In brief:

• Commercial real estate investments have historically offered higher income than bonds with inflation-correlated appreciation.¹
• The rapid runup in interest rates and resulting deal activity slowdown have meaningfully reset property valuations from early 2022 peaks, offering opportunities to invest in select, high-quality assets at significant discounts.
• Broad repricings have occurred across sectors, creating meaningful value in properties that remain fundamentally solid.
• 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 weathered a challenging period since mid-2022 as markets reacted to the surge in interest rates and a sharp slowdown in available investment capital. Overall transaction volumes throughout 2023 remained sharply lower than the peaks reached in 2021 and early 2022. This softness in deal activity has prompted a significant pricing reset that has been both broad and deep, often irrespective of property fundamentals. 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 an average -32% from their pre-pandemic peak² and continue to face significant headwinds as the market has been forced to adjust to lower demand resulting from the rise in remote and hybrid workplace models and general shifts away from large urban centers. Office vacancy rates are at all-time highs. In contrast, the spot market for residential apartment building values is down an average 29% from its 2021 peak,² even though rents are up an average 5% over the same period, amidst historically low vacancies. Further, a waning apartment construction pipeline should maintain upward pressure on rents over the long term. For apartment prices to fall so significantly in the face of such strong fundamentals now represents an outstanding buying opportunity.

Looking ahead, we expect this type of imbalance between valuations and fundamentals to begin to normalize. Transactions are expected to pick up significantly in 2024, based on refinancing and liquidity needs and as investors become used to new pricing levels in the context of an anticipated “higher for longer” interest-rate climate. This should lead to a preference for properties strongly positioned to perform well in the cycle ahead.

Megatrends also 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 for almost everything but also has created significant demand for fast and convenient transport and delivery of these goods and services. While many of the megatrends driving these changes had 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 larger spaces and more modern amenities that may be out of their price reach to own. For example, the large millennial generation has entered the family formation age, with a desire to leave apartments in favor of renting a more spacious home with room to work from home as well as an attached garage and yard for the dog and kids. This has opened new, attractive CRE investment opportunities, such as cases where homebuilders have been interested in selling vacant parcels for build-for-rent housing developments.
• Last-mile logistics: People are increasingly looking for goods and services to be delivered directly to or close to their homes. “Last mile” refers to the final step in this logistics journey and includes properties that enable it, 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 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, though 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 an opportunity to invest in some exceptional property 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 Great 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.³ Asset and sector selection will also likely 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 Private Real Estate: NCREIF Fund Index—Open-End Diversified Core Equity.

² Greenstreet as of 10/31/2023.

³ 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 Great 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.