Insights
Market Matters: Exploring Real Estate Investment Conditions & Trends
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JULY 24 EDITION
QUICK BITES
Inflation
April's PCE and May's CPI reports show renewed cooling.
- The fight against inflation is on track: most recently evidenced by June’s CPI print. On a three-month annualized basis, core measures of inflation are now trending at 2.1% y/y for CPI and 2.7% for PCE. Headline PCE (widely considered the Fed’s preferred target) is now trending at 2.5% y/y, which is the slowest pace registered since August 2021 (nearly 3 years ago when inflation hadn’t started to accelerate yet).
- We’re also seeing easing on core services: While core goods remain in disinflationary territory, the easing in core services was helped by moderations in discretionary areas such as airfares, lodging away from home, and recreational services; indeed, the consumer is dialing back certain discretionary spending habits amid mounting price pressures.
- The much-anticipated lagged relationship for housing inflation still exists: The stubborn lag between spot-market measures of rent and those surveyed showed ongoing traction. Both owner’s equivalent rent and rent of primary residences eased, with the latter expected to contract more as the full effects of easing market-rent growth work their way through the survey data.
KEY THEMES
Monetary Policy & CRE Fundamentals: Foundations of the Pyramid
Decidedly Dovish Shift from Powell
Just ahead of the June’s CPI release, Powell’s latest testimony to Congress also took a decidedly dovish tone. Not only did he acknowledge the progress made on inflation, but he also emphasized that they remain focused on the “balance of risks” facing the economy amid such restrictive policy. While they remain data dependent, and while he also emphasized the importance of central bank independence, Powell’s testimony suggested that he was comfortable signaling to the markets that they are paving the way or teeing up impending rate cuts.
Economy No Longer Viewed as Overheated
Powell also made specific and clear reference to his views of the labor markets in his testimony, emphasizing his view that “Labor markets have cooled considerably…” and that the “U.S. is no longer an overheated economy.” He emphasized that the “economy is more or less back by most measures to where it was before the pandemic,” and the trend prior to the pandemic featured a “strong labor market, but it wasn’t an overheated labor market.”
Don’t Overlook the Upside Surprises in CRE Demand This Quarter
While much of the attention has been placed on the pace of new construction in both Multifamily and Industrial, too little attention has been given to the robust demand formation for apartments. U.S. multifamily vacancies declined by 10 bps in the second quarter as absorption topped 138,000 units. With more than 500,000 jobs added in the second quarter, the resilient labor market remains supportive of new household formation as real wage growth remains positive. Year-to-date Multifamily absorption has nearly surpassed all of last year’s demand and is up 75% over the first half of 2023. Meanwhile, Industrial absorption more than doubled in Q2, and together with the easing in new sublease space, helped to ease some of the upward pressure on vacancy. With construction starts plummeting in both sectors, fundamentals should begin to recover in earnest in 2025-2026
Diving Deeper
What We’re Watching: The Power of Expectations & Influence on CRE Capital Markets
Market Expectations & Sentiment Have Shifted to the Upside
To appreciate the degree to which investor-oriented perceptions and financial market conditions have changed since the June CPI print, we can explore various high frequency indicators to monitor the undercurrents of investor sentiment. Chart 1 below reflects the forceful shift in expectations based on forward-looking expectations of monetary policy (shown in the form of probabilities for year-end target policy rates). The yellow series reflects the distribution of probabilities just ahead of the June CPI report (on July 10th). At that point, the market was assigning a 45% probability for 2 rate cuts by the end of the year. Yet, notice that more than 20% were still expecting just one cut. Meanwhile, the blue series reflects market-based probabilities following the latest June CPI print (as of July 12th); at that point, the market assigned upwards of 90% probability to the Fed executing a few rate cuts by year-end. Certainly, this can change based on incoming data, and markets tend to be poor predictors of Fed policy; however, the key message here relates to sentiment. Growing confidence around an impending rate cut meaningfully impacts business and investor psychology.
