The window to invest at cyclical lows may be short as values start to recover
Commercial real estate (CRE) has faced significant challenges over the past two years. Rising interest rates, recession fears and the mistaken impression that office market contagion would spread to other sectors have weighed on the asset class, pushing values down by 24.1% from their 2022 peaks.1
However, those concerns now appear overblown—and the challenging capital market conditions that once eroded property values are easing. Interest rates are falling. Debt is becoming cheaper and easier to secure. And transaction volumes are up more than 35% from their 4Q23 trough.2
With most, if not all, of the asset class’s primary return drivers on the upswing, CRE prices have turned the corner—and are likely to accelerate sharply in the coming quarters. Transaction market pricing, which was roughly flat earlier in the year, is increasing again and is now up by 4.1% over the past four months (Exhibit 1). In our view, this shift marks the start of a generational buying opportunity for CRE, which is still pricing at a steep discount to previous peaks but continues to benefit from healthy property cash flow growth.
How can we be so confident? Here, we analyze the fundamentals that will drive future performance, including falling interest rates, cheaper financing, improving liquidity, elevated occupancy, persistent cash flow growth and improving capital market conditions.
Falling interest rates provide a strong tailwind for real estate valuations
After embarking on the most aggressive rate increases since the early ’80s, the Federal Reserve (Fed) has pivoted quickly and is now easing policy rates. The first rate cut, a larger-than-expected 50 basis points (bps) reduction, came in September. With it, the Fed signaled a willingness to cut rates at an accelerated pace, boosting the prospects of CRE markets.
Forecasts of future cuts vary, but the Fed’s internal predictions imply that rates will fall by more than 240bps in a little over two years from September’s peak (Exhibit 2).
If realized, this rapid rate drop would put downward pressure on capitalization rates (cap rates).3 This would turn the sector’s biggest challenge into an opportunity and help real estate markets recover much of the value lost since prices peaked in the second quarter of 2022.4
Persistent demand helps keep occupancy elevated
Despite recent headwinds, commercial real estate’s underlying fundamentals remain strong. While some office assets continue to face challenges, occupancy rates across CRE remain higher than their pandemic lows, and overall occupancy is now 264bps above its long-term average.5
Demand is also growing. As of the second quarter, tenants are filling more space and net absorption is positive and increasing across all the major commercial real estate sectors.6 This strong backdrop has kept net operating income (NOI) rising and, unlike previous downturns in which property cash flows fell, NOI is 6.1% above where it was when pricing peaked in the second quarter of 2022.7
Additionally, supply trends are improving with construction starts down between 66% and 80%, depending on the sector.8 This will reduce deliveries of newly built properties in the coming quarters, setting up a more favorable supply/demand dynamic for owners. The improving environment should allow the industry to build on positive trends, making the short- and mid-term outlooks for property performance even better.
Real estate pricing trends are turning more favorable in all corners of the market
The public REIT market, which has already risen by 33% from its earlier trough, was the first to reflect this brightening outlook.9 It then spread to transaction markets. Real estate fund values, which lagged behind REIT and transaction pricing, are now also hitting an inflection point: As of the second quarter, nearly half of the reporting funds posted positive returns, although overall index performance remained slightly negative (Exhibit 3).
CRE pricing compares favorably to other asset classes
This has set up a unique (and favorable) dynamic in which private real estate values look particularly attractive compared to other asset classes. Unlike stocks and bonds, which have already experienced significant gains, real estate prices are still at or near cyclical lows. The U.S. stock market has climbed roughly 65% since its pre-pandemic peak, lifting the S&P 500’s price-to-earnings ratio close to some of the highest levels of the past decade.10 Meanwhile, private real estate values are about as low as they have been during this same period (Exhibit 4).
Although the difference is not as stark, the story is similar for fixed income assets. Bond yields imply less upside potential compared to CRE cap rates and—after also accounting for the appreciation component of CRE—spreads between expected CRE returns and high yield bond yields are well above long-term averages (Exhibit 5). This represents one of the most attractive entry points for private real estate in the past 20 years.
Historically, CRE has proven resilient over time, and—given the current market landscape—it is not unreasonable for investors to expect strong gains from the asset class in the years ahead. Thanks to a sizeable and stable income component, total returns for CRE stayed positive right through the bursting of the dot-com bubble in the early 2000s and only saw one quarter of modest decline during the COVID pandemic (Exhibit 6). This resiliency has not only delivered extended periods of consistent growth but has also helped diversify investors’ stock and bond portfolios, which can be more cyclical.
Conclusion: Time may be running out to buy into CRE at cyclical lows
However, investment timing does matter. As market transparency increases, CRE cycles appear to be intensifying and returns becoming more front-loaded. Given strong economic growth, the healthy fundamentals we see in CRE, the expectation of significant rate cuts by the Fed in the coming quarters and the sharp uptick in REIT pricing this year, private real estate values may be poised to follow a similar path.
With investor sentiment improving and leading indicators already rising, the window to invest at cyclical lows may be short. This means first movers are the most likely to benefit from what we believe could be a surge in pricing.