New Normal
After the pandemic, the war between Russia and Ukraine, inflation, global geo-political crises, climate changes, technological changes including artificial intelligence and so on, the commercial real estate investing will become transiting to a “new normal” environment regarding a shift in asset class preference, a focus on tech-enabled properties, a geographic considerations, new disruptors and risks, new key concerns, and new market changes.
The “new normal” on an asset class has been and will be shifted towards an industrial and residential classes after changing the investment preference. “The preference for specific asset classes within commercial real estate may shift. For example, there may be increased interest in industrial and logistics properties due to the growth of e-commerce and supply chain changes. Additionally, multifamily residential properties could continue to be attractive, especially in urban areas with strong job markets” (ChatGPT). According to Deloitte, boosted by growing e-commerce and third-party logistics providers, along with investments in reshoring initiatives to bolster stretched supply chains and domestic manufacturing, sustained demand for industrial locations has still led to high competition for existing space. In 2022, absorption has increased by 60% comparing to 2021, which had already doubled comparing to 2015-2019’s level, and as a result, the rent growth continues in North America by 18.6%, Europe by 10.8%, Asia/Pacific by 6.4%.
Accordingly, the multifamily rental sector has grown in rent price by 20% since 2019 in the United States: deflation in residential sales, while Canada and Australia had implemented a variable interest rate so that those countries has adapted quickly, more stable in housing sales prices and transactions. On the other hand, the United Kingdom and Germany have the latest started reacting the inflation after pandemic, the slow movers among those countries who are mentioned as the leaders in this context (Deloitte, 2024). The “new normal” in the multifamily sector can boil down to affordability; the rent price rises as the demand rises, yet the supply is comparably lower due to the inflation affecting to new development construction costs limiting the municipal and federal governments’ policies (Deloitte, 2024). Rosen interest rate caused abnormal residential real estate situation.
The third sector is hospitality, which has been recovering up to +14% (Americas), +13% (Europe), and -7% (Asia/Pacific) in RevPAR comparing to the pre-pandemic level. The hotel operators are concerning about “the quality equation” due to the rises in cost and shortage in labor caused by inflation. The demand which is still recovering does not reach to the near equilibrium point, and it leads to the higher expectation in experience (quality of service) per dollar spent comparing to the pre-pandemic level. In addition, the leisure travel has surpassed and will surpass the corporate travel in demand (Deloitte, 2024). In this aspect, the cost of operations will surpass the historical level of expenses, including the cost of capital when it comes to a new construction and refinance.
In his book, Am I being too subtle written by Sam Zell, as a leader he did in his early investment life, the nature of investment roots from a person’s desire of investment through assessing risks and return expectation. From my perspective and based on my knowledge, a person’s desire creates an investment culture, and it becomes a trend like a “new normal” because Wall Street always meets Main Street. Being proven in the recent phenomenon after the pandemic, the capital market system and the political environment are directly connected, and it proves the different outcomes among countries; some are more volatile, and the others are less volatile merging the investment trend worldwide. Today’s investment strategy is much more sophisticated due to the fast changing internal and external environment, technology, work-from-home, growing e-commerce, and so on. According to Zell, investors much care about Cash-on-Cash which was expected 50% of the return in the past in 1960s and 70s. Today, the opportunity has been much saturated; furthermore, much higher discount rate will reduce the real value of returns or vice versa depending on the sectors if the economy achieves soft landing, creating a new opportunity. Unlike during GFI in 2008, the office sector is no longer having a room for an extension for the existing owners because of the significant decrease from work-from-home phenomenon after pandemic. Refinance may also not be a solution due to the shortage of cash flow at exit or at the end of holding period.
The state of real estate debt market can vary over time and is influenced by various economic, financial, and market factors. The key assessment aspects include interest rate, credit availability, market conditions, investor sentiment, regulation, economic conditions, property types, global factors, technology and fintech, and default and delinquency rate (ChatGPT). Among these factors, the interest rate environment has played a chaotic role in the real estate debt market during and after pandemic period (to the present), particularly against the office sector. Due to the Fed’s monetary policy, there has been six interest rate hikes since last year. According to Wheeler at Goldman Sachs, only around 25 percent of loans now in the current CMBS universe could achieve a refinance from senior lenders. Bank, which historically have bought a high percentage of AAA-rated CMBS loans, have been largely absent from the market and insurance companies have become more selective, which has resulted in a small number of money managers to keep the market functioning (Commercial Observer, 56th NYU Schack Capital Market Conference). The relationship between CMBS spreads and the 10-year treasury rate is an important factor in the pricing and performance of CMBS securities (ChatGPT). The higher 10-year treasury rate tends to lead the higher CMBS spread; therefore, the less transaction volume will occur, leading defaults and cash flow deficits when refinancing (please see exhibit 1). Moreover, according to Professor. Chlopak, CRE debt origination has constrained in this year, down 50% year-of-year. The sharpest declined sector was CMBS and office properties, and $600 billion maturing debt through 2025 will be troubled (Professor. Chlopak).
