CRE Analyst

Here are the trends and events that we think will define commercial real estate in 2024.

Sea change... "What inning are we in?" "Is inflation transitory?" "What are the odds of a recession?" "How long will the yield curve stay inverted?" "Will the Fed finally cut short-term rates?" "Green shoots?" The themes that dominated discussions over the last few years all have a familiar thread: Risk on, risk off i.e., All good. All bad. All good again. Carry on. But what if this way of looking at the world is totally disconnected from reality? What if our benchmark paradigm gives us more comfort than insight? What if there's something much larger going on that won't be broadly appreciated without the benefit of hindsight? ---- Our working hypothesis ---- The "risk on, risk off" paradigm no longer applies. The tailwind of falling interest rates over the last 40 years masked nuances that will be much more evident, far-reaching, and performance-defining going forward. ---- An intoxicating 40 years ---- Between 1982 and 2020, the 10 Year Treasury fell 65% of the time (on an annual basis) by an average of 80+ bps. This is like batting 0.650 and averaging a double every time you get a hit. In about a third of the years following 1982, rates increased by an average of 51 bps YoY. So not only were falling rates 2x more likely, they were also 60% more powerful. The natural bias that this tailwind has instilled is almost impossible to overstate. How could a generation of risk takers NOT overestimate their skill when they batted 0.650 and consistently hit doubles for 40 years? How could they not believe that their hard work and insight will lead to favorable results? ---- This time is different ---- This chart could be anecdotal evidence of how "risk on, risk off" is dead. For 40 years, the annual difference between the strongest real estate asset class and the weakest real estate asset class hovered around 1000 basis points of total return. Since 2021, this performance gap has averaged 3000 bps. Will this gap stay at all-time wides? Unlikely. There's probably not another office sector waiting to implode. However, the underperformers won't likely be masked by falling interest rates and cap rates. Appreciation accounted for only 20% of total returns in the 40 years leading up to 2010. Since 2010, appreciation accounted for 50% of total returns. ...hard to not be intoxicated by the falling rate tailwinds, especially when those tailwinds accelerated after the GFC. But this is more than a hangover or a correction. ...more than a new cycle. We are in an entirely different world vs. the last 40 years. We'll continue to flesh out how this new paradigm will create risks and opportunities for investors and real estate professionals in future posts and on our website. If you value this content, please like/share/comment!

A trillion here, a trillion there... Eye-catching stats from Brookfield's recent pitch deck (slide 4) ---- Backstory ---- Brookfield, the second largest alternative investment manager, recently hosted its annual 'investor day.' Several familiar themes emerged... -- The big are getting bigger -- New funding sources (i.e., insurance) -- Retail channels are just heating up -- New products on the horizon -- Great investing environment -- Opportunity to lead in the rush to decarbonize -- Big infrastructure plays ---- Growth opportunities ---- But, out of the nearly 200 slides presented in its main slide deck, slide 4 stood out to us within the real estate portion of the discussion. Brookfield's claims: -- $2.8 trillion in loan maturities -- $52 billion of open-end fund redemptions -- 25% REIT discounts to NAV Our observations: -- Outstanding U.S. commercial mortgages total about $4 trillion. -- The total ODCE index is about $210 billion. -- Green Street has REIT values trading around NAV. Context: -- It took Brookfield 25 years to get to $1 trillion in AUM. -- Brookfield expects to get its next trillion in 5 years. -- Brookfield expects to deploy these assets in private investments. ---- Takeaway ---- A 10 trillion dollar market (i.e., the U.S. commercial real estate market at the recent peak) sounded huge when the largest investors were writing $100-200 million checks from billion-dollar bank accounts. But the real estate market may get very small as those billions become trillions. Ps -- Will this trend lead to increased capital availability for secondary/tertiary markets, non-traditional property types, and international investments?

