Investing in the Real Estate Recovery

Real estate has long been a cornerstone of investor portfolios, and for good reason. Not only does real estate grant exposure to tangible assets, but it can also provide an important source of diversified yield, total returns, and a buffer against inflation over time. That said, after a two-year downturn in which property values dropped 22%¹ from a recent peak as interest rates increased, the current real estate investment environment is one of the most attractive we’ve ever seen.

We see five key reasons private real estate equity and debt can play an important role in investors’ portfolios, both now and in any market environment.

1. Property values seem to have bottomed and real estate appears positioned for a potential upcycle. History shows that investors who wait too far into a recovery to invest risk leaving money on the table. Steady deployment into a diversified portfolio of equity and credit can position investors to capture the upswing of a market recovery.
2. Fundamentals are strong across most property types and markets, which helps to position high-quality real estate as a good inflation hedge over time.
3. Falling interest rates may put pressure on yields in traditional income investments, while sticky inflation supports the case for investing in hard assets like private real estate.
4. Today’s real estate entry points are attractive relative to other asset classes, including stocks and corporate credit, some of which are priced closer to all-time highs.
5. Real estate offers portfolio diversification, which is essential and getting harder to find given increasing correlations between public equities and fixed income, the traditional components of a 60/40 portfolio. 

1. Property Values Seem to Have Bottomed

The downturn that began in spring 2022 resulted in paralysis. A credit crunch precipitated by rising rates significantly reduced transaction volumes in the United States and Europe. That’s changing quickly.

One factor helping drive the uptick in transactions is the $1.5 trillion in commercial real estate loans coming due over the next 15 months (Exhibit 1). Property owners who borrowed when rates were low must either refinance at higher rates and lower leverage points than their original loans, find new equity investors, or sell to repay their debt. Owners faced with potentially costly refinancings are increasingly choosing to sell. Buyers and sellers sensing that property values may be close to a bottom are coming to the table to transact.  

EXHIBIT 1: Global Commercial Real Estate Maturities

We see the dislocation in capital structures across property types as an attractive entry point. Importantly, we prioritize high-quality assets that have been subject to the reset in pricing and potentially too much debt, but not fundamentally challenged properties. Poor quality, poor location, or sectors without long-term growth potential are still areas to avoid, in our opinion.

History shows that investors who wait too long risk missing the recovery. In the wake of the Global Financial Crisis, public REITs had already come close to doubling (+82%) by the time loan delinquencies peaked (Exhibit 2). Our analysis of the down cycles since 1953 shows that U.S. commercial property prices rose 21% in the three years after a trough, and the most severe down cycles showed even higher increases (Exhibit 3). All signs point to the recovery from the current real estate down cycle being underway, with U.S. commercial property prices up 3% since last year’s trough.² Public REITs are up 11.5% year to date through October 4 and in many cases are trading above the value of their portfolios as equity markets have also rallied. If that trend continues, investors who stay on the sidelines risk leaving money on the table.

EXHIBIT 2: Delinquencies and REIT Returns During the Global Financial Crisis

EXHIBIT 3: U.S. Commercial Property Prices (Performance Following Historical Troughs)

2. Fundamentals Are Strong

In the stock market, investors often look at a company’s fundamentals: financial performance, market position, and trends supporting longer-term growth. Private real estate has fundamentals too: supply of property, demand for property, and trends that influence the balance between the two over time. Fundamentals can also include occupancy rates and trends that could affect rent growth, such as the rise of e-commerce, demographic shifts, or migration trends. We think fundamentals in many parts of the real estate market are healthy.

Commercial real estate prices plummeted over the past two years primarily because of rising interest rates, rather than fundamental concerns such as a sharp decline in demand or overbuilding. The office sector, particularly older and less-well located buildings, is a notable exception in the United States and Europe and the place most true distress is concentrated. Dynamics have been different across Asia, where Japan has benefitted from an economic resurgence and a more resilient office sector in markets such as Korea and Australia have contributed to a lower degree of repricing.

