What may shape real estate (NEW)

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. 

Source: St. Louis Fed as of Q1 2023

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. 

Sources: BLS; Hines Research; as of May 2023

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. 

Sources: CoStar; CBRE; JLL; as of 2023Q1

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 12 years, but is not pred­ica­tive of medi­um-term per­for­mance (35 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. 

Sources: NCREIF; MSCI CBRE; Oxford Eco­nom­ics; as of 2023Q1

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.