2023 was a particularly tough year for the real estate industry. The decline in asset valuations that began in many markets in the second half of 2022 extended in the broader market throughout the remainder of 2023. Transaction volumes also continued to decline throughout the year, with pricing conflicts between potential buyers and sellers often paralyzing transactions.
Investors will be hoping for a better year in 2024, when prices find a bottom and the market returns to a more normal level of activity. When and how that will happen remains to be seen. Distress may rise, forcing sellers into the market. Or we may finally see interest rates start to fall and potential buyers regain confidence. Whatever the details of when and how we get to that point, the sudden market volatility we have seen over the past 12-18 months has changed the playing field. Investors are reassessing their real estate allocations and strategies to not only mitigate significant risks but also capitalize on the opportunities presented by this market dislocation.
The heady mix of structural and cyclical trends rocking the markets creates an investment environment characterized by a diversity of risk exposures and expected returns. In this blog post, we highlight some trends that can help investors navigate this challenging environment through 2024.
1/ The plight worsens as loan maturities approach
Distressed asset sales will account for only a small portion of the U.S. market in 2023, 1.7% of investment share, despite a steady rise in distressed asset levels since 2022. Still, there are reasons to believe that further forced capital events, including distressed asset sales, could be on the way.
The wave of maturing loans and the timing of maturities of these loans could lead to further forced sales. The most problematic loans are those that originated when real estate prices were at all-time highs and mortgage rates were at all-time lows, which includes many of the loans originated in 2021 and 2022. Many of these loans had short maturities. For example, of the 2021 loans that remained outstanding at the beginning of the fourth quarter of 2023, 67% are due to mature by 2027. As these loans mature, some investors will have a hard time balancing their capital structures in an environment of rising interest rates and falling valuations.
More conservative lending terms will likely force such capital events. Commercial loan-to-value (LTV) ratios for 7-10 year fixed rate products will average 57% in 2023, down 2 percentage points from 2021. LTVs for multifamily assets have declined even further. With more than $2 trillion in loans maturing through 2027, capital costs will return to historically typical levels, creating further opportunities for investors looking to acquire assets on the cheap as lenders continue to tightly manage risk.
Still, the structure of funding markets since the 2008 Global Financial Crisis (GFC) may provide more flexibility for lenders and borrowers in this downcycle than in the immediate aftermath of that disaster. At the time, rebalancing often took the form of foreclosures by loan purchasers or distressed loan sales by special servicers. Today, investors are looking for new avenues for rebalancing.
Loan maturities in the US are looming
Loan maturity dates by issue year. Loan balance as of Q4 2023. Data as of December 5, 2023. Source: MSCI Mortgage Debt Intelligence.
2/ Mind the gap: buyers and sellers need to meet
The current decline in liquidity in many global transaction markets is largely due to pricing uncertainty caused by interest rates rising sharply after years of low interest rates, making it harder for buyers and sellers to agree on pricing for properties and resulting in fewer completed transactions.
The size of the price gap that must be closed to return market liquidity to its long-term average has widened significantly in some of the major office markets in Europe and North America, as shown by the MSCI Price Expectations Gap (which shows that office, on average, performs worse than industrial and residential real estate).
The price gap for offices in German city A has widened from -7.5% a year ago to -36% in Q3 2023, on top of a 14% drop in transaction prices over the same period. This suggests that even bigger discounts than those currently on offer will be needed to attract buyers back into the market. A similar trend has been observed in San Francisco, where the price gap has widened to -27% on top of a much larger drop in transaction prices.
For more liquidity to return to the transaction market, there needs to be more agreement on property pricing, which in turn needs a clearer trajectory for interest rates. If investors expect inflation to fall and central banks to be near the end of their tightening cycle, then buyers and sellers may be able to come to terms. In the meantime, it's worth keeping an eye on the gap.
