Private real estate valuations are declining

Private commercial real estate (CRE) prices have been declining in the face of higher financing costs—stemming from higher interest rates intended to tame inflation—and wider credit spreads that prevail in times of economic slowdown. Unlevered CRE prices are down approximately 18.5% from their peak in the third quarter of 2022. We expect this repricing is at least two-thirds complete and will potentially continue into 2025. This follows a 14-year positive investment cycle fueled by historically low interest rates.

This magnitude of private CRE decline has only occurred twice in the past 40 years: 1) in the early 1990’s after the savings and loan crisis and, 2) in the wake of the 2008-2009 global financial crisis (GFC).

Listed real estate, a leading indicator for private real estate in both downturns and recoveries due to its liquidity and real time pricing, has foreshadowed these losses in the private space for the last two years. REIT total returns were down nearly 30% towards the end of the third quarter and reached a new post-COVID trough, down 33% from peak near the end of October 2023. The sell-off intensified in August, September and October as the 10-year U.S. Treasury yield peaked above 5%, the highest level since mid-2007.

In keeping with its historical behavior, REITs reversed course once it became apparent the Federal Reserve was no longer inclined to apply further monetary policy tightening. REITs rebounded 11.9% in November, the fifth largest monthly return ever recorded. As of this writing, listed REIT prices now stand almost 25% above their October 2023 lows. In our view, this turnaround has been decisive, fitting the historical pattern inasmuch as the inflation data continue to support the notion that the Fed’s job slowing the post-COVID economic boomlet is complete.

EXHIBIT 1

Private real estate values will likely fall further in 2024–2025 if listed REITs are an indicator

At December 31, 2023. Source: NCREIF, Bloomberg, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.

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Where listed leads, private follows

What are the implications for private real estate? Again, the historical pattern is very instructive. Private real estate prices usually take a year, plus or minus, to catch up to the capital markets reality reflected in REIT market pricing on a real-time basis.

This time appears no different. REIT prices peaked during year-end 2021 as the Fed signaled it would tighten to bring down inflation, even as private real estate valuation marks continued to trend upward until the final quarter of 2022. We are witnessing the standard one-year delay in private real estate values, indicating that, on average, these prices will persistently decrease through 2024. The Fed’s job of applying the brakes may be done, but the private real estate pricing mechanism will require another year to reflect the structurally higher rates that persist.

We view this as an attractive opportunity as such significant declines in private real estate occur once every 10–20 years and have historically resulted in subsequent strong return vintages. We believe the current repricing, which we are about two-thirds through, will result in the same. The sell- off and subsequent recovery will be disparate, however, with the weakest properties (older properties in coastal gateway markets) hit hardest, and the strongest properties (newer, amenity laden real estate in sunbelt locations) experiencing the most robust recovery.

Let’s take a closer look at the process by which this continued repricing of commercial real estate will continue in 2024.

Higher yields have major impact on higher real estate prices

The rapid rise of the 10-year Treasury yield to 16-year highs has negatively affected the commercial real estate market because of its direct impact on borrowing rates. The 450bp move higher, from approximately 50bp at the lows in 2020 to 5% in mid-October 2023, placed borrowing costs near prohibitive levels, compared with existing valuations. Of this move, 150bp occurred over the past seven months (Exhibit 2).

EXHIBIT 2

10-Year treasury yields undergo rapid ascent

Year-to-date yields

At January 12, 2024. Source: Bloomberg.
Data quoted represents past performance, which is no guarantee of future results. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.

These increases in financing costs have frozen the private market, thereby impeding price discovery, and consequently, have slowed transaction activity. This will remain the case until sellers and debt providers recognize the new market environment and accept lower prices.

One repricing catalyst we may see in the coming months and years is the impending “wall of maturities”—this refers to a short period of time in which a significant volume of CRE loans are scheduled to mature. Specifically, our analysis of Mortgage Bankers Association (MBA) data suggest that almost $1.6 trillion of loans are expected to mature between 2024 and 2026.

This represents approximately 35% of total outstanding CRE mortgages due, in part, to the abundance of short-term floating rate loans that were originated over the past several years. Indeed, throughout 2021 and much of 2022 when short-term interest rates were close to 0%, more than 60% of all loan originations were floating rate. However, the financing environment is immensely different today than when these loans were originated.

