Fed fuels hopes of US real estate recovery

November 15, 2024

As the participants in PERE’s US roundtable discussion meet on September 18, the Federal Reserve is expected to announce a 0.25 percent cut in its key borrowing rate. However, it later transpires the central bank begins its easing campaign with a more aggressive 0.5 percent cut, lowering the federal funds rate to a range between 4.75 and 5 percent.

Good news for a US real estate sector battered by two years of volatility? Probably yes, is the roundtable participants’ verdict. But even a larger- than-expected cut is unlikely to produce a material impact in the short term.

A rate cut is already “baked in” by the market, says Justin Gleason, managing director at global investment manager PGIM Real Estate, and portfolio manager for its US core-plus strategy. “Real estate is really priced for longer-term rates at this point. But this does maybe get some people off the fence on selling or transacting.”

The signal that rate rises are over, at least for the short term, will bring “a little bit of hope and stability,” says Kyle Jeffers, chief investment officer for commercial real estate debt provider ACORE Capital. Owners of assets that currently have issues with their capital structure might be prompted to take advantage of some of the undeployed capital raised recently and exit those positions, he suggests. Interest rate reductions will likely have a positive psychological impact, but there are plenty of other unresolved issues of concern for investors, adds Stephen Rabinowitz, co-chair of the global real estate practice at law firm Greenberg Traurig.

“We are dealing with a lot of distress across different sectors, and there is so much uncertainty over inflation, global political instability and the presidential election. Rate cuts could prompt an increase in activity, but there is a question of how long that will last in such a volatile macro environment,” he says. “Cutting rates could impact inflation, which might make people skittish again.”

Inflationary pressures could persist, comments Eric Wurtzebach, global head of real estate at Macquarie Asset Management, because whatever the outcome of the election both Republicans and Democrats expected to continue significant spending. “Postelection, I am interested in whether the Treasury starts more aggressively pushing banks to mark-to-market the real estate loans on their books.”

Bid-ask spread

CBRE research shows the trailing four-quarter volume for commercial real estate transactions decreased by 32 percent year-on-year to $341 billion in Q2 2024, the lowest total since Q2 2013. Can buyers and sellers now be confident that values have bottomed out, encouraging a pick-up in investment activity?

There is “growing consensus” the NFI-ODCE Index will reach its low point in 2024, says Ryan Krauch, senior managing director at San Antonio based manager Affinius Capital, although he questions whether office assets in these open-end diversified core funds have been fully repriced yet.

“Values have taken two years to correct, but now rates are coming down, the bid-ask spread is going away and inflation is moving in the right direction.

Add all that together and there is a sense that we are at the bottom from a real estate standpoint, and the fundamentals are still pretty solid,” suggests Gleason.

Debt markets will need to be sufficiently liquid for transactions to happen, however. That is still questionable right now, says Jeffers, because regional banks are largely out of the market for real estate loans while money center banks are focused on managing their existing loan books. The introduction of the Basel III financial regulations could further constrain bank lending by forcing them to bolster capital reserves.

He adds the increased willingness of banks to provide back leverage in the form of repo lines to real estate debt funds is a positive development, however, and there is some prospect that lenders’ cost of capital will begin to reduce. “If that happens, we will start to see more attractively priced debt, which encourages buyers and sellers, and with a little more activity it will become clearer what values should be.”

Numerator effect

Capital formation in the US private real estate market has been hit hard of late. PERE data shows only $46.7 billion was raised for North American private real estate strategies in Q1-Q3 2024, down from $62.5 billion during the same period in 2023. But there are now indications of a few green shoots, say the roundtable participants. “It has been a super-depressed few years of capital raising, the worst I have ever seen in my career,” observes Krauch.

The denominator effect caused by the falling value of equities initially impacted investor allocations to real estate, and while much of that effect has been eliminated by a recovery in share prices, the bond market is still lagging, he notes. Meanwhile, real estate also has a “numerator problem,” he adds. “By not marking our assets down fast enough like the public markets did, the industry has done itself a disservice.”

Investors generally have been content to park their money safely in bonds while waiting until the returns available in real estate are worth the risk again, says Rabinowitz. “Our real estate funds practice is starting to get a little more active again, but there is still a lot of dry powder on the sidelines that hasn’t been deployed.”

Many real estate equity investors have migrated to the credit space, says Jeffers. “People forgot for a while that they could lose money in real estate equity. Then when values fell, they realized they could go into credit and get pretty close to the same return, and with a 30 or 35 percent subordination in their position which means it’s a lot lower risk.”

Wurtzebach believes the potential to miss out on excellent buying opportunities can draw investors back to the asset class. “If you combine the sharp pullback in new supply with interest rates falling and the fact that there are a lot of broken capital structures that will need to be restructured, we expect that 2025 should be a good vintage for real estate funds. I have heard far more interest in investor meetings in the last three months than I have in the prior three years.”

Many investments are still structured as traditional joint ventures, with sponsors less inclined to employ funds or REIT structures because of the greater administrative and regulatory compliance burden, says Rabinowitz.

However, he notes there are some “creative hybrid entities” emerging in which sponsors collect a bucket of assets and then market them as a fund structure.

A growing number of investors want to have more influence over assets, and they are showing increased appetite for investing directly in operating companies, observes Wurtzebach. “They want opco exposure as well as LP real estate exposure. They think their access to worldwide information can be additive to how those businesses operate at a local level.”

