The state of the US CRE market calls for a "back to basics" approach

Investment managers adapt strategies to find opportunities in a more challenging environment

Many of the key issues that presented hurdles to commercial real estate (CRE) investment for much of 2023 are likely to remain in place in 2024. That dynamic market will continue to keep investment managers on their toes as they manage risks and work to identify investment opportunities.

Although seasoned investment managers have plenty of experience navigating downturns in the US commercial real estate market, including the Great Financial Crisis (GFC), no two cycles are ever quite the same. Some of the issues now sitting at the forefront of investment analysis and decision-making are geopolitical concerns, monetary policy, higher capital costs and tighter credit from lenders, as well as emerging technologies and changes in the demand and use of real estate.

“Today it seems as though there are more considerations that are necessary for any investment, but especially CRE where there are so many powerful and important forces in flux,” said Omar Eltorai, Director of US Research at Altus Group, during Altus Group’s Q3 2023 US State of the Market webinar. Eltorai was joined by US commercial real estate industry leaders Adriana de Alcantara, Senior Managing Director, Fund Manager at Hines US Property Partners and Victor Calanog, Global Head of Real Estate Research and Strategy at Manulife Investment Management. According to these experts, one of the biggest factors coloring the near-term outlook is a growing consensus behind the “higher for longer” view on interest rates and inflation. The higher rate environment is fueling tough questions for the CRE industry:

• Have interest rates reached their peak, and where will they land over the investment horizon of an asset?

• How will higher for longer rates influence underwriting on exit cap rates?

• With some debt investments now generating equity-like returns, what does that mean for capital allocations to CRE?

Investment managers are also navigating uncertainty and risks across a myriad of issues that include labor challenges, climate risk and rising operating costs that are putting pressure on property fundamentals, performance, and net operating income (NOI). “With the existing portfolio, it’s always back to basics. It’s all about cash flow and it’s all about the service to the tenant,” de Alcantara says. Location, asset quality and portfolio diversification are all top-of-mind in investment decisions. “Everything that I'm buying today needs to be valued at least at cost or higher than that the next quarter,” she says. There is greater risk of making mistakes in a market like this, which is why diversification and managing concentration risk is important, she adds.

Calanog added that Manulife Investment Management has adopted a disciplined approach to investment idea generation and thesis building. “What that means is that we combine a top-down perspective. You want to evaluate overall global, national and local economic conditions, and you want to figure out income pricing and overall return benchmarks that we should realistically adopt, but we should never forget that bottoms-up view,” says Calanog. He also noted that the investment team at Manulife works very closely with its asset managers, heads of transactions and portfolio managers to figure out how to adapt that top-down view to reflect the local market realities.

As an example, the concentration of office in the NCREIF-ODCE Index is drifting lower. What once was 36% is now 20% and some speculate that office concentration in the index could decline to 10%. However, that trend is very different across geographies, notes Calanog. Physical office occupancy in North America continues to hover in the high 40s in terms of percentage of workers who have returned to work on an average week, while Asia’s numbers are significantly higher than that with workers that are back in the office four or even five days per week. “We try to be as nuanced as possible when it comes to building a house view and how quickly we should adopt that to changing market conditions,” he says.

Calanog also agrees that it is important to go back to basics, such as looking at the cash flow when determining valuations. That's a basic premise for real estate investing, and that requires a lot of listening to stakeholders and diverse perspectives on the front lines of managing and transacting at those properties, he adds.

Leveraging technology and AI

Technology and AI will continue to dominate CRE conversations in 2024, and another big question that investment managers are grappling with is where to invest resources when it comes to evolving data and analytics sources into actionable tools and insights. “I want to make sure we think through how these things actually work. Yes, we are making bets on certain data sources and approaches to analytics. But we're all still admittedly trying to understand the approach that works best for us, for our shop and for our investors,” says Calanog.

Versions of AI have been around for many years. Calanog illustrates this point by sharing that more than a decade ago, he helped introduce the first natural language programming (NLP) applications for AI in CRE. His team created a platform that auto-generated narrative analysis for over 2,000 markets and submarkets, including property-level comps analysis. That analysis would change dynamically depending on whether certain assets within the comps set were selected or deselected. “What makes today’s applications a bit different is that modern LLM (large language model) platforms have really done well to anticipate what the next logical outcome or result ought to be,” he says.

Whether it's Google completing and anticipating what you're searching for, or Chat GPT following up a well-framed prompt to use Python packages like Folium to create interactive maps with building data, modern AI does offer more opportunities. “AI at this point has the potential to take many parts of our existing processes and automate certain steps, increasing productivity,” says Calanog. “But will that translate to actual innovation – the new introduction of products and processes that represent a real quantum change in how we do what we do? I think that remains to be seen.”

Innovation drives investment opportunities

There is a push and pull regarding AI, and innovation sometimes tends to be incremental. Right now, investment managers broadly have yet to accumulate enough data points to really evaluate AI-driven investment approaches. “In my mind, there is great potential for increased productivity, but it is still an open question as to its net effect on innovation in CRE investing and the economy as a whole,” he says. “We are experimenting with a whole range of applications. That's fun, but at some point, we're going to have to decide whether concepts get translated to actual uses.”

