“Unbuckle your seatbelts because it’s probably going to be a slow, careful ride. Disruption won’t happen like a roller coaster. It’s gonna be slow going, and you’re just gonna have to do your homework when it comes to specific details and specific places and specific property types.”
A New Era Comes into Focus
This is what will be. A consensus is growing in the commercial real estate community that the world we’re looking at now is the world we’ll be living in for a while. The worst of the COVID-19 pandemic has long passed. We should no longer expect a sudden U-turn to the way things were in the prepandemic times.
After three years of holding out hope, industry leaders have finally concluded that most of us really won’t be returning to the office nearly as often, and some not at all. The implications for our industry are profound, and not only for office owners, managers, and brokers. Collateral impacts will also be seen on downtowns and other property sectors that depend on a vibrant office market. Investors need to rethink long-held canons about how to construct portfolios. These are all topics we explore in the following pages of this 2024 edition of Emerging Trends in Real Estate®. As the contours of a new era in real estate become increasingly clear, one overarching theme to emerge is one we’re calling “The Great Reset.” The past is no longer prologue; old assumptions—about market dynamics, pricing, and risks—must be visited.
Another central element in this new era: the reluctant acceptance of “higher for longer.” As a leading investment banker said, “The good news is that we have more clarity, more certainty, but the bad news is we don’t like what we see because the rates are higher for longer.”
Respondents to this year’s Emerging Trends survey believe the worst of inflation is behind us, with over half expecting inflation to decline in 2024 and another third believing inflation will at least stabilize. That should give the Federal Reserve Bank permission to stop hiking interest rates. But only three in 10 survey respondents expect commercial mortgage rates to drop in the coming year.
The good news of greater market certainty must be tempered by the latest smoke signals from the Fed suggesting that the mantra should be “higher for even longer.” Paired with forecasts of slower future economic growth—another theme this year—owners must prepare for more painful property value losses.
Itching to Buy
Given all the negative press about commercial real estate markets, one perhaps surprising result from our survey: investors are eager to acquire new assets. The Emerging Trends Barometer for 2024 registered its highest “buy” rating since 2010, likely reflecting recent and expected price declines, making this a more favorable entry point for acquisitions after a decade of relentless appreciation. In addition, almost half of survey respondents expect cap rates to rise further next year, further depressing values.
Yet sales transaction levels are down, and many in our industry see a negative loop where buyers and sellers cannot agree on pricing because the shortage of sales limits price clarity. The reality does not seem so bleak. Transaction levels in the first half of 2023 fell about a quarter (26.1 percent) from the first-half average in 2015–2019—harsh, but not historically horrible—and they are well above levels in 2020 when the markets really were at a standstill during the economic lockdown. But there is no doubt that wide bid-ask spreads between buyer offers and seller expectations are limiting transactions, particularly in the beleaguered office sector, where sales are down over 60 percent from 2015 to 2019.
Said an executive with an asset management firm, “We’re in a fairly good pause while there’s a realignment of expectations between buyers and sellers. Sellers have not yet fully adjusted their expectations to current market conditions.”
Investors want more assurance about where prices will settle. “We think we’re seeing good opportunities, but it’s hard to evaluate what a good opportunity is today because we don’t have price comps,” explained one fund adviser.
Industry participants also blame the debt markets. “Interest rates and cost of capital” remains the top concern in the survey, followed closely by “capital availability.” Debt is viewed as slightly more available than last year for all sources except commercial banks. Still, respondents believe that both debt and equity underwriting will become more rigorous.
“We’re in a fairly good pause while there’s a realignment of expectations between buyers and sellers. Sellers have not yet fully adjusted their expectations to current market conditions.”
Not So Bad. Or Great.
Despite these capital market challenges, many in the industry remain at least somewhat hopeful, if less optimistic than typical. Over 40 percent of survey respondents rate their firm’s profit outlook as good to excellent, but that is the lowest share since the 2011 edition of Emerging Trends, when the industry was still trying to climb out of the Great Financial Crisis (GFC). Conversely, just 13 percent rate their firm’s profit outlook as abysmal or poor—though that’s the highest such share in over a decade.
Despite the weakness in real estate capital markets, this guarded optimism seems appropriate as property fundamentals remain surprisingly resilient in the face of considerable market dislocation and economic uncertainty. The office sector remains a conspicuous exception on this score, but its deep problems should not tar the entire industry. Said one industry strategist, “With office in such doldrums, it’s easy to paint with a very broad brush about commercial real estate and think it’s all bad.”
Reflecting the view of many investors we interviewed, one firm’s strategy head said, “I think it will take ‘til 2024 for an uptick in transaction volume, but it’ll come. It won’t necessarily hinge on a lowering of interest rates by the Fed. It could happen before then as people get used to the new higher rates and start to transact again.”
The sentiment of developers seems similarly bullish but cautious. Said one mixed-use developer, “We’re keeping the foot on the gas and getting lease deals done, but we’re watching closely for when it makes time to deploy new capital again. I think it’s difficult to make big capital deployment bets until we start to see some stability in the interest rate markets and some settling of capital costs.”
Meanwhile, more opportunistic funds are raising capital and circling, looking for distress, but not finding much yet. “I don't know when that date is going to be, but I think that there’s going to be more distress, so I think that there’s gonna be more opportunities,” said the head of an asset management firm.
Although the broad contours of the commercial real estate (CRE) sector are coming into greater focus, the path forward will not necessarily be easy to discern or navigate. As noted in the quotation that opened this section, we’ll still need to do our homework.
The mixed sentiment expressed in the survey also reflects the diversity of outlooks among industry participants, which seems greater now than during either the GFC or the COVID lockdown, when most people seemed to share a common market mind-set. According to one adviser to pension funds, “There’s different people in different places for different idiosyncratic reasons. There’s some investors that are full speed ahead, some are starting to pick up their pencils, some that are still pencils down.”
Many investors, especially “core” institutional funds, remain on the sidelines, waiting for the right entry point when prices will fall enough to make returns compelling. But that might take a while because few owners face enough distress to force inopportune sales. And most investors are looking for the end of interest rate hikes, which seems close at hand, though the wait for actual rate cuts will take longer.
The good news here is that the Merrill Lynch Option Volatility Estimate (MOVE) index, which measures bond market volatility, was at its lowest point in 18 months as of mid-October 2023 and generally trending down. Unfortunately, the index remains highly elevated by historical standards at its second-highest level since it was initiated in 2002. Thus, the markets likely need to calm down considerably before investors feel comfortable to re-enter the market.
