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Market Matters: Exploring Real Estate Investment Conditions & Trends

Welcome to the latest edition of “Market Matters”; a perspective of current Capital Markets themes from Cushman & Wakefield's research professionals. In this newsletter, we explore current conditions, short-term developments and long-term economic trends so you can better understand their impact on the real estate investing environment. 

  MAY 21 EDITION  |  APRIL 24 EDITION  |  MARCH 28 EDITION  |  FEB 22 EDITION  |  JAN 17 EDITION


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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 
 
following the flow reportAfter 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.

CPR Structure

  • 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.

The-Power-of-Expectations-Market-Matters-April-2024

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  

 

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.

Deciphering-Debt-Video-Graphic-Market-Matters-March-2024


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.

ChartsforMarketMatters328242


FEB 22 EDITION  

QUICK BITES 

We Knew the Road Would Have Some Potholes, But We’re Still On Course  

KEY THEMES

  • Denial Is Not Just a River in Egypt: Too Much Focus on a Fed Pivot and Not Enough Acceptance of HFL: As we’ve seen in the last few weeks, the rate cut cycle probably won’t look like what the market is predicting as the year kicked off, and the markets appear to be tempering their enthusiasm. Keep in mind that a Fed pivot will likely just shift the short-end of the yield curve, while most economists expect the long end of the yield curve to hover near or in the 4%-range.
  • Buy-side Optimism: will form on the back of the Fed’s cutting cycle, and momentum will continue to solidify in 2H 2024. However, expectations for a sharp bounce-back in capital markets activity should be tempered.
  • Sell-side Stubbornness: A big justification for tempering velocity expectations gets to the fact that many sellers have utilized the anticipation for rate hikes as rationale towards either waiting to bring their assets to market, waiting to meet the market from a pricing/valuation standpoint, or simply just as justification towards holding at a certain valuation.

DIVING DEEPER

  • CRE’s Performance Disconnect to The Economy Signals Dislocated Value: Real Estate is the “economy in a box,” which means it generally mirrors the performance of the broader economy because the economy needs real estate (to varying degrees, by sector, etc.). Shown in Chart 1, the S&P 500 is up 3% since Fed started raising rates, while REITs are down 20%, and the gap between real estate performance and the broader economy is trending at the widest it has ever been. Inevitably this disconnect will converge, implying that now is a unique and attractive time to invest.

  • Contextualizing the Wave of Maturities:
    Maturities – the topic du jour as of late. Anticipating whether a loan will move through the refinance process, whether the owner will opt to sell upon maturity, and whether the lender will have an appetite to work with the borrower all vary significantly. Origination year, , implied current LTV, the sector’s perceived uncertainty as it relates to cash flows, and the asset’s underlying quality/performance all play significant roles in that analysis.

    Given that much of the maturity story links to origination year and the degree to which the property has accrued value appreciation, Chart 2 reflects all loans maturing over the next two years (2024 and 2025), segmented by origination year.

    First, notice the rather significant dispersion of maturities by origination year. Over half the loans originating over the next two years were originated in the mid-2010’s. These loans will face higher debt costs upon maturity, but their earlier origination year implies that they have crystalized enough NOI growth and asset appreciation that they may not require significant cash in, and may be able to cash-out on refinance. Sounds great on face value, but is that really the case?

    Indeed it is: the orange dashes in Chart 2 reflect estimated implied current LTV’s, accounting for 1) accumulated appreciation since origination, 2) outstanding loan balance since origination, and 3) peak-to-trough value losses
    of approximately ~40% (forecasted to occur) due to the ongoing price reset. Narrowing-in on the 2015 origination year, which for example comprises the most oncoming maturities, notice that the implied LTV stands at roughly 48.5%. Behavior and decisions of borrowers (and lenders for that matter) will vary significantly if the loan is carrying a more conservating prevailing LTV and more conservative metrics related to debt service and cash flows.

    Alas, accrued appreciation and origination year are both meaningful pieces to the nuanced puzzle when it comes to determining what path the asset and loan might take looking forward.
    It’s tempting to look at the wave of maturities and paint them with a broad brush, whether that be at the sector-, ownership-, lender- or market-level, but predicting the degree to which oncoming loan maturities will result in widespread “distressed” opportunities requires a more granular characterization of the sorts of conditions facing each loan, borrower and lender.