If borrowers fail to secure new financing or extend existing loans, they are likely to find themselves in default or be forced either to inject fresh equity into their properties or sell properties to fulfill repayment obligations. In such a scenario, forced sales would likely exert downward pressure on prices owing to the surge in supply (Exhibit 3). And the result could be a historic opportunity for deploying fresh capital in private real estate.

The sectors most exposed to potential defaults are office, multi-family and industrial.

EXHIBIT 3

A high number of CRE loans are set to mature by 2026

Maturing loans could cause distress

At June 30, 2023. Source: Mortgage Bankers Association, St. Louis Fed, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin.

Negative leverage, higher capitalization rates and the shape of the decline

This upward shift in interest rates not only affects the cost and availability of real estate debt, but also reflects how real estate assets are valued by the appraisers that determine private real estate valuation marks. When real estate debt providers are charging more, providers of real estate equity will ultimately demand higher returns as well, all things being equal.

The capitalization rate indicates the approximate initial cash flow return that the investor expects on an unleveraged basis. However, when the cost of debt rises to a level on par with or greater than the investor’s capitalization rate, a very unsatisfactory condition exists whereby the investor’ return is diluted, rather than enhanced, by the use of debt. We call this “negative leverage”. Real estate debt costs are currently greater than nearly all the capitalization rates being used by appraisers valuing private assets today. This widespread persistence of negative leverage historically provides a strong signal that asset prices need to decline in order for real estate assets to attract willing providers of new equity. This unfortunate reality for old providers of equity takes time for appraisers to reflect this in their valuations—and for these new valuations to be published. This process is in full swing today and informs our view that asset prices have another 5–10 percentage points further to fall.

It should be noted, however, that this expected fall in prices will be less severe than the GFC, which was caused by risky lending practices that needed unprecedented government intervention (Exhibit 4).

But while the fall will not likely be as deep as the GFC, we believe the selloff will be similar in duration. In fact, while the initial descent was sharper than the GFC, the relative steepness has moderated since. We note that the peak to trough decline in levered property returns in the wake of the GFC was even greater at nearly -45%.

It is our belief that private real estate investors will likely need to be patient in finding opportunities that begin to emerge as we near the bottom, with opportunistic and distressed investment prospects revealing themselves in the nearer term.

EXHIBIT 4

Cumulative change in unlevered private CRE prices

The current move down is expected to be less severe than the GFC

At December 31, 2023. NCREIF, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not represent the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance listed above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. There is no guarantee that any market forecast set forth in this presentation will be realized.

Entry points emerging

With private real estate poised to drop a further 5–10 percentage points, we believe 2024–2025 will offer the best entry points into the asset class since the GFC. Because of these impending opportunities, we believe committing capital at this stage is prudent, as a dynamic, flexible strategy is required to capture these value windows.

History shows the best vintage returns have been generated in the aftermath of markets such as today’s, with post-2008 vintages a prime example (Exhibit 5). We expect returns for 2015–2020 vintages to meaningfully decline as capitalization rates reset higher and valuations decline in the coming years.

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CAP RATE =

Net Operating Income (NOI)

Market value or acquisition cost of property

NOI represents the income generated by the property after deducting all operating expenses but before deducting interest and income taxes.

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EXHIBIT 5

Post-2008 vintages have historically generated attractive returns

Average of the median internal rates of return (IRR) by vintage for closed-end funds⁽¹⁾

At November 14, 2023. Source: Preqin, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not reflect the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. Analysis based on U.S. business cycles as determined by the U.S. Conference Board Coincident Indicator. (1) Internal Rate of Return (IRR) – a measure of return on investment. Expressed as a percentage, the IRR is based upon the realized cash flows and can be expressed as gross or net of fees and carried interest. Private real estate funds are represented by global closed-end funds that own core and core plus real estate. Data consists of 279 funds with aggregate commitments of $84.6bn launched from 1999 to 2020. (2) Less than 15% of the 2015 – 2020 vintage funds have been liquidated compared to nearly 60% of 2009 – 2014 vintage funds and more than 85% of 1999 – 2008 vintage funds. Median IRRs are subject to change as properties are sold at then-current market prices. (3) The midpoint of a 6.5% to 8.5% estimated IRR range based on DCF sensitivity analysis. This compares to net median IRRs for the 2006, 2007 and 2008 vintages are 7.7%, 6.8% and 6.9%, respectively. We believe a higher net median IRR for the 2015-2020 is warranted since we don’t anticipate this downturn to be as severe as what occurred during the Great Financial Crisis.