According to Johnson at NYU Schack Capital Market Conference, “If office is totally illiquid, it would make logical sense that one of the ways to reduce is just to run off the other asset classes to a certain extent, and push those out into the refinancing market and get some activity going.” Hom at GIC added the office sector may eventually play out similar to malls, which had their valuations peak in 2015 before fundamentals weakened due to changing consumer behaviors toward more e-commerce purchases coupled with oversupply. CMBS market activity for top-tier malls in single asset, single borrower deals while middle-class assets have no bank support with lenders instead trying for modification to amortize cash flow (Commercial Observer, 56th NYU Schack Capital Market Conference). The top tier assets in the asset classes including multifamily, industrial, hospitality, and so on have a better position in the debt situation especially in refinance, but the office sector especially the middle-class has the worse position at its refinance situation in CMBS and other loans. From the development perspective, only great projects are going to get done. Furthermore, in the near term, the CRE finance market will likely see some added volatility from the 2024 election cycle, but is unlikely to lead to any massive change in valuations. A fiscal conservatism in terms of reining in spending would be ideal to combat inflation and avoid higher interest rates, but noted that Donald Trump also ran up the federal deficit at high levels similar to President Joe Biden (Balkan, Commercial observer, 2023). From the aspect in government reaction, printing dollars do not help this commercial market debt crisis, so called a part of fiscal policy, but it only opposes from the goal of soft landing. According to Chinese independent economist broadcast at Bloomberg TV, “do not print money anymore” (Bloomberg TV). For example, as more money is deployed, and implemented on the social welfare, the higher inflation will cause other rate hikes, and eventually it will cause an unbalanced economy from the United States’ standpoint, farther from soft landing. For the 2024 outlook, Wheeler at Goldman Sachs said her office is projecting roughly $64 billion of commercial mortgage-backed securities issuance compared to less than $40 billion in 2023. The 2024 CMBS volume will comprise a very small percentage of office properties, and most likely only in conduit transactions, but that many borrowers in other sectors are motivated to execute five-year refinance loans at fixed-rate terms rather than continuing to seek extensions (Commercial Observer, 56th NYU Schack Capital Market Conference).
From UBS, global bond yields on 10-year US Treasury breached 5% in mid-October, some of the highest levels since 2007, and they have declined to 4.44% (as of 19 November). The sharp fall in borrowing costs comes after the latest Fed meeting, where Fed Chair Powell struck a more balanced tone than markets had expected. There is a raising holes the US hiking cycle is over. This expects government bond yields to fall in 2024, supporting positive returns and slowing inflation should contribute to lower interest rate expectations. The UBS strategizes their investment in 2024 from fixed income to equities (UBS, 2024). According to Bloomberg television, the highest rate growth is expected by Goldman Sachs, and the lowest rate growth is expected by UBS.
Real estate equity markets have significantly declined in 2023, down over 50% year-to-year. Investment volume has been down across all capital groups, institutional investors and REITs have the most dramatic declines, likely more sensitivity to cost of capital (Professor. Chlopak). When it is at booming cycle, investment activities are more likely active, and vice versa. When it comes to the sector analysis, according to Sakwa at Nareit, in addition to the self-storage and apartment sector feeling the impact of new supply, healthcare companies especially senior housing was decimated during COVID; the industrial sector looks likely to be sustained. In a macro level of investor sentiment, next year could be good if the rate is stabilized, Romano said (Nareit). Moreover, AI will fuel a wave of building in the date center space in the next three to five years that REITs can take advantage of, Johnson said (Nareait). Like the industry professionals forecast, the real estate equity market has been down, but it will be better in 2024 as interest rate will be more stabilized and cost of capital will decrease, and inflation will be slower down even causing deflation in some sectors in the economy. However, Erwin at JP Morgan Private Bank said 2% mandate will become the inflation floor, not the ceiling. The investment environment will still be high due to inflation, just not as high as the recent years (JP Morgan Private Bank, 2023). As Bureau of Labor Statistics forecasts, the domestic demands and personal expenditure will be soaring in 2024, yet government and private investment will not significantly increase, and the net export volume will decrease in 2024 (Bureau of Labor Statistics, please see exhibit 2). It will may cause a higher cost of capital, which may be used in new developments; the consumer demand is going up, and the supply on this sector shorts, then eventually the dry powder will be deployed to domestic goods on a consumer spending just as of the law of market, capitalism, or sitting in one’s bank account.
