CPE Asks: Is CRE’s Long-Awaited Reset Here?

CRE transaction markets remain relatively sluggish. According to CenterSquare Investment Management’s latest global market outlook, real estate is facing the aftermath of a valuation bubble that ended in 2022. But, with interest rates remaining higher for longer, investors are anticipating a pricing reboot in 2024.

Commercial Property Executive talked to Uma Moriarity, senior investment strategist & global ESG lead at CenterSquare, about what investors can look forward to this year.

What are your overall investment expectations for 2024?

Moriarity: The public REIT market globally has been under pressure as a function of the synchronized rate hiking cycle across most major economies. The end of that rate hiking cycle should provide a catalyst for global REITs, especially off their depressed values today when compared with equities broadly and private real estate.

While the short end of the interest rate curve could come down this year, as central banks reduce their policy rates, the long end of the curve—such as 10-year yields—is likely to remain higher than they were in the prior cycle, and real estate needs to reprice as a function of this new cost of debt.

The transaction market has been relatively frozen as buyers were waiting for rational pricing in relation to elevated debt costs, while sellers were refusing to sell at what they deemed to be discounted valuations compared to the prior few years. Appraisals are still materially lagging and will need to continue resetting throughout the year.

For the real estate debt market, traditional lenders are likely to remain limited in their ability to deploy new capital as repayments of existing loans—let alone prepayments—remain muted. As a result, alternative debt providers are likely to find opportunities to fill the gap in the capital market and achieve equity-like returns on debt-like risk.

Will this year be a good entry point for investors?

Moriarity: Historically, these periods of reset, like following the savings and loans crisis or the Great Financial Crisis, have proven to be great entry points for real estate investors. But not all real estate investments are created equal.

We believe the most successful investments will be for those who can deploy capital with conviction across sectors that will enjoy asymmetric payoffs as a function of strong real estate fundamentals: low supply, resilient demand. The lack of debt availability is not only curtailing new construction starts but also creating a powerful competitive advantage for the best borrowers who can access debt.

Across the private market, we are most bullish on the following property types:

Purpose-built rental communities: Amenity-rich, single-family rental communities located in under-supplied suburban submarkets. These are ideally suited for Millennials aging into the single-family lifestyle as well as Baby Boomers trying to move out of homeownership responsibilities.

Service industrial: Shallow-bay, multi-tenant industrial product in high-population growth, infill submarkets with average tenant suite sizes below 5,000 square feet and short lease duration. Tenants occupying these spaces typically provide services tailored to the surrounding market or submarket. Their spaces are mission-critical for their business.

Essential service retail: Unanchored shopping centers with e-commerce-resistant tenants whose customers must visit a physical location to consume the service, such as food and beverage, fitness, beauty, health and business services.

How do you anticipate the repricing of commercial mortgages and the adjustment of property valuations to impact the overall dynamics and investment landscape of the CRE industry? Are there specific sectors or markets that you believe will be significantly affected?

Moriarity: We anticipate the credit market is likely to accelerate the private market’s needed repricing. More than $700 billion commercial mortgages were set to mature in 2023—many of which have been extended into 2024 and 2025—and over $600 billion that are set to expire in 2024, per the Mortgage Bankers Association. As these get refinanced, a change in valuation must occur to meet debt service coverage ratio requirements. While the resetting of private market valuations has occurred modestly in 2023, we anticipate it to continue in earnest through 2024 as debt markets drive this shift and plentiful capital remains on the sidelines waiting for transactions to meet the market.

The office sector is undergoing a reckoning and low-quality product is facing true obsolescence risk as demand consolidates into relevant, high-quality office real estate. We also anticipate low-quality malls are likely to experience additional pain, following the negative impacts on this property type from e-commerce and COVID-19, as we head into another recession. However, these are the only notable structural concerns within the real estate world.

Elsewhere, fundamentals screen incredibly strong for many property types like data centers or senior housing as secular trends like digitalization and the aging population drive demand in sectors with supply constraints. There are some passing clouds to note, primarily associated with the recent overbuilding of multifamily, industrial, and life science lab space in certain markets. This especially reigns true in the context of an economic slowdown. However, the structural demand tailwinds for all these sectors remain.

For those investors in the private market who can take advantage of the dislocation in the market and invest with conviction behind long-term positive fundamentals, this will be a great year.

Public REITs are also likely to emerge as relative winners given the strong balance sheet positioning through the last economic cycle—REITs have low leverage levels and are financed largely via unsecured, fixed rate debt, allowing these companies to deploy their balance sheets to play offense.

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Given the divergence in pricing trends between public and private markets, what shifts do you foresee in the broader CRE industry as it adapts to the new reality of increased debt costs and changing valuation metrics?

Moriarity: Public markets tend to overreact, and we believe the REIT market has done so again. However, we believe the REIT market is directionally correct about where real estate prices should be in the context of higher long-term interest rates. Appraisals across private markets still need to be readjusted in a meaningful way—cap rates across core funds, like those in the ODCE index, are still seeing assets appraise below 4.5 percent in a world where the 10-year treasury yield is hovering around 4 percent. Meanwhile, REITs are priced closer to a 6 percent cap rate.

In order for many of these appraisals to be readjusted, we need to see the transaction market open up and provide comps for appraisers, and that transaction market is likely to open up once we see some stability across the debt markets. We’re starting to see the early signs of that already so far this year. Our acquisition pipelines across private equity strategies have already increased in size as we kick off the year.

How might this influence investment decisions and risk considerations for industry stakeholders?

Moriarity: When you can achieve a roughly 5 percent return on a money market fund, you start to think twice about deploying capital elsewhere. Investors are going to be more discerning about where they deploy capital and have higher hurdles for required return.

We remain disciplined across pricing, using data and market indicators across public markets as well as private equity and private debt markets, to help triangulate where we believe pricing should be for real estate assets as interest rates reset, and focusing on property types where we see strong fundamentals.

Are there any specific factors or asset classes where you expect cap rates to be particularly sensitive to these changes?

Moriarity: Property types with the lowest cap rates are likely to see the most meaningful impact just as a function of the base effect—a 50-basis-point increase in cap rates is more impactful when your asset is priced at a 3 percent cap rate vs. when it’s at 7 percent. Here, core multifamily and industrial assets that were developed or acquired during the peak of the real estate cycle with 0 percent interest rates will likely see meaningful corrections in cap rates.

Meanwhile, neighborhood shopping centers, which didn’t really see cap rates fall to really low levels—because capital wasn’t chasing this property type the same way it was chasing industrial or multifamily—might not see much expansion, if any.

Data centers have strong fundamentals, and we’re likely to see more investors entering this sector going forward. How do you see this evolving in 2024 and beyond?

Moriarity: Demand for data centers is booming as data creation, consumption, and usage continue to proliferate. Simultaneously, new supply remains restricted in major markets, which are primarily driven by power availability. Consequently, data centers are experiencing low availability and strong pricing power unlike anything the industry has experienced in the last few decades.

Added to this is a new demand driver in the form of artificial intelligence where data center demand will unfold in two stages: Training and inferencing. The training phase requires incredible amounts of power and computing provided by large enterprise data centers. We anticipate enterprise hyperscale data centers will experience strong fundamentals in 2024 driven by elevated demand associated with this training phase of AI, especially in non-traditional markets where power is available, cheap, and the overall environment is business-friendly.