The growing gap between buyers and sellers on pricing
Office properties only. Source: MSCI Price Expectations Gap, RCA Hedonic Series
3/ Office performance could cause a double-dip recession
The commercial real estate market has been in turmoil for the past few years, making it even more difficult than usual to predict the bottom of the investment cycle. After an initial interest-rate-driven decline in the second half of 2022, we cannot rule out a second downturn in real estate performance due to factors such as a prolonged period of higher interest rates and slower global economic growth.[1] Weakening tenant demand from the office sector is also an important factor.
The biggest driver of fluctuations in real estate performance is capital appreciation, which is driven by pricing. One signal regarding pricing is provided by the MSCI Price Expectations Gap. According to this analysis, of 143 market segments measured in Q3 2023, 99 will require further price cuts to restore liquidity to their long-term averages. Such a correction, in turn, could trigger further declines in valuations.
Furthermore, office properties are expected to require the largest price cuts, averaging just under 17% across the market. A closer look at MSCI's quarterly indexes reveals that some markets, such as Australia and Ireland, are heavily weighted to the office sector. As such, any such price cuts could have a negative impact on capital appreciation once trading begins.
We've already seen the first downturn in real estate performance
Capital value weights as of Q3 2023. Source: MSCI UK Quarterly Property Index, MSCI/SCSI Ireland Quarterly Property Index, MSCI/REALPAC Canadian Annual Property Index (unfrozen) Quarterly Issue, MSCI US Quarterly Property Index (unfrozen), Australian Real Estate Institute/MSCI Australian Annual Property Index (unfrozen) Quarterly Issue
4/ Investors are grappling with a rapidly changing risk and return landscape
Global real estate investment has undergone significant change over the past year and a half, with the shifting economic and financing environment shifting investor perceptions of value across and within asset classes. This shift is particularly true for real estate. Real estate is not only directly impacted by debt financing and the impact of interest rates, but also more broadly and indirectly impacted by rising risk-free rate benchmarks against which all asset classes are priced. Investors are also reassessing their capital allocation within real estate due to changing risk and opportunity dynamics. This is driven by changing cash flow expectations and asset repricing that are impacting different aspects of the market in different ways. Risk from core to opportunistic strategies is one key aspect.
Against this backdrop, it is instructive to compare the return characteristics of core open-end funds with closed-end funds that are dominated by value-add and opportunistic strategies.From December 2007 to June 2023, the Burgis Global Real Estate Fund Index slightly underperformed the MSCI Global Real Estate Fund Index (Core Fund) by 150 basis points (bps) per year, mainly due to a significant underperformance during the Global Financial Crisis. During the intervention period up to June 2022, the Burgis Index outperformed the MSCI Index by 70 bps per year, and returned -3.1% during the most recent downturn (12 months to June 2023), compared to -9.4% for the MSCI Index.
In the current downturn, core investment has lagged so far.
Fund returns. Source: Burgis Global Real Estate Fund Index, MSCI Global Real Estate Fund Index (Core Fund)
5. Climate change casts a long shadow
The threat of climate change has loomed an increasingly ominous shadow over the planet in recent decades, with scientists predicting that 2023 will break several notable weather records and be the warmest year on record.[2] For real estate investors, these changes in weather patterns could impact portfolios in a number of ways, including physical damage and transition costs. The MSCI Climate Value-at-Risk Model estimates that up to 5.5% of the MSCI Global Annual Real Estate Index could be vulnerable to transition risks and 3.0% to physical risks over the next few decades.[3]
Another, more direct way that climate change could affect investors is through insurance costs. If extreme weather events become more frequent and severe, as climate models predict, these costs will likely have to increase, and evidence of this trend may already be emerging. Data from the MSCI U.S. Quarterly Real Estate Index shows that over the five years to September 2023, insurance costs as a percentage of available income more than doubled, from 1.0% to 2.3%. These cost increases are driven by more frequent and more severe extreme weather events, as well as higher reinsurance premium rates.[4] Costs are particularly high in states such as Florida and California, where the MSCI Climate Value-at-Risk model estimates that properties face above-average risks related to physical climate change.
Insurance premiums in the United States are rising, especially in high-risk states.
Insurance expenses as a percentage of revenue received. Source: MSCI US Quarterly Property Index
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