Niche sectors

Despite the market volatility, investors can also access opportunity in the real estate space by investing thematically in undersupplied sectors, argues Gleason.

“There are things that you can structure your strategies around that can act as a guidepost and transcend some of the uncertainty out there.” He notes that meeting the differing rental housing needs of the two demographic “bulges,” the baby boomers and millennials, and digital transformation are key themes.

“There is a shortage of housing in the US and construction starts are down, so the fundamentals are great, and industrial is also undersupplied,” says Jeffers. “You have to segregate office from the other asset classes because it is going through so much change.”

The investable universe in real estate has evolved, says Wurtzebach. “Practically speaking, there used to be four asset classes. Remove retail and offices, and that went to two. The niche asset classes are now the third popular bucket for investor capital alongside industrial and living. Specialist knowledge helps gain access to niche sectors though, which is reinforcing the demand for opco exposure from many investors.”

Investors need to bear in mind that emerging sectors such as data centers, cold storage, life sciences and energy projects are very capital intensive, says PGIM’s Gleason. “The returns are there, but they are not for the faint of heart.”

He identifies data centers as a “hot topic” among investors right now because of the surge of demand from cloud computing hyperscalers. “There won’t be any shortage of capital chasing the sector. The gateway issue is access to power.”

Gleason also singles out senior housing as the sector he feels “most bullish” about currently. “It has bottomed, the supply is about to drop off and there are great opportunities to acquire distressed assets. It is primed to take off just at the time that the first boomers turn 80.”

Krauch points out the average age for people to move into senior housing is 83. “We all thought it would start happening 15 years ago for the baby boomers. Everybody got really excited about it, and then said, ‘Wait, where is everybody?’ And it was because people delayed moving into their 80s.

Now we are finally seeing the demand materialize.” Macquarie has been active in niche asset classes including manufactured housing and self-storage, but the firm has been more cautious in others including film studios and life sciences.

To be successful investing in niche sectors often requires ownership of strong assets in very specific geographies, while there is a limited opportunity to partner with skilled operators, warns Wurtzebach.

“In some niche sectors where there is significant institutional demand there are bound to be mistakes. Some operators are not as well qualified and might operate in secondary or tertiary markets where oversupply risks only become obvious during periods of elevated volatility. We are seeing the results play out today,” he says.

Opportunistic credit

Amid the market uncertainty of the past two years, many real estate investors have chosen to deploy their money in the credit space. “Right now, we are seeing a lot of interest in debt investing among our clients because the perception is that’s where they are getting most bang for their buck,” says Rabinowitz.

While the risk-return profile of equity investing will vary through the cycle, real estate credit is now an established element of many allocations, says Krauch. “Most investors now recognize that whatever point you are at in the cycle some exposure to real estate credit is a good thing. It’s just a question of where they choose to play in the capital stack.”

Workouts of defaulting loans have been a feature of US real estate markets of late. “There are a lot of people selling debt and there’s an opportunity to buy it and get to the assets at a great basis,” says Rabinowitz. The participants agree that workout situations have become less contentious over recent years, with most borrowers and lenders focused on finding the most efficient way of restructuring capital stacks.

With a wave of refinancings expected to happen over the coming year, and many banks preferring to reduce risk by lending at lower LTVs, there is an attractive opportunity to plug the gap between debt and equity, says ACORE Capital’s Jeffers. “We are seeing a lot more interest in the opportunistic credit space that lies between equity and senior debt in the 65-85 percent range. It is a hybrid for investors who don’t want to invest in equity because they want more safety, but they want a little more juice on their return than they can get in senior credit.”

Assessing risk

The US is on the eve of what is widely regarded as a potentially historic presidential election. But the impact of the vote on real estate will probably be limited, says Rabinowitz. “The perception is that election day is going to be this great thing. But no one can really identify the risk of a Democratic or Republican win. For instance, it’s unlikely either party will tax capital gains more heavily.”

He has noted accelerated efforts to get certain transit or energy-related transactions completed before the end of the year while valuable Inflation Reduction Act benefits are still available, however.

The participants are cautiously optimistic about the outlook for US real estate investing conditions in 2025. If a hard landing and recession can be avoided, they expect the 10-year risk-free rate to stabilize at 3.5-4 percent.

Meanwhile, asset prices are gradually resetting, a process Krauch describes as a “painfully slow drip” that will continue for a while longer.

During the era of ultra-low interest rates, the challenge facing many managers was how to deploy capital.

They can now return to focusing on what they are good at: assessing risk, argues Wurtzebach. “We like where the market is. We think there are great opportunities because the disparity in return for different assets and geographies is wider than it has been in years. If you can assess risk well, you can find very good risk-adjusted returns.”

“For a while timing became the dominant factor in real estate investing,” adds Rabinowitz. “You bought at a certain time, you waited for cap rates to do their magic, and you sold it. We’re getting back to a place where to create value in real estate you need vision, creativity, experience and management expertise.”

Krauch agrees with that assessment. “Traditionally, real estate investing was about income-producing high-quality assets and hedging against inflation.

When everybody was just buying assets and waiting for cap rates to compress it created an unrealistic expectation,” he says. “But the question is whether investors will still expect 20 or 30 percent returns when that isn’t generally what real estate investing is supposed to produce. When it reverts to the traditional role that it should play within their portfolios, will they continue to allocate the same volume of capital to real estate?”

That question is likely to be answered only when the current turmoil subsides, and the market reset is more advanced. In the meantime, US real estate investors will be keeping an eye on the opportunities emerging from the shake-out.