    Lender desire and willingness to work with borrowers will also vary significantly. For the banks, there’s no question that existing relationships and deposits come into play, and banks are clearly pruning back the transaction relationships that don’t meaningfully contribute to deposits, but depository relationships are likely taking a back-seat to other considerations like the viability of the asset and the willingness/ability of the borrower to infuse required equity to ensure the asset meets required loan thresholds etc. Lenders of all types, including banks, are taking the first/second/third steps to evaluate their portfolios and communicate with existing borrowers as well as to build up loss reserves ahead of loan charge-offs.

    A lot of it also comes down to the specific bank and what their overall CRE portfolio and exposure looks like. Smaller banks generally have higher CRE concentrations than their larger bank counterparts, which means that smaller banks are going to have to be much more careful about thinking through who they work with, why and how….

    Office refinancings are going to become significantly more challenging, particularly at lower valuations and debt service coverage ratios, so it depends largely on the property type, the timing of the asset’s initial origination, the asset’s fundamentals, and the borrower’s proclivity to remain as ownership as well.

    Regulators are in the process of assessing and addressing risk throughout the banking sector. Their heightened scrutiny and oversight will likely result in banks growing increasingly proactive for Office in particular. This proactive approach (either in working with borrowers or in recognizing losses more promptly) has the potential to aid in the price discovery process, either generating loan sales or lender-assisted sales that will introduce opportunities for the abundance of dry powder on the sidelines seeking opportunistic and value-add returns.

Market-matters-image-1-feb-2024

market-matters-image-2-feb-2024


JAN 17 EDITION  

Reasons for Optimism In 2024 

This year will be characteristically different from last year. First off, from a macro stance, we are farther along than we once were heading into 2023. Inflation is better today that it was last year (at 3.4%, y/y Headline CPI is now 300 bps below where it was this time last year). December’s Core Inflation print edged below 4% y/y for the first time in two and a half years (compared to 5.7% in December 2022), and the trend should slow further as consumer demand eases and as the downshift in Shelter Inflation gains momentum. The labor market continues to cool, all as wage growth is making a slow, yet stubborn descent to more comfortable levels for the Fed. Moreover, Inflation expectations also remain anchored; a fact which reassures the Fed while suggesting that CRE returns will be attractive on a comparative basis in the years ahead. All that said, we’re also starting to see the weight of interest expense gradually weigh on consumers. Consumer credit card debt has reached an all-time high, and delinquencies on credit card and auto loans have edged up, both of which naturally weigh on consumption patterns, with fading pandemic savings off in the background. Rising interest expenses are also gradually weighing on revenues in the corporate sector, which eventually curbs business investment and growth. Thus, the slow burn of the rising cost of capital is gradually lending itself to easing, yet resilient growth.

2024 will be characterized as a year of endurance and re-establishing a more solid footing. Higher interest rates have been slowly percolating their way through segments of the economy (CRE, tech, financial services), yet so far, the economy has been taking the punches with remarkable resilience. Soft-landing prospects are very different from “no-landing prospects”, and some softening below potential growth is still required to satisfy the Fed while cooling inflation below wage growth. We still expect growth to slow further and unemployment to rise as the full force of monetary policy flows through to the corporate sector and the consumer. As growth slows in 2024, upside potential for 2025 and 2026 remains strong. For a more distilled view into how all of this is expected to play out, check out my revised GlidePath.

We’re nearing a turning point in rates and are standing at a different juncture in the monetary policy cycle. Greater clarity on terminal rates and slightly more dovish messaging from the Fed has allowed financial conditions to loosen over the course of the last several months. A word of caution remains, though, as the Fed has not fully declared victory, and will not back down until they see sustainable progress made in sustainably cooling (Core PCE) inflationary forces. There is no silver bullet towards a swift or easy CRE capital markets recovery, yet optimism will gradually form on the back of an eventual Fed pivot and on greater interest rate and yield clarity.

Debt market-thawing process is in the early stages, but nevertheless underway. The Fed has clearly signaled that we are at or near the peak (terminal) rate, which has helped tighten base interest rates about 100 bps relative to their October ’23 highs. CRE risk spreads are still elevated given lender risk assessments and uncertainty in the macro-outlook. Reaching a terminal rate will be a significant milestone in allowing broader financial conditions to loosen. Lending standards appear to be at least inflecting, which also helps to suggest CRE debt liquidity will improve as rates stabilize. If the yield curve un-inverts sometime in late 2024, it will also allow banks (CRE’s largest lending source) a theoretically better foundation upon which to both maintain their depository bases, triage their existing portfolio liquidity needs, as well as to eventually free up more capital to lend on new originations.

