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Commercial real estate prices that continue to decline, a potential rebound in listed REITs, and a commercial real estate debt market that we believe is healthier than many observers think.
Watch this month’s Real Estate Reel to find out what these data points mean for our 2024 real estate investing outlook.
Commercial real estate price declines. A potential rebound in listed REITs. And the health of the CRE debt markets.
That’s what I’m watching heading into 2024.
Welcome to the Real Estate Reel where we discuss three data points we’re watching each month. This month, we’re focused on what to watch next year.
First, we expect commercial real estate prices to continue falling on the back of the 10 to 15% declines (shown in this chart) that we have already seen from their peak.
In total, we expect CRE prices to decline roughly 25% to 30% from peak to trough, which means private CRE valuations are only halfway to our projected declines.
However, there are signs that the worst is behind us as quarterly declines are slowing. The third quarter of 2023 saw private valuations, as measured by the NCREIF ODCE index, decline for a fourth quarter in a row by -1.9% compared to -2.7% in the second quarter, -3.2% in the first quarter, and -5.0% in the fourth quarter of last year.
The next leg lower in CRE prices may be a slow grind that plays out over the next year and a half. It will be driven by distress that is rising as loans mature and force weaker hands to sell properties.
We see this selloff and subsequent recovery creating a historic opportunity for strong returns for private real estate investing, but we believe it will also create winners and losers.
On the losing end, we believe, will be many legacy funds because they purchased properties at or near peak valuations, particularly in 2022 when private funds were the only investor type that net acquired assets. Those funds have been slow to markdown existing assets given a lack of transactions that would otherwise provide pricing transparency. The result is that they may not have ‘dry powder’ to invest when prices become attractive.
On the winning side, we believe, will be new funds with fresh capital. Indeed, history shows the best vintage returns are generated in the aftermath of markets like we are experiencing today, with post-2008 vintages a key example as you can see in this chart.
We expect returns for 2015 to 2020 vintages to meaningfully decline as cap rates reset higher and valuations decline in the coming years. Additionally, the property types that worked last cycle, may not work this cycle. For instance, shopping centers, which were largely ignored by current private funds launched in the prior generation, are the best-performing asset class in 2023 year-to-date. By comparison, most private funds that are heavily weighted to industrial and multifamily sectors have the lowest cap rates.
The second development we’re watching into 2024: The potential rebound in listed REITs.
Listed REITs have already priced in much (if not all) of the headwinds now facing private CRE as they lead in both downturns and recoveries. Prices are down almost -30% from their peak at the end of 2021 with total returns since then of -24.4% as of November 28, 2023, but we see a more favorable backdrop emerging.
Indeed, as you can see in this chart, listed REITs have already rebounded 13% from their trough last month and are on track in November for the 12th best month ever with month-to-date returns of 10% as of November 28th. An analysis of the prior 11 best months ever shows that listed REIT returns have never been down over the next 12 months after those months.
The recent rally was aided by a 40bp decline in real rates from the highs in October. Real rates, along with investment grade corporate credit spreads and net operating income growth, are the three factors most critical to the performance of listed REITs in 2024.
Let’s level set on those three data points. Current real rates are 2.1%. Credit spreads are currently 109 bp. And Net Operating Income (NOI) growth for listed REITs was 4.6% as of 3Q23 according to the National Association of Real Estate Investment Trusts, known as NAREIT.
With that as the fundamental backdrop, here’s what we might expect for listed real estate in 2024 given various scenarios:
If current real rates decline slightly to 2% and credit spreads are unchanged in the year ahead while net operating income growth slows to the mid-3% range next year, then we would expect mid-to-high single digit returns.
By comparison, if real rate rates decline to 1.5% as the Fed continues to control inflation while net operating income growth slows to mid-3% range and credit spreads are unchanged, then we see potential for returns in the mid-teens. And keep in mind listed REITs can often overshoot fundamentals to the upside as evidenced by listed REITs returning +20% annual returns in six different years since 2009.
We think a harder economic landing where real rates fall toward 1% while credit spreads widen and growth slows, could produce positive returns for listed REITs given what’s in the price. The risk is interest rates remain higher for longer.
Bottom line, we think risk-reward skews positively in 2024.
The third development to watch in the year ahead is the CRE debt markets. Lending conditions are undeniably tight, which is creating challenges for borrowers that have loans coming due. Investors should expect delinquencies as well as distressed sales to rise, but we don’t think the reality is as bad as the media headlines suggests.
First, the Fed’s Senior Loan Officer Opinion Survey suggests that we might have already seen peak tightness in lending standards. As a reminder, lending standards are important because there is a strong historical relationship between YoY changes in CRE prices and the Senior Loan Office Opinion Survey, which you can see in this chart.
Second, MSCI recently analyzed the health of real estate’s loan collateral. They found that the price of 81.5% of the properties securing loans has dropped in the past 12-months, but only 40% of loans are estimated to have decreased in value since their origination. This is due to price appreciation over the loan’s lifespan prior to recent corrections.
In other words, more loans may be able to refinance than feared. This is supported by our analysis of CMBS loans that matured in 2023. It showed that 80% of these loans paid off at or before their maturity date. Some of the other loans that have higher effective loan-to-values will be modified and extended by the lenders who may not want to foreclose on properties.
Bottom line, there are real headwinds facing the CRE debt markets. But we think the market is coming to terms with the fact that headwinds facing commercial real estate debt will be a slow burn over a longer period rather than the collapse that the market feared in March.
Overall, we think 2024 will mark an inflection point in real estate investing. We believe private will continue to selloff. Listed real estate is likely to rebound. But markets are in better shape than many observers may believe.
Thanks for your partnership this year, and we look forward to speaking with you in the next year.
Watch November’s The Real Estate Reel: The listed REIT selloff, valuations, and the private CRE correction
Head of the Private Real Estate Group James Corl spoke with Institutional Investor about the emerging opportunity within private real estate as the asset class reprices and why this might be the most attractive entry point into private real estate since the GFC.
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