Economy
Many asset managers are increasingly confident that private real estate is at or very close to the bottom of its cycle and presenting an opportunity for outsized returns. It’s a major shift from last year when many funds had to put limits on redemptions. This year, institutional investors are increasing allocations in anticipation of an improving macro environment.
Additionally, many believe that concerns about commercial real estate are exaggerated. Other than the office sector, most segments have strong fundamentals. Recently, deal volume has improved as sellers have come down on price. Overall, it’s estimated that prices are down on average by 18.5% from the peak.
Over the last decade, private real estate in the US generated annual returns of 6.4%. According to James Corl, the head of private real estate at Cohen & Steers, returns will average between 10% and 12% in 2024 and 2025. He added that returns in private real estate are highest a year after the Fed stops tightening.
Many investors are anticipating attractive deals in the coming months as there could be several forced sellers with many borrowers needing to refinance at higher rates. Over the next 2 years, $1.2 trillion of commercial real estate loans will mature. At the end of the year, it was estimated that about $85.5 billion of this debt was distressed.
Finsum: Asset managers are increasingly bullish on private real estate. History shows that the asset class generates outsized returns in the periods that follow the end of a Fed tightening cycle.
An unusual recurrence in the markets is the ‘January effect’. This is the phenomenon of downgraded debt consistently outperforming in the first month of the year. This has taken place in 18 out of the past 21 years. 2024 is no different as the ICE US Fallen Angel High Yield 10% Constrained Index outperformed the ICE BofA US High Yield Index by 56 basis points. This year, the fallen angels index is composed primarily of real estate, retail, and telecom.
JPMorgan sees some risks of further downgrades in the coming months. Currently, the high-yield market is collectively worth $1.3 trillion. Of this, $1.05 trillion is rated BBB- by at least one rating agency, and $111 billion is on negative watch by at least one agency. The bank sees risk of sector-specific weakness in real estate leading to more downgrades. It also notes a lesser risk of the economy slowing leading to more downgrades.
Over the last 3 months, 5 REITs have joined the fallen angels index and now comprise 12% of the index. Some issues are leverage, lower renewal rates, lack of recovery in office vacancies, and higher insurance costs. The sector is expected to remain under pressure, especially in commercial real estate, as $2.2 trillion in loans is expected to mature between now and 2027.
Finsum: REITs are the largest component of the fallen angels’ index due to secular issues in commercial property and cyclical pressures created by high rates.
There have been concerns that the housing market could be on the verge of a decline given the stress created by high interest rates and a weakening economy. However, one reason to be sanguine about the housing market despite near-term headwinds is that household balance sheets are in strong shape.
It’s sufficient to dismiss alarmists who see another housing crash on the scale of the financial crisis and Great Recession in 2008. While economic headwinds have started to damage the standing of renters, young people, and those with lower FICO scores, there is no indication that homeowners are in a troubled position.
In fact, bankruptcy and foreclosure rates have remained low even after the expiration of the CARES Act moratorium. This is a departure from the Great Recession when many households were overly leveraged, and higher rates led to a surge in foreclosures. Another major difference is that regulations have led to higher lending standards and the disappearance of exotic mortgages.
Following the housing crisis, most buyers gravitated towards 30-year fixed mortgages. Periods of ultra-loose monetary policy also led to major waves of refinancing. Cumulatively, this means that the vast majority of households continue to enjoy low rates and have seen the value of their homes rise.
Finsum: Inflation and higher rates have been damaging to certain segments of the population. Yet, homeowners are an exception as they have locked in low rates, while showing little indications of stress.
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The last few years have been brutal for first-time homebuyers. Prices have been trending higher for the last decade and accelerated in the post-pandemic period. The last couple of years have also seen affordability take a huge hit due to interest rates making mortgages more expensive, a consequence of the Fed’s battle against inflation.
Further despite many headwinds, home prices have remained flat rather than go down and provide relief to buyers. This was, in part, due to low supply as many homeowners elected to hold onto their homes and low monthly payments rather than move. However, there are some signs of positive developments.
The major one is the Fed pivoting and starting to cut rates which is expected sometime in May or June. One caveat is that declines in the mortgage rate in the summer and winter of last year led to sizable jumps in mortgage applications, indicating a healthy amount of pent-up demand if conditions ease. This means that any relief could be short-lived as prices could resume rising if activity picks up. In the interim, one group of winners could be cash buyers given that there could be some forced sellers who are unable or unwilling to refinance at higher rates.
Finsum: The sharp rise in home prices in the post-pandemic period and spike in interest rates has been brutal for prospective home buyers who have seen affordability crumble. Here’s why 2024 could present more favorable conditions.
The crisis in commercial real estate (CRE) is starting to have knock-on effects on banks according to Federal Reserve Chair Jerome Powell. In an interview with 60 Minutes, he remarked, “It feels like a problem we’ll be working on for years… it’s a sizable problem.” He added that most of the negative impact would be concentrated on smaller or regional banks who have greater exposure to CRE.
Already, the Fed stepped in following the collapse of Silicon Valley Bank in June of last year to prevent further damage that could impact the broader economy. In addition to this stress, banks are dealing with an inverted yield curve which has made lending less profitable, and it has led to the uncomfortable position of paying out high rates on deposits while holding loans made at much lower rates in the past.
Ultimately, the crux of the problem is that demand for office space has declined due to more companies adopting remote work or hybrid arrangements. According to estimates, there could be 1 billion square feet of unused office space by the next decade. Another cause for concern is that over the next few years, loans will mature and need to be refinanced in a much more difficult environment. Given these bleak fundamentals, it’s inevitable that lenders will take losses.
Finsum: In a 60 Minutes interview, Fed Chair Jerome Powell warned that weakness in commercial real estate was starting to impact the banking sector. Already, the Fed intervened last year to prevent contagion following the collapse of Silicon Valley Bank.
Cohen & Steers believes that 2024 will mark a turnaround in private real estate following years of being plagued by issues like a drop in office occupancies and high interest rates. The firm emphasizes that real estate remains a cyclical business with many indications that we are near a trough in the cycle. It acknowledges that some pain is still coming as large amounts of debt will mature in the next couple of years and require refinancing, likely leading to more defaults and distressed assets.
However, this will present an attractive opportunity for investors according to Cohen & Steers. The firm sees private real estate following the same trajectory as public REITs, lower prices in the interim before a gradual recovery as the Fed shifts to cutting rates later in the year.
The firm favors newer properties in the sunbelt over older properties in coastal markets. It sees migration out of high-cost cities and into the suburbs continuing, facilitated by technology and remote work opportunities.
In terms of various segments, it sees less opportunity in Industrial properties due to high prices and indications of a supply glut and lower occupancy levels. It sees office properties as continuing to struggle given unfavorable secular trends. Specifically, it recommends staying away from older office properties which were built for a different time and workforce.
Finsum: Cohen & Steers believes that private real estate is near the bottom, and that buyers at these levels will be rewarded in the long-term.