Real-time CRE insights Offer Green-Shoot Perspective
Just as market implied probabilities are a useful tool in monitory financial markets, public REIT pricing trends arise as a powerful barometer of CRE investor sentiment and trends in private performance ahead. Indeed, in the wake of the June CPI report posting, REITs had one of their best weeks since the rate hiking cycle began. As shown in the LHS of Chart 2, below, the All-Equity REIT index improved over 4% in a single week as shifting rate cut expectations catalyzed investors’ renewed focus on real estate. In connection to the improvements in REIT pricing, we’ve also been tracking a tightening in REIT-Implied Nominal Cap Rates.
Meanwhile, shown in the RHS of the chart, while REIT pricing still stands roughly 21% below its prior peak, the public markets are in recovery mode (even for office), as evidenced by the fact that all peak-to-current % changes in the RHS of Chart 2 are better than their peak-to-trough declines. Certainly, disparity exists by property type, but the key message is one of recovery. While the private markets are still in correction mode, in most cases, it is just that: a correction to the one-off adjustment to higher interest rate environment. The rebound in the public market underscores that recovery follows adjustment; investors are keenly aware of this fleeting window of opportunity, and our experts in the field continue to indicate rising buyer demand.
So, What Does a Fed Cut Really Mean for CRE?
Think of it in terms of three “C”s, starting with
- Clarity on the path ahead: The first cut implies that the broad “soft-landing” narrative is holding, which gives consumers, businesses, investors, and lenders more clarity and confidence to make decisions. More business clarity begets more business growth and demand for credit/investment, which in turn supports demand for the built environment (a fortuitous cycle). More clarity also provides buyers and lenders with a more solid foundation upon which to underwrite NOI growth and forward-returns, which will inevitably help more deals pencil on the buy-side.
- Curve Shifts: Fed cuts will gradually bring the short end of the curve in and will help generate some additional debt spread compression. With longer-dated Treasuries pegged to low 4%-equilibrium range, full un-inversion isn’t expected until the end of ’25 (at least assuming growth remains in a soft-landing scenario, underscoring the Fed’s patience). The eventual flattening and un-inversion of the yield curve naturally stimulates longer-term credit growth for lenders and borrowers.
- Contraction in CRE Debt Costs: Fed cuts influence the short end of the curve, which certainly helps debt tied to floating rate instruments. We can also expect some spread compression as uncertainty fades, however, debt spreads have already been tightening, so the impact of rate cuts is likely to be felt more so in base rates with marginal spread compression to follow.
As Debt Costs Come In, Neutral/Positive Leverage Can Be Restored
Negative leverage conditions (i.e. when going-in cap rates are below debt costs) remain a significant hindrance to velocity. While some investors have stomached negative leverage over the last several years (with the intention of growing out of it with NOI growth), many have taken to the sidelines to wait for prices to correct enough such that cap rates become more amenable.
Chart 3 tackles a common question as it relates to timing – i.e. when can we expect positive or even just neutral leverage conditions to reemerge? Currently, fixed debt for higher quality (i.e. Top Quartile cap rates) are still negative (-70 bps for Residential, -25 bps Retail, -65 for Industrial, -87 for Office and -35 for Hotel). Fixed rate longer-term debt is poised to return to neutral/positive leverage conditions within a few quarters as base rates come in, yet keep in mind that longer-dated Treasuries are still expected to anchor around the mid-to-low 4%-range. Meanwhile, floating rate debt spreads to SOFR are more negative; assuming cap rates remain stable and spreads hold constant (for simplicity’s sake), it will take upwards of 5 to 6 rate cuts until floating rate debt returns to neutral or positive range. Of course, some spread compression and cap rate compression are likely to follow rate cuts, so the timing to restore neutral/positive leverage could shift ahead to 3-4 cuts, depending on product type and leverage utilization. As the CRE capital and debt markets near that neutral/positive leverage tipping point, liquidity conditions stand to significantly gain traction.
Fed cuts will translate to neutral/positive leverage conditions gradually (not immediately), so it is best to think of the capital markets recovery as sequential in nature, not necessarily as a flood-gate opening upon the first rate cut. Encouragingly though, fixed rate product is effectively at or very close to squeezing out neutral/positive leverage, signaling that more traction is expected to form in the quarter(s) to come. Such mounting momentum continues to be corroborated by our Debt and Capital Markets experts, who are noting robust deal pipelines and growing buyer interest.
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%).