Navigating real estate cycles

After a more than decade-long bull run in the commercial real estate sector, investors are shifting gears to contend with a market downturn. Even for industry veterans, finding opportunities – and avoiding potential downside risks – presents formidable challenges.

Investors are moving cautiously amid headwinds that now include slowing economic growth, persistently high inflation, and constriction of credit. But perhaps the biggest challenge ahead is uncertainty around the cost of capital on both the debt and equity side. “That is a super fundamental question, and that's why I think everybody's debating it and largely on the sidelines because we don't know where it's going to land,” says Jeb Belford, Managing Director, Chief Investment Officer at Clarion Partners.

Belford participated in a panel discussion on Navigating Real Estate Cycles at the 2023 Altus Connect conference. Throughout the discussion, a key theme emerged – how do industry players navigate in a cycle that is fraught with uncertainty? “A big part of this uncertainty is you just don't know where things are going to go in the near term, much less the longer term,” says Richard Kalvoda, President of Altus Analytics Americas.

Uncertainty around changing capital costs, property valuations and the broader investment market has resulted in investors that are generally risk-off, adds fellow panelist Brandon Flickinger, Senior Managing Director and Co-Chief Investment Officer at Bridge Investment Group. “We’re spending a lot of time with our investor base, with our LPs, really trying to communicate our opinion and perspective on where things are going,” he says.

Although it varies by asset class, there are a lot of owners, borrowers and investors that are “shell-shocked” by what's going on. “If you were a lender and made a 55 to 60% loan on a stabilized office asset, it never occurred to you that your position may be underwater,” says Flickinger. On the industrial side, the asset class is performing really well. However, there are some broken capital structures where people bought long duration assets and financed them with short term floating rate debt, which creates a different set of issues. “So, it really is becoming increasingly important that we talk about this on an asset class by asset class basis, rather than cap rates or credit or just real estate,” he adds.

Reading the tea leaves on rates

On the heels of 10 consecutive rate hikes, the Fed took a pause on further increases in its June meeting. However, there is still a wide range of opinions on future Fed action, where long-term and short-term borrowing rates are going to settle out, and ultimately, what that means for cap rates. The Fed is indicating that the federal funds rate is going to be roughly 5.4% by year-end, while the market is predicting that it’s going to move lower.

“To me, what's so interesting is there is such a wide difference of opinion on where it's going to settle. That's essentially why we're not seeing levels of transactions,” says Belford. There's no conviction on whether the market is going to revert back to a relatively lower cost of capital world, or if the rate environment now meaningfully different, he says.

Flickinger expects interest rates to remain at current levels, or potentially move marginally higher by early 2024. All of the regional Fed presidents seem to be fairly uniform in their communication to the market that they are committed to fighting higher inflation. “I think that’s going to result in higher for longer,” he says. “We’ve seen a decrease in the growth of inflation, but I’m certainly not going to bet against the Fed. I think it's higher for longer.”

The optimistic view is that capital costs return to more of the pre-pandemic market where cap rates were in the 4s with the 10-year Treasury at 2.5%. Another scenario could put the 10-year Treasury at 4%, potentially with cap rates in the high 5s. “We as a firm would tend to say we’re somewhere in the middle, maybe on the slightly optimistic side of the middle,” notes Belford.

The question for investment managers is what to do now. Do you do nothing and wait until interest rates settle and then transact? Or are there opportunities out there that investors can take advantage of today? The way Clarion views the current market is that if they can price assets to the downside, and it still works, if the market turns to the upside, then that outcome looks really good. “If an asset is pricing to the middle or to the more optimistic case, we're not a buyer. So that's the way we've chosen to navigate the market,” adds Belford.

Digging for investment opportunities

Investors have been challenged by the dearth of transactions and what continues to be big bid-ask spreads in most cases. Although good buying opportunities are scarce, they do exist, particularly where people need to sell for some reason. “There are transactions that have come across in the last six or eight months that do, in our opinion, underwrite to that more negative scenario,” says Belford. “And therefore, you feel comfortable buying them and investing in them now – but there aren't many – and that's the whole problem with the space.”

Event-driven transactions are more the norm in an environment where transaction volumes are down 50 to 65%. However, an event-driven sale doesn’t necessarily mean there is something going on at the asset level, adds Flickinger. Bridge acquired a stabilized industrial asset in early 2023 because the seller had a liquidity need resulting from some challenges in their non-real estate operating business. So, there are some interesting opportunities in the sale-leaseback space, particularly among sub-investment grade companies that have seen their borrowing costs skyrocket, he says.

In addition, there is some expectation that the industry could be in the very early innings of seeing new opportunities coming to the market on the debt side from loan pool sales. It's going to be very interesting to see how the borrowers and the lenders behave in situations where either it's a healthy property type and it’s a recapitalization issue, or whether the situation is an issue with both fundamentals and recapitalization.

Much of the emerging loan stress is likely to be concentrated in the office sector. “I think it's going to be two to three years before we know what the future of office investment looks like,” says Flickinger. “If anyone knows how to underwrite the residual value of an office building that's not priced to the downside, I'd love to buy you dinner.” Despite the uncertainty on how remote working will impact demand for office space, the sector is seeing a growing gap in “haves and have not” properties.

Although office has become the “problem poster child” that needs to be worked out, it also is important to note that office is a smaller slice of the overall real estate market, representing roughly 20% of the NCREIF ODCE Index. The majority of investment is in other sectors such as industrial, multifamily, retail and alternatives. “You've got a huge chunk of our space where the fundamentals still look really good,” says Belford. In fact, fundamentals for sectors such as industrial, multifamily, necessity retail and some of the alternatives, such as self-storage, look very solid, he adds. Challenges in office, as well as certain parts of retail, are likely to drive more movement of capital into other parts of the real estate market that are better positioned for growth or resiliency in a downturn.

Dry powder waits on the sidelines

The common view is that there is still a significant amount of capital on the sidelines that has not yet been deployed. Looking back at the period before the pandemic, as well as the 12-18 months before Fed rate hikes accelerated, we saw robust transaction activity. Activity began slowing dramatically in the second half of 2022. The “gut feeling” in the marketplace is that the capital is still there.

In addition, there is significant untapped capital in the US wealth management space. The total universe of investible capital across individuals, pensions and other institutions is roughly between $600 trillion and $700 trillion. However, there is roughly 2 to 3% penetration into alternative assets – real estate, private credit and private equity, notes Flickinger. Most of the big investment managers are orienting their growth around downstream capital and taking that market share or that allocation from the current 2 to 3% to 5% or higher. So, while the near-term uncertainty is slowing capital inflows, there is the potential for very robust capital inflows into the space long term.

The big question is what is it going to take to move capital off the sidelines and thaw the transaction market? The simple answer is more clarity on capital costs. The expectation is that most investors are not going to be comfortable investing until there is a settling out on pricing, which means investors first need to know where the cost of debt is going to land.