10 capital markets observations from a discussion with Eastdil's President 1) Great news for borrowers: Borrowing rates are down 175 bps from 6.75% to 5-5.25%, driven by big drops in base rates and spreads. 2) Debt liquidity up across the board: CMBS was just opening up a year ago but is “extremely liquid” now, pushing all other lenders on proceeds and spread. Even the CLO markets (which finance lenders) are back up and moving. 3) Banks: Largest 25 banks are quoting, but smaller banks are pinched with low-yielding assets and portfolio challenges (e.g., office exposure.) Lower short rates will drop deposit yields and spur MBS payoffs, which should lead to more small banks getting back into the market over the next year. 4) Construction loans: Still priced at nearly 8% (mostly debt funds), but could see coupons come down to 6.5% over the next year as banks (especially large banks) continue to get back into the market. 5) Office: Still very little debt but REIT bonds and CMBS are charting a path. E.g., 5% coupon for mid 30s LTV, CMBS pricing 6.5-7% coupons at 10-11% debt yields. Balance sheet lenders remain on the sidelines, but liquidity is gradually coming back. 6) Distress: “Rapidly accelerating distress cycle” driven by office lenders in short sell situations. Buyers are non-institutional, but appetite is growing with some values down 75% from the recent peak. 7) Multifamily: Strong liquidity with all major lender types actively quoting. Cap rates have moved from mid-3s to 4.5% on best assets with significant support overall between 4.75% and 5.25%. 8) Transaction volumes and valuations: Bottomed in 1Q24 and steadily accelerating. Lot of activity in 2025 and even more in 2026. Public markets typically lead private markets, and recent REIT performance “screams asset values are going to go up.” 9) Buyer pools: Primarily driven by offshore investors, pension funds, REITs, and PE-owned insurance companies with big annuity businesses. Significant dry powder with closed-end funds looking for higher-yielding opportunities. 10) Fundraising: Very challenging environment over the last 18 months. Many funds haven’t hit their targets. LPs want to see sales, and ODCE valuation questions have weighed down the overall market. Investors have plenty of liquidity; they’re concerned about relative value. Transaction activity picking up will give appraisers more data points which will help with valuation questions and lead to net inflows into closed-end and open-end funds next year. Special thanks to Green Street, Cedrik Lachance, and D. Michael Van Konynenburg for continuing this annual series. Your ability to pack meaningful takeaways into a 30-minute discussion is unmatched. PS - Link to the full discussion in the comments.

Quick rundown: Robots, "corporate bastards," and alcohol imports 1. Who is on strike? 45,000 members of the International Longshoreman’s Association (ILA) went on strike earlier this week after a new contract couldn't be reached with shipping companies. The ILA handles container shipments in ports ranging from Boston to Houston. 2. Labor: Don't automate our jobs "As everyone has heard by now my Boss is taking a hard stand on the never ending threat of automation that is infiltrating our industry, and I have heard the remarks from those that say we need to learn how to deal with it! Well I have a message for those people 'kiss my fat A$$'!" "...Sam’s, Home Depot, Lowe’s, Walmart and many and many more have continually sold the general public on the premises that by going with automation it will save the public money, with the FACT being thousands of good tax paying jobs went away and the CEO’s and CORPORATE EXECUTIVES are getting rewarded and richer by getting raises and bonuses for making record breaking profits while your dads, moms, brothers and sisters are pushed out of work, not to mention the same retailers that sold “you the general public” on the idea that it will save you money has actually gone up on the price of groceries and supplies of all kinds!" "So don’t be so quick to judgment on us the longshoremen of this country for fighting for our jobs because who knows when it will be your turn next!! We are fighting for our rights to make a honest living not to allow a robot to wipe us out so that them corporate bastards can buy another vacation island somewhere!!!!" "Big Jack" Pennington, President of ILA Local 24 in NJ (9/30/24) 3. Shipping companies: What else do you want? "Our offer would increase wages by nearly 50 percent, triple employer contributions to employee retirement plans, strengthen our health care options, and retain the current language around automation and semi-automation.” 4. Trade Implications East Coast and Gulf ports accounted for 60% of container shipping as of 2022, but as this contract dispute has come into view, port users have redirected shipping to West Coast ports, which now handle nearly 50%. Expect price increases. 5. Commodity price implications Most commodities seem relatively balanced between East and West Coast shipping but East Coast ports handle 260% more alcoholic beverages, 160% more wood, and 175% more fruits/nuts. 6. Estimating the effects "A week’s strike may lead to 4-5% of global capacity being disrupted through knock-on effects." JP Morgan Analyst 7. Strike busting? President Biden is the self-proclaimed most pro-union U.S. President. The administration has stated they have no intention of invoking Taft-Hartley to break a strike, but a strike lasting longer than a week would likely turn up the heat on all sides. --------------- How long will this last? A) < 1 week B) < 1 month C) Longer than 1 month

Redemption gates, Wall Street predators, and retail investors… Media: ‘Scam! Non-traded vehicles won’t give investors their money!’ Page two of Goldman’s recent non-traded mortgage REIT prospectus: “There is no guarantee that you will be able to sell your shares at any given time or in the quantity you desire.”