Looking forward, supply pipelines look tight in many sectors, largely because construction has gotten more expensive. Though overall inflation is slowing, the cost of labor and building materials remains elevated in the United States (Exhibit 4). As property values have fallen, it is often more expensive to build than to buy, a dynamic that provides support for prices. Good locations are also finite, another factor that tends to be supportive for prices of well-located, high-quality properties over time.

EXHIBIT 4: Construction and Labor Cost Indexes 

On the demand side, long-term trends continue to boost demand across our favored sectors. Rental housing is an important component of overall housing supply, and demographic shifts all over the world support long-term, stable demand for housing of all kinds. In parts of Asia, for example, ongoing urbanization and a trend towards smaller household sizes is driving up demand for housing. Millennial household formation is a factor in the United States, and both in Europe and the United States there is also demand for specialty housing.

In the industrial sector, strong deliveries of new construction have caused net absorption of available space to slow, but the pipeline of new supply is slowing dramatically. The 309 million square feet of industrial space under construction as of the third quarter of 2024 is the lowest level since 2018,³ which should support demand for existing property going forward. Trends like onshoring and e-commerce favor long-term demand for industrial space as well. In Asia, our team is also seeing reshoring drive demand, while in Japan, we are seeing industrial opportunities from corporations shedding non-core real estate assets to improve shareholder returns.

Fundamentals are also strong in real estate credit, where a pullback in available bank capital in the United States has created a greater need for private debt capital. Some worry that falling interest rates will make real estate debt less attractive, but we also think bank retrenchment is a secular trend, which means that private lenders with the ability to lend at scale will find their capital to be in high demand for the foreseeable future. At the same time, we think rising transaction volumes and refinancing activity should shake loose more attractive opportunities to lend. All-in, we think real estate credit will continue to offer very compelling risk-return for investors.

Strong fundamentals are clearly important for real estate investments, but we think real estate owners have the opportunity to build on solid fundamentals with good management practices. Our goal is to start with attractive fundamentals and then add value on top.

3. Interest Rates Are Falling and Inflation Protection Remains Paramount

After the fastest rate-hiking cycle in 40 years, the U.S. Federal Reserve is cutting rates, as have the European Central Bank, the Bank of England, the Bank of Korea, and several other central banks in developed markets. Lower interest rates tend to be positive for real estate equity investors, unless they are accompanied by a precipitous drop in economic activity. However, our macroeconomists foresee slowing growth (with slowing, but still higher, inflation) rather than an outright recession. Historically, recessions are caused by bubbles in construction spending and inventory investment, but those areas are running at below-trend levels (Exhibits 5A and 5B), and unemployment is also relatively low.

EXHIBIT 5A: Inventory and Construction Capex Contractions Have Driven Recessionary Downturns across Cycles

% of GDP Recession Explained by Inventories and Construction

EXHIBIT 5B: Investment in These Categories Is Still Recovering from the Pandemic

Real Spending: Inventories and Construction (4Q19 = 100)

Capitalization rates, which measure the net operating income a property produces against its purchase price and are a metric used to track property prices across the market, tend to fall as borrowing costs fall. We believe that as short-term rates continue to fall, we will see an improvement in real estate valuations and an overall reduction in risk premiums associated with the asset class.

Finally, yields have remained relatively elevated in real estate credit while income-seeking investors face the prospect of lower yields in traditional investments that offer inflation protection, such as TIPS, as rates fall. Since real estate equity investments are backed by real property, they also tend to appreciate and offer protection against inflation.

4. Real Estate Valuations Are Attractive Relative to Other Asset Classes

In many corners of the financial markets, valuations have gotten quite expensive over the last few years, while others repriced at different rates and times. The S&P 500, for example, is in the 96^th percentile of where it has traded over the last 20 years, and that value is concentrated in relatively few stocks.