Hines is putting tech to work in a variety of applications, including using a bot in its apartment leasing where a prospective tenant can request an appointment and the bot (Elise) responds. Because it has been in use for several years, it has now learned so much that when people come to a property, they ask for Elise because they think it is a real person, notes de Alcantara. “So, there is a lot of innovation that is occurring,” she says.

Innovation is also driving more interest in tech-centric property sectors such as data centers. Hines is looking at three different types of data centers as an area of growth and potential opportunity. In the case of powered shell data centers, the landlord owns the shell building, and the tenant owns the interior infrastructure. A colocation data center, on the other hand, has multiple tenants renting the space. Finally, hyper-scale data centers that are used by large tech companies such as Google and Amazon. Location and access to power are both key, and currently Virginia is the largest data center market in the US, but there are many other growing data center markets such as Portland, Silicon Valley, and others.

“AI by itself isn't necessarily the solution at the end, but you can see that by leveraging AI there is the potential for wide application across various sectors,” adds Eltorai. For example, there is the opportunity to use AI to create efficiencies around things like cash flow analysis, as well as interaction with tenants. “I think there could be big growth here, but at the same time I would echo the skepticism of seeing how AI alone could change the CRE landscape,” he says.

What’s ahead for CRE in 2024?

The US entered 2023 with the backdrop of inflation at 40-year highs; the Fed was still aggressively hiking rates; and the broad equity markets were down nearly 20%. Treasury yields were up more than 2.5 times with similar yield increases across the corporate sector. These market conditions led many in the CRE and broader capital markets to believe that 2023 would be the year of the most anticipated recession on record, notes Eltorai. “Yet here we are in the fourth quarter, and there is still no recession,” he says.

Inflation is down, but not quite tamed. The futures market is still showing that many of the markets still expect that the Fed may increase rates before the end of the year. Although those probabilities have come down quite a bit in recent weeks, an additional rate hike is not fully off the table. While equities markets are in the green for the year, they have yet to recover all of the ground they lost in 2022, and there is still considerable uncertainty. All of these factors are now influencing the CRE outlook over the next 12 or 18 months.

Calanog’s current view is that the Fed is at (or close to) its final rate hike given recent trends in inflation, and that view is influencing certain expectations over the next 18 months around two key aspects:

1. “When you've got CRE benchmarks like the 10-year Treasury spiking the way it did particularly in October – well, it’s produced quite a bit of hair-pulling because it’s typically used as the floor or risk-free rate against which risk premia are applied,” says Calanog. According to Calanog, if the U.S. is at the peak of its rate hiking cycle, a likely scenario is that the 10-year Treasury could decline by 100 to 150 basis points over the next 12 to 24 months. However, there is a floor to how low the 10-year Treasury can go because then the yield curve will resume its upward slope. If the Fed sticks to its expectation that the long-term overnight borrowing rates will hover around 2.5 percent, then that is the higher for a longer situation.

2. A second expectation over the next 12 to 24 months is a repricing in private CRE markets. Public CRE price indicators looking at US REITs show that the public market is trading at around a 10 to 20% discount, versus private CRE prices. Public REITs are a leading indicator with a lag of about six to 12 months. “So, if public CRE markets have bottomed out, that suggests that private CRE cap rates may still rise by some amount, more perhaps for property types like office and less for sectors like multifamily and industrial where demographic drivers remain favorable,” says Calanog.

Identifying investment opportunities

In the current environment, Hines continues to have strong conviction pertaining to the living sector (e.g., multifamily, student housing) industrial and alternatives – such as data centers, medical office buildings and self-storage. “It’s not going to be an easy two years. I do think that rates are going to remain high for a little longer,” says de Alcantara.

In multifamily, there is a housing shortage in the US. So, over the long term, apartments are well placed to outperform the market. However, there are also some problems brewing with “cheap money” that is no longer available. Operators have to deal with interest rate expenses and operating expenses that are rising rapidly, which could put some properties in trouble. In Miami, for example, insurance costs have tripled in the past two years from less than $700 per unit to now over $2,000 per unit, notes de Alcantara. “A lot of multifamily deals are not being closed because of insurance,” she adds.

Industrial fundamentals are still very good, particularly in high barrier to entry markets, dense locations, and locations in close proximity to airports, ports or labor. One of the attractive characteristics of alternatives, such as data centers and medical offices, is that tenants tend to be very “sticky,” adds de Alcantara. “The wild card is going to be office, and not all office is the same. The flight to quality is real, and the best office is really doing so well,” she says.

Higher interest rates also are fueling more interest in credit strategies. Equity indices such as the S&P 500 typically return about 10%, and there are now some high-yield debt instruments that are generating similar equity-like returns. “Now we're going to have to think very carefully about what that means for our allocations and investment decisions,” says Calanog. However, that is not a wholesale endorsement for debt at this point in the cycle because if interest rates were to decline soon that would represent risk to debt investments depending on the usual bond math considerations revolving around duration, he cautions.

Current conditions are such that there is increasing demand for credit right now with $2.6 trillion of maturities coming due in the next five years, according to the Mortgage Bankers Association. That volume of maturing debt will create both challenges and opportunities within the CRE market over the next 12 to 24 months, as well as drive demand for creative approaches to building capital stacks and financing projects.