"Here comes the sun" (kind of) Good news: transactions will pick up in late 2024/2025. Bad news: many sellers won't like pricing. Good news: some buyers will like pricing. Bad news: most would-be buyers will have sat on their hands. Good news: no one will backtest headlines. ========== Bloomberg just reported: "The Commercial-Property Market Is Coming Back to Life" (9/24) A pickup in sales activity is a prerequisite for recovery, so this is great news! ...but before switching to "risk on," let's revisit some narratives from the last few years. ---- Recent headlines ---- "Global Property Market Faces $175 Billion Debt Spiral" (Bloomberg, Jan 2023) "Mitsubishi UFJ Expected to Sell SF Building at 80% Discount" (TRD, April 2023) "Huge Midtown office building sells for a 97% discount" (NY Post, Aug 2024) Theme: the real estate market is unraveling and there may be no end to value declines. Do reporters intend to lead you to perilous conclusions? No. Their job is to pull together anecdotes under thematic headlines. ...but the absence of framework-based thinking leads readers to focus on "worst case." Why does this matter? If you're focused only on downside scenarios, you will misprice opportunities. ---- Framework example ---- In mid-2023, we posted: Every time there’s a meaningful change in market conditions, transactions halt. Why? Because sellers are inclined to see value from a “glass half full” perspective and buyers with cash when cash is king are inclined to see value from a “glass half empty” perspective. The gulf between these perspectives kills transaction activity and throws a blanket over property values. In the same post, we estimated peak-to-trough value declines based on our estimates of accretive REIT yields: On balance, cap rates have been hovering around 6%, which generally isn't an accretive level for REITs to buy. But if they fell another 11% to 6.8%, REITs would likely be buyers. This 11% bid-ask gap varies substantially by sector. Assuming REITs set a pricing floor, here’s how far values would fall from recent peaks… Office -55% Residential -36% Retail -31% Industrial -20% ---- Takeaways ---- Our worst-case estimates proved to be overly bearish, but they set a confident floor that allowed us to evaluate other scenarios. E.g., widespread bank failures? Didn't see it. A repeat of the GFC or S&L Crisis? Almost impossible. ...all because of this simple framework revolving around what well-capitalized buyers could reasonably pay. Our updated views and frameworks suggest the bid-ask gap has closed meaningfully (even for office), which will almost certainly lead to a near-term pickup in transaction activity. We consistently find Green Street's information to be actionable and insightful (no paid endorsements here.) This is a good example. We used Green Street's CPPI as a proxy for what buyers will pay vs. where REITs could accretively buy properties.

Cash is ____. Last forty years: "overrated." From now on: "king." The value of real estate cash flow over time... If you bought a stabilized real estate cash flow in 1986, you likely would have discounted that cash flow by an 11% discount rate (the market discount rate back then per Green Street). Similarly, if you sold that same cash flow at the market's peak in 2022, you likely would have sold it to a buyer discounting the cash flow by 5.6%. In other words, by simply maintaining that originally anticipated cash flow, i.e., without creating any incremental income or value, the value of the property would have increased by 46%. This tailwind (driven by cheap and plentiful debt and increasing allocations to commercial real estate) was a major contributor to real estate's incredible forty-year run. But the tailwind is gone. What next? Here's the nominal change you would have seen in value by entry year, compared to the 2022 peak... 1986:    45% 1987:    46% 1988:    46% 1989:    44% 1990:    44% 1991:    46% 1992:    46% 1993:    46% 1994:    41% 1995:    41% 1996:    41% 1997:    41% 1998:    36% 1999:    36% 2000:    37% 2001:    37% 2002:    33% 2003:    27% 2004:    21% 2005:    16% 2006:    12% 2007:    9% 2008:    14% 2009:    26% 2010:    19% 2011:    15% 2012:    11% 2013:    9% 2014:    8% 2015:    4% 2016:    2% 2017:    3% 2018:    3% 2019:    1% 2020:    0% 2021:    3% 2022:    -3% 2023:    -10% 2024:    -12%

For the last ten years, real estate players were asking, “what inning are we in?” We believe we’re playing an entirely new sport. Who will be the ultimate winner in the next cycle?

A walk down memory lane... The commecial real estate sector has been in a balance sheet recession for nearly two years. The Fed's shift in policy likely signals another meaningful turning point, but before we move on... Here's a road map of how we got here, as told by 12 CRE Analyst posts over the last 20+ months.