Parsing the data: Altus Group’s Q4 2023 NCREIF ODCE index analysis

CRE is still correcting

Through the fourth quarter of 2023, unleveraged commercial real estate (CRE) declined 3.3% compared to the third quarter. The Q4 2023 decline marked the fifth consecutive quarter of negative returns and the quarterly decline was more significant than the prior quarter, reversing the trend of moderating declines. The CRE asset class declined by 8.7% in 2023 - the worst full-year performance since the global financial crisis.

Figure 1 - Headline returns – Quarterly to Q4 2023

Affecting all property types, the Q4 2023 returns were similar in magnitude to the quarterly setback the CRE market experienced at the end of 2022, when CRE markets were starting to show the effects of significant monetary tightening and the resulting market disruption. Interest rates were still in “tightening” territory in Q4 2023, as they were in Q4 2022. However, unlike the 2022 period, the overall macro and market sentiment was generally improved in Q4 2023, given the market’s expectations for near-term interest rate cuts and still-resilient economic data supportive of a “soft-landing” narrative.

Figure 2 - All property returns – Quarterly to Q4 2023

So while sentiment from investors in the broader capital markets, to business leaders and consumers is generally improving with expectations for cooling inflation and rate cuts through 2024 (and few signs of major economic trouble), the CRE asset class remains very much on a downward trajectory, as it continues to price in cooling inflation in its cash flow projections and a higher yield environment.

Five years, four distinct periods of appreciation

Over the last five years, like many other risk-assets, CRE has gone through four distinct periods of returns. In the first period, the year preceding the pandemic, CRE returns were driven by consistent income growth coupled with a steady appreciation return. During the second period, the pandemic, cash flows dipped slightly, though appreciation declined more sharply. However, the impact of the COVID correction was quickly reversed in the third period, the post-pandemic period, when appreciation drove overall CRE quarterly and annual returns to the highest levels on record. This period lasted for seven quarters, until Q3 2022, when the Federal Reserve’s (Fed) interest rate hikes began to take their toll on CRE transactions and valuations, as CRE entered the fourth and current period – the interest rate correction period. The asset class has remained in this corrective territory for the past six quarters, posting negative quarterly returns driven predominantly by negative appreciation, in addition to emerging signs of softening cash flows.

Figure 3 - All property quarterly returns

Throughout these four periods, inflation and interest rates have been major drivers of asset value and returns. While the CRE asset class generally benefits from inflation, as it can capture increased cash flows that generally keep up with inflation, it remains sensitive to interest rates. So as inflation has cooled and interest rates remained elevated, the CRE asset values and returns to investors have continued to struggle.

While the yield on the 10-year US Treasury security did move down through Q4 2023 – ending the quarter at 3.88%, down 71 bps from Q3 2023 – the benchmark yield remains elevated and well above the 1.92% at the end of Q4 2019. And despite expectations for the Fed to begin cutting the Fed Funds Rate in 2024, many CRE investors and valuers are still expecting the yield on the 10-year US Treasury security to be around 4 to 5% longer-term, an assumption being incorporated in many transaction underwritings, which partially explains why transaction cap rates continued to trend upward through 2023.

Figure 4 - Yield effect – Q4 2023 versus Q3 2023

This shift in assumptions to a higher-for-longer yield environment is clear in the Q4 2023 valuation data. Looking at the Q4 2023 yield effect – driven by discount rate and exit yields – shows how these assumptions were clearly stepped up in an order of magnitude in the final quarter of 2023, across all property types.

Values down, property sector dispersion up

Over the last five years, CRE values, as measured by aggregation of all property sectors, have experienced a peak-to-trough decline of 17.3% and values are currently down 1.0% from their pre-pandemic levels. However, increasing dispersion among property sector returns and valuations complicates these stats and requires a deeper dive into the different sectors to fully understand how CRE is performing as a whole.

First, consider the peak-to-trough declines in values across the different property sectors. During the recent corrective period, the office property sector has lost nearly a third of its value since 2019, the apartment sector values are down 17% (Q4 2023 accounting for about 5 percentage points), industrial and other, which is comprised mostly of self-storage, values are down approximately 11%, and finally, the retail sector is down nearly 9%.

Figure 5 - Appreciation to Q4 2023 – From peak versus pre-COVID change

Second, in order to contextualize these value declines, figure 5 shows the current level of CRE and CRE property sector values compared to their pre-pandemic levels. While the recent corrective period has brought aggregate CRE values (“All Property”) down by 1% from pre-pandemic levels, the individual sectors reflect very different experiences. Compared to pre-pandemic valuation levels, industrial sector values are still up over 50%, values for the other sector are up nearly 20%, apartment values are about where they were pre-pandemic, the retail sector is down approximately 19%, and office values are down more than 30%. As a result, there is more than an 80 percentage point (pp) difference in terms of valuation changes across the different property sectors when compared to their pre-pandemic valuation levels. This is illustrative of the importance of sector selection and allocation, and is an increasingly significant explanation for differences in CRE portfolio performance.

Emerging property sector themes

Figure 6 - Appreciation to Q4 2023 – From peak versus pre-COVID change

While appreciation and the yield effect have been the primary drivers of the recent negative returns, there are a number of emerging themes across the four main property sectors:

Apartments: The apartment sector is starting to see some signs of rebalancing between gateway and sunbelt markets. The large gateway markets are now showing more strength than in prior quarters over the last four years when they were not able to keep pace with the rapidly growing sunbelt markets. Major metros including New York, Chicago, and Boston, are performing more in line with the stronger sunbelt markets. However, two other gateway markets, Washington DC and San Franscisco, continue to lag their peer gateway markets. At the same time certain sunbelt markets are starting to show more signs of correction, as their operating performance, which is driving cash flow expectations, are being dialed back and more supply is delivered to market. An example of this sunbelt pullback can be seen in the -5.2% quarterly total return clocked by both San Diego and Phoenix.

Industrial: For the industrial sector, the most recent results show some signs of normalization of rents setting in across different markets. It appears that rent growth across many of these markets has reached a peak threshold. Most of this normalization is happening in markets which were recent powerhouses of the industrial sector, capturing major rent increases and seemingly defying gravity given super tight supply – specifically these metros include New York, the Inland Empire, and Los Angeles. Meanwhile, markets such as Houston, Chicago, Atlanta, and Washington DC, appear to be reestablishing themselves and experienced more modest value declines in Q4 compared to the prior quarter.

Office: With no further let up in the cash flow and appreciation headwinds it faces, the office sector continues to struggle with over-supply and investor skepticism nationally. The major gateway markets, with largest supply of office, are those markets which are most challenged and where the outlook is most grim. While some markets, such as Miami, Atlanta, Dallas, have higher office utilization rates and lower supply compared to these major markets, even these markets are not able to fully escape the negative impact to values from reduced market rent growth rates, increased capital costs, and higher cap rates.

Retail: With much stronger market rent and market rent growth assumptions than any other property sector, retail is proving to be quite resilient in the current economic environment. Even though the property sector has seen overall negative appreciation, similar to the other sectors given the broader macro and market backdrop, the retail rents have supported overall cash flow effect, alleviating at least some of the negative impact. While the sector has been right-sizing for many years, its recent results suggest that it may be closer to being rebalanced, and not as oversupplied as it was, allowing it to benefit from the strong demand.

Figure 7 - Sector CBSA – Total Q4 return and quarterly difference