying all or nearly all redemption requests in recent quarters.

Are Capital Allocators Still Considering CRE As Part Of Their Portfolio Construction Or Has The Recent Rate Paradigm Shift Meaningfully Changed Broader Asset Allocation Models?

Institutional allocations are still holding steady and have increased 20%+ over the last decade from the single digits (8.9%) into the low teens (10.8%). Investment managers also don’t expect to see overall allocations meaningfully shift in the near future (i.e. surveys produced by organizations such as Institutional Real Estate’s Allocation Monitor and Hodes Weil & Associates indicate that target allocations are expected to hold steady around 11%).

MARCH 28 EDITION  

QUICK BITES  

• Progress on Inflation is Evident, but the Fed Maintains a Patient Stance Amid Persistent Price Pressures and Resilient Growth. Several key measures of inflation (including those linked to housing and core services) remain concerning to the Fed. Yet, the Fed continues to maintain a relatively objective stance and continues to reiterate that they do not intend to overreact to any given month’s worth of incoming data; they acknowledged that there was likely some noise and seasonality throughout recent incoming data and maintain consistency in their messaging (which is understandably frustrating to markets that tend to get ahead of their skis, but ultimately a good thing for maintaining credibility and anchoring expectations). The Fed’s quarterly Summary of Economic Projections (“SEP”) also offered a valuable lens into the bigger picture; they still expect three cuts this year but continue to see upside risks to inflation that could necessitate holding rates higher for longer, and longer-term rates are not returning to zero (they actually slightly increased their median longer-term target to 2.6%, implying that they acknowledge neutral policy rates over the long-run will need to be higher). As it stands now, they also acknowledge that they do not feel like they’re in much of a hurry; economic growth remains resilient in the face of rate hikes.
• Acclimating and Conditioning: Despite that the markets are eager for a rate cut, this period of patience on the part of the Fed is allowing all market participants (CRE included) to accept and grow conditioned to a normalized rate paradigm – a conditioning process that is already serving CRE well. Plenty of market participants are anticipating rate cuts and expecting base rates and spreads to come in after the pivot, but there may be more upside risk to longer-term rates, which provides motivation to act now. The Fed pivot influences the short-end, which certainly influences floating rate debt costs, but the long end is not likely to shift as much, at least for the time being. That means a near-term flattening of the yield curve before an outright un-inversion that will require more time for the short-end to come in. Check out our Deeper Dive section, which delves into all the reasons that longer-term rates could face more upside pressure than many are considering, all of which has meaningful implications for near- and longer-term investment strategy.
• Public Market Rally & Easing Denominator Effect a Noteworthy Green Shoot: The denominator effect has been at the forefront of portfolio management conversations between investors, investment managers and consultants over the course of the last year and a half as public equities fell amid the market volatility that followed the Fed’s rate hiking cycle. While still very much on the radar and a part of portfolio management conversations today, the overall effect is moderating for many institutions as the public equity markets have rebounded, and as private real estate valuation write downs are collectively bringing broader portfolio allocations into better balance. Capital is cautiously shifting back into real estate as the pendulum for the denominator effect has shifted, and institutions are once again either appropriately weighted or even under-allocated to CRE.

KEY THEMES

Deciphering the Debt Market

• Change is in their air: Stronger demand-side interest to place both debt and equity capital, as well as tightening debt spreads, continue to generate more momentum throughout the debt markets.
• In both the video and article, I took a few moments to highlight several important implications for investors, managers, and lenders to keep in mind as they formulate an outlook for ’24 and beyond.

DIVING DEEPER

Interest Rates on a Structurally Higher Path

With so much anticipation and focus directed towards a Fed pivot, it’s easy to lose sight of the fact that the Fed primarily influences the short-end of the curve and that there are a lot of bigger forces that shape the long-end.

In addition to inflationary dynamics (which obviously require higher policy rates), interest rates are also fundamentally determined by the balance (or equilibrium) of savings and fixed investment. The more savings (supply) or lower fixed investment (demand), the lower the interest rate. The less savings (supply) or higher fixed investment (demand), the higher interest rates. Whether it comes from the demand- or supply-side varies at any given point, but the larger (often secular and longer-term) factors driving that relationship are key to determining the level of interest rates.

Over the course of the last 40 years, several common global forces or threads influenced both the supply of savings and the demand for investment, collectively serving to drive real interest rates down.

• Aging demographics throughout many advanced global economies contributed to generally lower consumption (lower demand), greater savings, lower private investment, and lower rates of innovation and productivity growth.
  