Winners and losers

As these investment opportunities reveal themselves, this downturn will look vastly different than what we have seen for the last decade. It will create winners and losers.

On the losing end, we believe, will be many legacy funds that purchased properties at or near peak valuations, particularly in 2022, when private funds were the only net acquirers of assets. Those funds have been slow to mark down existing asset prices given a lack of transactions that would otherwise provide pricing transparency. Redemption queues for these funds are also building. The result is legacy funds may not have sufficient capital flexibility to reposition themselves for the new cycle as they will be more likely to be facing calls for redemptions from investors.

On the winning side, in our view, will be new strategies with fresh capital as the property types that worked last cycle, will face increasing difficulties this cycle. Notably, most private funds, especially those heavily weighted to industrial and office, are starting to underperform as capitalization rates reset higher.

As a case in point, the industrial sector ranked as the top performing real estate sector every year between 2016 and 2022. Times have changed, however, and a meaningful rotation in property types and sector leadership is now underway.

EXHIBIT 6

Sector performance patterns in private real estate

What worked last cycle, may not work this cycle

As of September 30, 2023. Source: NCREIF and Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. The information above does not reflect information about any fund or account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance reflected above. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend will begin.

Industrial real estate assets enter this new cycle with asset pricing still at elevated levels. Our view is this pricing regime is being challenged as the asset level performance is beginning to underperform the lofty expectations that investors have grown to expect. A supply glut, slower leasing, declining occupancy and decelerating rental rate growth are a recipe for contraction.

From there, office property is undergoing a similar cycle to what malls went through over the last several years. Most of the buildings built to accommodate the Baby Boomers generation are ill-suited to the increasingly millennial-dominated workforce. These concerns have been well documented by us and by the financial press. Many core funds are sitting on long held, heavy weightings in office properties as there has been little opportunity to exit these properties since profound challenges came to the fore during COVID. Offices will continue to suffer for some time as tenants gravitate towards newer buildings in today’s favored locations and away from older buildings in legacy locations. Undoubtedly, however, there will be a few very targeted opportunities that will arise out of this office malaise.

In addition, we are seeing more systematic opportunities in certain types of retail real estate and in certain housing markets. Open-air, necessity-driven shopping centers are experiencing improved occupancies and rents. Online retailing is running into limitations and there is renewed demand from both existing store-based retailers and digitally native retailers for the convenience and cost structure of shopping centers. The decline in popularity for traditional enclosed malls is also contributing to more demand for space in open air shopping centers.

Funds with fresh capital may benefit from private real estate repricing, while legacy funds may experience weakness.

Finally, housing remains an important investment theme and will present opportunities once repricing has taken place. Last cycle, many investors over-indulged in multifamily housing investments at high multiples. As a result, this sector has been decidedly impacted by rising interest rates and negative leverage. Many markets are also burdened by a supply glut and slowing rental growth or outright declines in rents. Because of this, there has been an acceleration in the flow of distressed capital structures in this area.

Longer term, the U.S. remains structurally under-housed and unprepared to accommodate the millennial generation, which has reached its family formation years. Disruption near-term will ultimately give way to long-term renewed strength, which will make for motivating investment opportunities.

Within these sectors, we believe opportunistic returns can be unlocked by either acquiring high quality assets from distressed sellers or buying assets that need to be re-tenanted or repositioned to capture the tailwinds of long- term rent growth.

The landscape of private real estate is undergoing a tectonic shift, particularly as transactional values take the lead in shaping the market. With loans maturing and CRE asset owners encountering challenges from the new cost of financing, the real-time nature of transactional values becomes the key factor. Just as we’ve seen in the past, this unfolding scenario creates opportunities for investors who are strategically positioned and have liquidity to capitalize on the new pricing regime.

Private real estate is set to fall a further 5–10 percentage points in 2024 and potentially into 2025, which showcases the opportunity.