As of today, December of 5th, 2023, the Federal Funds rate is between 3.25% and 3.5%, which has been down compared to early this year and last year. By next year, it will be anticipated to down further this rate. From my perspective, a recession compared to the inflation periods is going to happen, and accordingly the consumer spending will decrease. According to UBS, there is 300 USD is out there in the private infrastructure industry in the U.S, and the transaction is not active since the equilibrium point is not created between the seller and buyer (UBS). However, 2023 YTD, the U.S. transaction volume financially has been surpassing the European level for the first time since 2023 (UBS). From my perspective, as interest rate is expected to decrease, the transaction in this sector will generate a higher volume. According to ChatGPT, the private infrastructure includes private transportation infrastructure, energy infrastructure, utilities, social infrastructure, real estate development, renewable energy projects, telecommunications, social housing, data centers, mining and natural resources, and renovation and upgrades (ChatGPT). These are all based on real estate. In ChatGPT, “private infrastructure investments are typically made by institutional investors, private equity funds, infrastructure funds and corporation” (ChatGPT). If the expectation on private infrastructure transaction volume increases is right in the future, the public and private collaboration will happen; the rates are down, and the transaction volume is up. Frankly, it applies to every sector in real estate except hospitality sector niched in international transient, business, SMURF, and so on. It is because the weaker currency value, the stronger in demand in this sector, then this specific industry is likely booming. However, in the U.S., domestic travelers account for a significant consumer power; thus, it is not as much as affected by the decreased interest rate.
According to Professor. Chlopak, risks facing commercial real estate include economic downturns, market oversupply, tenant defaults, location risk, regulatory changes, capital market volatility, environmental and sustainability risks, technological disruption, natural disasters, political and geopolitical factors, liquidity risk, and tenant industry risk. That is why, “investors in commercial real estate must conduct through due diligence, assess these risks, and have strategies in place to mitigate them to make informed investment decisions” (Chlopak, 2024). From ChatGPT, the mitigants include diversification, through due diligence, market research, tenant diversification, long-term leases, strong lease agreements, professional property management, risk assessment, insurance, capital reserves, stress testing, legal expertise, environmental compliance, exit strategy, market timing, responsible financing, professional advisors, tenant credit analysis, and comprehensive exit due diligence. All of the risks and mitigants are the general knowledge in real estate, and it becomes extremely difficult when it has to be faced and resolved. For example, when economic downturn, there is no way that real estate professionals including investors to resolve this issue, but they have to find the best way to mitigate the risk, a diversification. For another example, when one of the real estate sectors faces tenant industry risk, further the liquidity risk caused by the tenant risk, a through legal expertise is required. A standard lease historically rooted sometimes does not work because of market situation change, economic downturn, and so on. In this aspect, a commercial lease risks the most due to the longer lease term, typically five to ten or more years; it is all based on the forecast by the real estate professionals after consistent research and studies. However, due to the “invisible hand,” it does not guarantee anything; thus, there are risks and mitigants.
The real estate disruptors come from the unforeseeable circumstances. According to Professor. Chlopak, remote work and flexible work arrangements, technology and smart buildings, e-commerce and logistics, sustainability and green building practices, urbanization and mixed-use development, demographic shifts, space repurposing and adaptive reuse, coworking and flexible office spaces, health and wellness considerations, and regulatory changes and policy shifts. “these disruptors have the potential to reshape the commercial real estate development industry, prompting developers and investors to adapt their strategies to meet changing market demands and trends (Professor. Chlopak). In my understanding, the real estate disruptors are a trigger to the “new normal,” and it needs tremendous efforts in financial, time, manpower, sovereign, and corporate aspect.
We are in the middle of the “new normal” faith, and being observed in New York City case, higher number of refugees, asylums, migrants, and other people including children reside in shelters; some of them have stayed at hotels where contracted with the city during COVID era and after-COVID era. The federal government has relocated those who need housing and government supports to New York City, and there has been a significant downside from this policy. This is another downside of “new normal.” According to Professor. Chlopak and Bloomberg, a public transit in New York City averages about 60% of pre-pandemic levels (please see exhibit 3). It has been recovering, but it needs to recover more up to the level of pre-pandemic. In fact, New York City Subway is increasing its fare by 5.5% from $2.75 to $2.90 according to AmNY (2023) (please see exhibit 4). Is this from inflation, or from low-demand, or higher supply level? It probably has to run its operation, but there is a deficit. A higher cost and lower income. It is interconnected with real estate because they are one of the business sectors under macro-economic situations.
Investors might be able to think about weighing more portion to their portfolio filled with industrial, residential, and hospitality sector, probably a private infrastructure. Furthermore, a student housing, tech-related, gaming, and healthcare due to the relatively rapid demographical changes compared to the relatively slow growth in the number of general population.
-Written in Dec 2023-