In a period of economic uncertainty and rising interest rates, the U.S. real estate market still shows signs of fundamental strength.
The COVID-19 pandemic has accelerated preexisting structural shifts in the U.S. real estate market that—combined with ongoing demographic trends—are changing the ways that Americans live, work and consume.
Signs of weakness are appearing in the U.S. real estate market: Rent growth is slowing, debt financing is drying up, and transaction volumes are decreasing sharply.
Unleveraged price depreciation is likely to reach low double digits—between 10%–15%—in 2023; we expect a full peak-to-trough decline of 15%–20% this year.
Despite market headwinds, we continue to see attractive near-term opportunities in mezzanine debt lending in commercial real estate, and in residential housing development.
Looking beyond 2023, we expect to see new investment opportunities arise as multiyear structural shifts and demographic trends reshape the U.S. real estate landscape.
Policy risks cloud near-term prospects for U.S. real estate market
A fog of macroeconomic uncertainty hovers over the U.S. real estate market. Inflation may have peaked, but—at the time of writing—the U.S. Federal Reserve (Fed) was continuing to hike interest rates in its bid to restore consumer price stability.
Necessary as the Fed’s approach may be, the probability of a U.S. recession is rising, with clear implications for the U.S. real estate market. Signs of weakness are appearing: Rent growth is slowing across most property sectors, and debt financing is drying up. Transaction volumes and values are decreasing, led by the challenged office sector. Despite these difficulties, U.S. real estate fundamentals remain largely favorable: Commercial vacancy rates are still comparatively low, and rent growth is still trending above its long-term average.
Near-term opportunities do exist, even as rent growth moderates and property valuations trend downward. Although we anticipate an unleveraged value decline for commercial real estate of 10%–15% this year, we see attractive entry points for mezzanine debt lending in commercial real estate, and in residential housing development (specifically, build-for-rent single family homes). By the end of 2023, asset valuations should stabilize.
Longer term, we think investors need to look beyond the current risks in U.S. real estate and explore emerging opportunities. The COVID-19 pandemic has accelerated preexisting structural shifts that, combined with ongoing demographic trends, are changing the ways that Americans live, work and consume.
Economic challenges signal price corrections ahead
As real estate reprices in response to the higher cost of debt capital, all U.S. real estate sectors will likely be affected.
Last year could be characterized as a struggle between opposing forces: rising interest rates (and more stringent lending standards) vs. strong underlying real estate fundamentals. Our conclusion: We are currently at the front end of a real estate price correction amid worsening economic conditions.
Transaction volumes in U.S. real estate are already down 21% (as of 3Q 2022) compared with a year ago. The office sector is seeing the steepest declines, while residential, industrial and retail are faring somewhat better (Exhibit 1A). In the third quarter of 2022, the NCREIF ODCE index registered the first quarter of negative appreciation since 3Q 2020 (Exhibit 1B). Commercial mortgage-backed securities and lifetime mortgages have all delivered negative returns over the past year.
How low can it go? We expect to see unleveraged depreciation in low double digits in 2023—between 10%–15%—but at ODCE levels of leverage that translates into a 15% to 20% peak-to-trough decline. The downdraft in pricing may persist throughout much of the coming year, and borrowing costs are rising sharply, reducing the availability of debt capital in the markets.
All U.S. real estate sectors are likely to be affected. Residential and industrial sectors, which had capitalization rates in the 3%–4% range in 2022, have recently seen rates rise above 4%. Quality still equals resilience, however, and select retail assets—grocery-anchored shopping centers and top-quality malls—have solid net operating income (NOI) expectations despite the recent price declines. The best properties, which currently have cap rates of approximately 5%, are likely to demonstrate greater pricing resilience.
Repricing creates attractive near-term entry points
As the U.S. real estate market recalibrates, we are seeing near-term opportunities emerging in mezzanine debt (junior lending within the capital stack), residential housing (specifically, single family rentals) and—subject to the evolving economic climate—core real estate funds. These three near-term opportunities are described in more detail below:
Mezzanine debt: Core mezzanine lending constitutes a timely way to invest in the current market dislocation in commercial real estate. Providers of senior loans are now offering lower loan to value, mindful that valuations are likely to fall from here. Meanwhile, the next tier of lending in the capital stack, mezzanine debt, has seen returns remain positive and steady, while also lending at reduced proceeds and at wider spreads.
Single family rental housing: Even in a recession, people still need a place to live, and opportunities are appearing in the build-to-rent single family space. Since 2015, rental prices have been rising, and price growth in urban gateway cities—such as Boston, Los Angeles and San Francisco—is up nearly 40%. Key Sunbelt markets—such as Charlotte, Orlando and Phoenix—have seen 70% rental growth. Despite those increases, it is still cheaper to rent than to own (Exhibit 2).
As mortgage interest rates approach 7%, conditions in the for-sale housing market look increasingly messy. Higher rates are pushing standing inventories closer to levels reminiscent of the global financial crisis. Financial distress across the homebuilding industry may create more opportunity in the months ahead, and buying standing inventory to convert from for-sale to for-rent properties—a strategy we have actively pursued since 2020—will significantly boost available stock in key markets.
Core real estate: By the end of 2023, core real estate will represent a key area of focus for our team. Although we anticipate a 10%–15% decline in prices this year, that decline has already occurred in the spot market, and appraisers are catching up. Our own analysis indicates that while investing on the cusp of a recession can lead to disappointing returns, once the repricing is over, forward returns typically look attractive. Whether or not the U.S. slips into a recession, we are projecting a normalized pattern of returns for core real estate by the end of this year.
Thinking longer term about market transformation
In the wake of the pandemic, Americans are using real estate in a fundamentally different way. How we consume, live and work will, in our view, never be the same. Social megatrends that pre-dated the crisis, such as the move toward flexible work patterns, are driving these changes, which have accelerated since 2020.
Investors need to start thinking about how to reposition their portfolios to take advantage of the new economy, and we would encourage them to focus on opportunities in “extended” subsectors, such as truck terminals, outdoor storage, single family rentals, age-restricted housing and life sciences buildings.
Perhaps the easiest way to think about these categories of activity—and their transformative impact on traditional real estate sectors—is to consider the changes we have observed to date:
How we consume: E-commerce is continuing to transform the industrial and logistics sector. We are focused on last-mile, infill warehouses close to population centers where development is restricted. We are also seeing niche opportunities in logistics, such as outdoor storage and truck terminals.
How we live: Living preferences are changing with demographic trends, including the aging of the U.S. population. We see development opportunities in growth areas that address the entire life cycle—from garden apartments to single family rentals to age-restricted housing.
How we work: Working patterns are still undergoing tremendous change as flexible arrangements become embedded. We are focusing less on traditional office spaces and looking at opportunities in amenity-rich newer buildings, which appeal to tech-focused and biotech tenants.
Conclusion: Near-term challenges should give way to strong long-term trends
If a recession occurs, we expect it to be short and shallow. Inflation appears to have peaked, and interest rates may normalize as soon as late 2023. Although a period of uncertainty lies ahead, the U.S. real estate market is operating from a position of fundamental strength: Pockets of demand still exist. We are watching for entry points in mezzanine lending and the for-sale housing market (to increase the supply of rental housing stock).
Looking out beyond 2023, we will shift our long-term strategic positioning to capitalize on the changing ways Americans choose to live and work. Our allocations to traditional office and retail sectors will shrink, and we will focus on sectors with sustained demographic tailwinds and favorable prospects for income growth.
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