  
• Throughout the course of the 1980’s and 1990’s, Ben Bernanke also argued that a global savings glut pushed rates down, as many emerging market economies throughout Asia, South America or Eastern Europe began to run account surpluses (i.e. more savings supply) that ultimately made its way into safe, liquid and highly investable advanced economies like the United States, serving to drive real rates down. With rising globalization, global capital markets opened, allowing for a freer flow of capital across the globe, significantly distorting the supply of investible capital relative to the scarcity of investment.
  
  
• More recently, over the last 10 to 15 years, and following economic disruptions such as the GFC and the Global Pandemic, many global central banks also responded with unveiling dramatic monetary stimulus programs to buttress the liquidity in their economies (i.e. quantitative easing measures). These accommodative global monetary policies promoted foreign reserve accumulations and infused lots of capital into the system creating more savings relative to profitable investment opportunities, thereby driving down real interest rates.
  
  
• Following the GFC and the Pandemic, many households (particularly in the U.S.) undertook a deleveraging cycle, which reduced the global demand for capital and increased the global supply of savings, collectively serving to drive real rates down.

Interest rate levels are likely to experience upward pressure from several trends looking ahead, including:

• Investors will want to be paid for increasing volatility. In a higher inflationary and more uncertain environment, duration risk should matter more than it has over the last several decades, which implies higher term premiums. In addition to exerting their own unique forces on fundamental factors influencing rates, each of the following examples below also contribute to potentially higher inflation and at least more volatility in the chapter ahead.
  
  
• Persistently higher (swelling) government deficit and debt levels. The concept here gets to the fact that investment in public debt tends to “crowd” out private fixed investment, which reduces the supply of investable capital, which increases real rates.
  
  
• Increased uncertainty and appetite towards holding “risk-free” government securities amid policy-maker drama and debt-ceiling debates. While U.S. government bond securities will remain a global safe-haven instrument for capital, bond investors could very well place less emphasis or value on these instruments from a liquidity and safety standpoint. Such reduced demand and higher required risk premium could impact longer-term government bond yields for the U.S.
  
  
• Potentially higher productivity growth brought on by advances in AI. Higher productivity growth implies interest rates must be higher to entice and compensate a lender for the opportunity cost of deploying that capital into other more marginally productive outlets.
  
  
• Historically tight labor markets, low unemployment, and more persistent labor shortages throughout certain segments of the economy will act as an additional upward force up interest rates by siphoning capital (income) from business owners to workers. Greater shares of capital paid to workers versus businesses would, in one sense, curtail demand for additional private investment.
  
  
• Rising political tensions, the Pandemic’s supply-side shock, and resultant de-globalization. The pandemic highlighted already-strained supply chains, which shifted many companies’ focus on supply chain orientation. Nearshoring/onshoring to the U.S., Mexico, and Canada also have the potential to translate to higher inflation, as goods are produced by higher-cost workers, with those costs passed through to the end consumer (curtailing supplies of excess capital on both the consumer and business side). Meanwhile, current tensions around the Suez Canal also highlight the myriad additional worldwide geopolitical risks, which have the potential to generate upside inflation risk. Collectively, the potential for future geopolitical tensions and the supply side shocks those tensions cause ultimately induce more inflation volatility into the equation than we’ve historically seen since the shocks in the 1980s.
  
  
• Climate change can drive up interest rates by fueling inflation as well as by impacting capital flows and the demand for capital. The most intuitive link between climate change and interest rates likely comes to mind when considering the impact that rising insurance costs can have on inflation. Premiums continue to rise dramatically in states like California and Florida, and those premiums are inherently measured as part of inflation (through cost of housing). The more that insurance costs remain an outsized growth component within key measures of inflation, the more that higher interest rates could be required to balance rising cost pressures. Similarly, the drought throughout the Panama Canal arises as an example of the effect that climate change could have in driving inflation: the drought threatens and distorts the flow global trade, which places upward pressure on inflation as long as those conditions persist. Meanwhile, apart from inflationary-dynamics, the outsized demand and need for global capital to fuel investments in climate-resilient businesses, technologies and infrastructure could also place upward pressure on interest rates.

As a result of these larger, more secular dynamics, we expect more upward pressure on (or upside risk to) longer-dated treasuries than downward pressure, even as the Fed kicks off the cutting cycle. Such upside rate pressure could serve to compel buyers and sellers (who might have been waiting on near-term Fed cuts to shift the pendulum dramatically) to instead act sooner rather than later.