What may shape real estate
The article represents subjective opinions of Hines Interests Limited Partnership (“Hines”)1, the sponsor of investment vehicles offered by Hines Private Wealth Solutions LLC (“Hines Private Wealth Solutions”). Other market participants may reasonably have differing opinions.
After nearly two years of monetary tightening, the global economy has generally digested higher rates relatively well. Still, this represents a seismic shift from the “no-rate” policy that preceded it and highlights the notion that value creation (rather than financial engineering) may be the driver of long-term investment success. As the economy continues to adjust, Hines believes several forces will likely be reshaping the real estate investment landscape in the decades to come. One of these is deleveraging.
Abrupt change may create opportunity
Historically, periods of profound market change have offered opportunity for investors. In 2023, Hines was a very selective buyer when many others were sellers. With greater liquidity than at any time in its history, Hines is ready to (and expects to) deploy additional capital in 2024 as prices continue to rationalize. The challenge during this process is identifying and understanding the likely impact of deleveraging on the real estate industry.
It is no surprise that historically, higher rates initially led to fewer transactions (no one wants to catch a falling knife). There are many examples, but to highlight U.S. public debt, leverage appears to have hit a cyclical peak. Can it go higher? Perhaps, but governments cannot continually add debt that taxpayers will have to repay downstream. Over time, governments will either need to grow their way out or inflate their way out, just as they did in the post-WWII era, which would translate into higher inflation for a longer period. Spoiler alert – inflating it away could be much easier.
The central banks of the world must remain vigilant against greater inflation. After all, it would not be a stretch to imagine policies that, like in the 1970s, led economies down a similar, reckless road. Some hopeful headlines have emerged, but as shown by the blue line in the graph below, it would be easy to give back recent gains in the fight against inflation. Hopefully, policymakers will not repeat the mistakes of past cycles.
Cautious investors choosing liquidity
The anticipated shift in monetary policy implied by 2024 interest rate futures2 could create renewed volatility in key financial markets. There are already signs that investors are holding more of their funds in assets with higher liquidity and lower volatility, refraining from locking their capital into specific asset class positions that could prove difficult to unwind should market conditions markedly shift3.
As a result (and as expected), transaction volumes and fundamentals have been weakening. Hines anticipated the recovery would be bifurcated (with capital markets improving before fundamentals), but for now, both have yet to turn a corner. It seems more evident that the 40-year run of declining interest rates is over and markets will likely be working through higher costs of capital for much longer than most might think. The unwelcome news is patience will be needed, as this process will take time to play out.
The Leasing Environment Health Score measures the relative health of a market’s current Leasing Environment. It combines Vacancy rates, trailing annual rent growth and trailing annual demand growth into a composite score. The score is backwards looking snapshot of where the market is today and can be predictive of fundamentals performance over the next 1–2 years, but is not predicative of medium-term performance (3−5 years). The score measures the environment relative the prior environment in the market’s own history. A score of 100 is a strong leasing environment, stronger than 100% of the market history. A score of 10 is a weak environment, worse than 90% of a market’s history.
Some positive signs
The Fed has all but announced its intention to cut rates in 2024, and it is likely these actions could make it easier for funds to “ungate” (allow shareholder redemptions). Such developments could also help increase investor confidence, but Hines Research has identified two concrete examples of a possible turnaround. Transaction activity has occurred and has increased, and liquidity has improved. Hines has seen interesting deals on a global scale, and these are getting done despite the current environment. Second, the development pipeline has shrunk – which should support better fundamentals in the future. The market appears poised for rent growth, specifically, as replacement costs have exceeded asset values in many markets. This pattern, supported both by the lack of future supply as well as the functional obsolescence of many assets, should lead to a better picture for property fundamentals down the road.
The “Price-to-Trend” factor is a metric used to evaluate market pricing by comparing current market prices with their historical trendline (representing the market’s long-term intrinsic value). This metric, expressed as a percentage, helps identify where a market is in its cycle: a negative Price-to-Trend suggests current prices are below fair value, indicating a potentially attractive basis to buy, while a positive Price-to-Trend implies prices are above fair value, signaling that market pricing is expensive. Capitalization (cap) rate spreads compare the yield of a real estate asset (the cap rate) to, in this case, the yield of a 10-year sovereign (or Treasury) bond. The difference is the cap rate spread.