In brief:

• The rapid runup in interest rates and resulting deal activity slowdown have meaningfully reset property valuations across all sectors from early 2022 peaks.
• This is creating opportunities to invest in select, high-quality assets with strong operating fundamentals at significant discounts to where they would have traded three years ago.
• The market appears to be at an inflection point, with the latest data on deal activity and pricing now showing an improvement.
• Opportunities are also being driven by major shifts in how people consume, live and work due to changes in demographic, technological and social trends that continue to reshape how people use real estate.
• We see potential in single-family rentals, last-mile logistics and development optionality as the market begins to recover and evolve through the current cycle.

Commercial real estate (CRE) investors have weathered a challenging period since early-2022, as markets have adjusted to the surge in interest rates and pullback in available investment capital. Over the past 18 months, transaction volumes have fallen 60% below their early 2022 peak.¹ Irrespective of property fundamentals, which we believe remain sound, this softness in deal activity has prompted a significant pricing reset that has been both broad and deep. The result for investors with capital to deploy: a tremendous potential buying opportunity for high-quality assets.

Dissonance between valuations and fundamentals offers opportunity

The broad repricing environment has helped to skim off much of the market’s froth. Of note, every major CRE sector has been affected by the recalibration in valuations, despite notable differences in underlying market dynamics and outlook.

For example, consider offices versus apartments. Both sectors have experienced meaningful pricing pullbacks relative to their market fundamentals. Spot prices for the former have fallen by 37% from their pre-pandemic peak² and continue to face significant headwinds. The market is still adjusting to lower demand as a result of increased acceptance of remote and hybrid workplace models as well as a general shift away from large urban centers. As a result, office vacancy rates are at all-time highs and still climbing.³ In contrast, the spot market for residential apartment building values is down 26% from its 2021 peak,⁴ even though rents have remained resilient, staying positive over the past two years despite elevated supply. Further, a waning apartment construction pipeline should maintain upward pressure on rents in the short to mid-term. We believe this sharp drop in apartment prices in the face of such strong fundamentals, represents an outstanding buying opportunity.

Capital markets at an inflection point?

Looking ahead, we expect capital market conditions to begin improving, and there is evidence that this may already be underway. First, seasonally adjusted transaction volumes in the first quarter grew for the first time since Q2 of 2022.⁵ Second, according to Green Street, spot market pricing across all sectors has been on the rise for the first time since early 2022. Finally, the debt markets are showing signs of improvement. Although all-in borrowing costs remain elevated, spreads have tightened notably and liquidity has improved as more lenders reenter the market.⁶

It’s also worth noting that although they have been flat over the last few months, publicly traded REITs have already rebounded 13% from their late 2023 trough.⁷

Megatrends driving market transformation

Additionally, we believe it can be beneficial to approach CRE investing with an appreciation of the potential growth opportunities offered by the changing ways people use real estate today compared to years past. How we consume, work and live have all fundamentally transformed.

Housing demand is being driven by changes in lifestyle preferences and demographic trends, including the aging of the U.S. population. Working patterns continue to undergo tremendous change as flexible arrangements become embedded. The acceleration of e-commerce has changed not just how people shop, but has also created significant demand for fast and economical delivery of these goods and services. While many of the megatrends driving these changes emerged long before the COVID-19 pandemic, the crisis certainly accelerated momentum – as well as the real estate opportunities poised to benefit from them.

Specific market segment beneficiaries

These trends are playing out across a range of CRE sectors, property types and market themes. Some of the most attractive appear to be:

• Single-family rentals: The dynamics between owning or renting a home have been rapidly changing, driven by a U.S. housing shortage, escalating home values and rising interest rates. At the same time, people are looking for homes that offer more space, better schools and safer neighborhoods, but often can’t afford to buy them. For example, the large millennial generation has entered their peak family formation years, and is now looking to transition from apartments to homes with amenities and characteristics that better fit their new life circumstances. This has opened new, attractive CRE investment opportunities in build-for-rent housing developments.
• Last-mile logistics: People are increasingly looking for goods and services to be delivered directly to their front door. “Last mile” refers to the final step in this logistics journey and includes properties that enable fast and efficient delivery of goods, such as industrial outdoor storage, truck terminals and local warehouses. Many of these operations tend to be in areas where it can be difficult to build new capacity, providing added value to existing facilities. The segment is not just limited to shopping for goods. There is a growing movement for services in areas such as medical care and recreation to also be delivered to end users in a more convenient way through strip centers and other closely located retail options.
• Development optionality: Right now, it generally costs less to buy an asset than build a new one. However, at some point, the reverse will be true. With this in mind, investors should look for real estate investment managers able to 1) take advantage of today’s discounts with available investment capital and 2) pivot to development when the environment changes. This should help offer the greatest flexibility for long-term investment success from both equity multiple and volatility perspectives as the market naturally evolves over time.

In contrast, sectors such as traditional office and mall properties are likely to face continued headwinds, although even in those segments there are pockets of opportunity.

In summary: A generational opportunity to invest at very attractive prices

In our view, investors able to see past the recent CRE volatility and surrounding market noise have a chance to invest in exceptional assets at significant discounts. History shows that periods of CRE valuation corrections are usually followed by attractive rebounds, particularly in times like these when vacancy rates are low and assets can be purchased for cheaper than it would cost to build them. For example, the peak-to-trough drawdown of -13.3% in the early 1990s was followed by a rebound of 11.5% compound annual growth rate (CAGR) for the subsequent 15 years, the drawdown of -37.8% during the Global Financial Crisis was followed by an 11.2% CAGR for the subsequent 10 years and the -1.6% drawdown during the COVID-19 pandemic was followed by a 16.3% CAGR for the subsequent two years.⁸ Asset and sector selection will be key to ensure the greatest long-term success, both today and in the future as demographics, technology and social forces continue to shape how CRE is used.

¹ Source: Real Capital Analytics as of 3/31/2024.

² Source: Green Street as of 5/31/2024.

³ Source: CoStar as of 3/31/2024.

⁴ Source: Green Street as of 5/31/2024.

⁵ Source: Real Capital Analytics, J.P. Morgan Asset Management as of 3/31/2024.

⁶ Source: NAREIT as of 3/31/2024.

⁷ Source: Green Street as of 5/31/2024.

⁸ Source: NCREIF, J.P. Morgan Asset Management as of 9/30/2023. The subsequent total return for the early 1990s represents returns from 9/30/1993 – 6/30/2008. The subsequent total return for the Global Financial Crisis represents returns from 3/31/2010 – 3/31/2020. The subsequent total return for COVID represents returns from 9/30/2020 –9/30/2022.