Some of the conservatism, uncertainty and outright hesitance towards lending will be able to ease as terminal rates are achieved and as cutting gradually ensues because both lenders, buyers and sellers will be able to better model NOI growth and exit assumption, which will help to bring in debt spreads a bit, while also expanding or improving debt terms (required LTVs and DSCRs). One of the problems right now is that debt is indeed selectively available; it is just expensive (often cost-prohibitive) relative to where sellers are holding going-in yields. The more that base rates and debt spreads (i.e. overall debt costs) can compress as pricing adjusts, the more that a virtuous cycle of meeting-the-market will ensue.

Generally, there is greater acceptance of higher-for-longer (normalized) rate environment, which will help narrow the buyer/seller divide as both sides acknowledge the ramifications to values, going-in yields and exit cap assumptions. Sellers also can’t avoid reality (i.e. normalized higher real yields and comparative yield spreads) forever. The adjustment process is painful, and requires a diminution in value, but the sooner that expectations surrounding value align, the sooner fluidity and a more efficient marketplace returns.

Maturities are mounting, and distress will aid the price discovery process. From a magnitude standpoint, RCA is tracking about $80 billion in actual loan-level distress, which is still below that seen during the GFC at $200 billion (there is potential to surpass that given the scale of oncoming maturities, as well as the significantly higher rate environment such loans are maturing into). While many lenders have chosen to extend 2023 maturities into 2024-205, the equity requirements such maturing loans will ultimately face given higher rates, higher LTVs and more stringent lending thresholds will present opportunities for new investors. Forced sales will gradually come to bear for those that aren’t able to find equity injections, which will help bring the market into equilibrium. The distress process, at least historically, has been gradual and unfolds over years (took GFC 7+ years). There’s a lot of capital ($150 billion in the Opportunistic profile tracked by Preqin) waiting for these opportunities, but it’s still early. We delve more into the topic of distress in our 10 Critical Questions for 2024 as well as our prior in Market Matters edition that focused more closely on the floating-rate debt exposure in the Multifamily sector. External Link

Capital is patient, but it can’t wait on the sidelines forever. Over $400 billion in dry powder sits on the sidelines globally ($250 billion targeting the U.S.). Institutional allocation intentions to CRE remain firm (at around 11% of total assets), with 84% of institutional investors expecting to increase their allocations to CRE long-term. Investors also recognize that periods of dislocation make for strong vintage years; they seek to diversify their acquisitions across the cycle so as not to have a track record of only buying at the peak. The denominator effect will also come into play as broader equity markets strengthen causing an under-weight to CRE for institutions. As is also typical in prior cycles, Exit- and Entry- Queues tend to inflect and reverse quickly sharply coming into and out of downturns. As greater clarity forms, redemption requests will sharply turn, and soon we will be tracking mounting Entry-Queues. 

The public markets have adjusted and are bouncing back. Last year, the public markets witnessed a fair share of volatility as higher costs of capital were priced-into broader REIT valuations more swiftly. REIT pricing has stabilized and even recovered most recently (the Dow Jones All Equity Composite REIT Index has bounced up 20% from its October 2023 trough). 

This will be the year of creativity, where expertise can shine. Periods of dislocation offer significant opportunity to utilize one’s expertise as the process unfolds. Some capital stacks are challenged, which offers equity and debt market experts an unparalleled window to connect both the side needing capital infusion as well as the side looking to place capital. We’re seeing this take place in the Real Estate Secondaries space, we’re also seeing it in small scales with private capital sources gaining an opportunity to step up to high-quality deals. 

Fundamentals are Shifting Cyclically, but Solid Stage is Set: The supply wave is still working its way through Multifamily and Industrial, but construction starts have sharply fallen. The last time U.S. multifamily construction starts were this low (about 60,000 in Q4 2023) was in 2012. The contraction in starts will set the market up for recovery on the other side of this construction wave in 2025 and 2026.  NOI growth prospects are still attractive. While NOI Growth is cyclically downshifting in the near-term, forward perspectives are still robust (check out our U.S Macro Outlook for NOI growth forecasts by sector). 

No shortage of conviction points for CRE long-term, and a big difference between the influence of cyclicality and secular dynamics. CRE will be at the intersection of several tidal-wave-sized megatrends (demographics, climate change, technology and innovation) that will require the industry to respond with renovated, repositioned, and new product to meet demand. 

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