Valuations in private real estate equity are below 30% of both their 20-year average and the recent market high of 2021 and are also quite low relative to most other asset classes (Exhibit 6). Real estate credit valuations, on the other hand, have risen this year. Many investors have realized that a decline in bank lending has created a vacuum that private lenders are well-positioned to fill and that in this vacuum, lenders can potentially choose high-quality assets on attractive terms. We think the risk-reward is compelling and valuations that are well below the 20-year-average still present a compelling entry point. Real estate overall compares particularly favorably to public equities and public bonds, as the S&P 500 and S&P US Aggregate Bond indices are among the most expensive assets we track.

EXHIBIT 6: Valuations Across Asset Classes

5. Real Estate Offers Potential for Portfolio Diversification

At a time when interest rates and inflation are elevated relative to the decade prior to the pandemic, correlations between stocks and bonds (the core components of the classic 60/40 portfolio) have increased. This means bonds can no longer act as the same kind of buffer to stock market volatility that they once did.

Unfortunately, our Global Macro & Asset Allocation team believes we are in a period that will be characterized by rolling disruptions in parts of the market, as we saw in both the U.S. regional bank crisis in March 2023 and the unwinding of the yen carry trade in the summer of 2024 and disappointing job numbers in August. Forward returns for the S&P 500 at volatility levels like we saw in August have historically been very weak (Exhibit 7). Private real estate is, by definition, not listed or traded. Its returns are therefore closely tied to the value of properties and tend to be less impacted by market sentiment and trading activity than publicly traded assets.

EXHIBIT 7: S&P Forward Returns at Different VIX Levels

Correlations with other asset classes are even weaker when real estate equity and real estate debt are blended together in a thematic real estate strategy portfolio (the Custom Thematic Real Estate Index in Exhibit 8).

EXHIBIT 8: A Thematic Private Real Estate Strategy May Offer Portfolio Diversification Benefits Relative to Traditional Asset Classes

In addition, the tax advantages of private real estate can be hard to replicate in other asset classes. Hard assets like real estate properties depreciate, which means that some or all of the income generated by real estate assets can be treated as Return of Capital (ROC). Income that is treated as ROC for tax purposes generally reduces an investor’s cost basis instead of being taxed as ordinary income (Exhibit 9). Therefore, higher ROC means a higher share of income is tax-deferred and would eventually be taxed as long-term capital gains at a lower rate than ordinary income. This can make investments in private real estate attractive on a relative, after-tax basis compared to other income-producing asset classes such as fixed income, even when yields are relatively high.

EXHIBIT 9: How Return of Capital Affects After-Tax Distribution

Illustrative example of $100,000 investment with a pre-tax yield of 5%

Conclusion

We see private real estate equity and debt as important diversifiers at all times for investment portfolios, given the exposure they offer to uncorrelated real assets. However, investing today offers a compelling opportunity at the beginning of a new real estate cycle, with traditional lenders mostly out of the market and fundamentals largely intact. For those with scaled capital and a view of the whole market, there are attractive opportunities to acquire properties and lend at compelling risk-adjusted returns. However, we have seen from history that by the time stress peaks, most of the gains may be gone. We think the current valuations on private real estate in both equity and debt offer an interesting entry point to an asset class that investors can benefit from owning now and anytime. 

^1. GreenStreet Commercial Property Price Index as of October 1, 2024. All Property CPPI® weights: retail (20%), office (17.5%), apartment (15%), health care (15%), industrial (10%), lodging (7.5%), net lease (5%), self-storage (5%), manufactured home park (2.5%), and student housing (2.5%). Retail is mall (50%) and strip retail (50%). Core Sector CPPI® weights: apartment (25%), industrial (25%), office (25%), and retail (25%).

^2. GreenStreet Commercial Property Price Index as of October 1, 2024. 

^3. Cushman & Wakefield. “MarketBeat” United States Industrial Q3 2024” https://www.cushmanwakefield.com/en/united-states/insights/us-marketbeats/us-industrial-marketbeat