The state of real estate markets

TL;DR: 

Rising interest rates impact valuations across all assets, including real estate. But not all real estate is equal - think Salt Lake City residential vs. San Francisco offices.

Real estate can be a source of diversification, growth potential, and income. But risks exist: illiquidity, changing trends, rates, and regulations. 

Don't play the timing game. Invest across cycles, geographies, and property types.

For any questions or comments, don't hesitate to reach out to us at investments@withcompound.com.

What happened over the last few years?

We recently published two pieces on how to invest in public and private real estate (and we have additional background on real estate here). 

This piece is focused on what’s happening in the market today. But first, we’ll zoom out and focus on recent events and their market impact. COVID and the Fed’s interest rate hikes have dominated headlines, economies, as well as impacting global real estate. 

Let’s remind ourselves what the pre-COVID real estate world looked like: 

• A rebound from the Global Financial Crisis and more-than-a-decade of persistently low interest rates fueled valuation appreciation across many property types. 
• Significant government stimulus in response to COVID and tax incentive programs like Opportunity Zones were created and led to excess invested capital, fueling development and asset appreciation. Though it remains to be seen to what extent the program has fulfilled its intended purpose. 
• New investable themes have emerged such as data centers and e-commerce warehouses with changing . Legacy brick-and-mortar retail continued to struggle. 
• The rise in single-family home prices has far surpassed wage growth, making homeownership unattainable for many, despite historically low financing costs. 

The chart below shows how the Commercial Property Price Index (an aggregate representation of real estate prices) has risen since the late 1990s and the impact from the Federal Funds Rate (interest rate floor managed by the Fed).

COVID’s impact

On the supply side:

• The shuttering of businesses and ports led to skyrocketing costs, especially for construction, which have increased by 37% since Feb 2020. 
• New building supply experienced longer delays due to these cost increases (recall the price of lumber). 
• An existing tight labor market paired with mandated work stoppages during this time also slowed new building construction, in some cases by 100%.

On the demand side: 

• Tier 1 cities saw residential and office vacancies rapidly increase as the WFH revolution led ~2 million people to search for more space in suburbs or lower-cost states. 
• The price of single family homes exploded in some pandemic “boomtowns”, with cities like Boise seeing ~38% increases in one year. 
• For those who experienced financial hardship, economic impacts from the pandemic were somewhat offset by rental assistance programs and the eviction moratorium.  These programs also had the impact of reducing landlords’ ability to collect rental income.
• With limited travel during COVID, hospitality and leisure properties struggled considerably with revenue per room falling by +50% (though demand has since rebounded). 
• Commercial offices still struggle with office workers slow to return to in person work. A silver lining has been in industrial assets, especially those deeply embedded with ecommerce supply chains.

Rising interest rates

As the pandemic recovery took off and inflation grew, the Fed took action by raising interest rates. This has created challenges for the real estate industry. 

‍Higher interest rates means more expensive financing costs, and at a certain point, the math doesn’t work for investors who start to reconcile with the tradeoff that comes from investing in real estate as opposed to risk-free assets like treasuries. 

The impact of the “math not working” for many buyers and investors creates a market with demand, prices, and potentially reduced future supply.

An important term in real estate is capitalization rates (or “cap rates”), which is another way to think about an asset’s yield just like that of a bond in traditional fixed income. 

The best way to think about the relationship between interest rates and cap rates is: the higher the interest rate, the higher the cap rate, the lower the valuation of a real estate asset. Why? Because investors can get an equally attractive yield from investing in other assets (like treasury bills) and assume much less risk. The chart below shows how cap rates have changed across property types in the pre & post COVID eras.

More recently, concerns have started to arise in commercial real estate debt markets: 

• Regional banks own somewhere between 40%-60% of the $4.7 trillion of US commercial real estate debt. 
• About half of all commercial real estate debt is floating rate, which becomes more expensive for borrowers as interest rates rise, and a significant amount of this debt is coming due for re-financing in the coming years at these much higher rates. 

What happens next?

• The real estate industry depends on growth, construction costs, and cost of capital. 
• A recession or extended demand softening could significantly impact a building’s rental growth profile. 
• A shift in the financing markets that makes the cost of capital more expensive implies that quality matters (40% of buildings have no vacant space, while 10% of buildings account for 60% of office vacancy). 
• Construction loans have an elevated risk profile as there’s no guarantee the building will be built or will rent as planned. 

Interest rates, the upcoming maturities, slowing growth or a recession, and the changing landscape of the lending market will all put pressures on real estate investing over the coming years. 

Below is a more detailed commentary on both property type and asset stage:

The bottom line

In truth, the state of real estate is not one thing but a collection of many. Rising interest rates have introduced significant challenges to the industry, and we think some property types (like multifamily residential and industrial) are better positioned to succeed in this environment. Others (like office and retail) are facing secular headwinds that may persist for sometime. Should higher interest rates persist, we may see more stress paving the way for opportunistic specialists.

Though the future remains unclear, we continue to recommend real estate investments for clients as a diversifier to their asset allocations. We source and continue to recommend, where appropriate, illiquid and semi-illiquid private investment opportunities in the multi-family, net lease, and opportunistic spaces. Investing across types, stages, and market cycles is critical to maintain a healthy amount of diversification 

‍Feel free to send any questions or comments to investments@withcompound.com. 

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^{Disclaimer: Compound Advisers, Inc. ("Compound") is an investment adviser registered with the Securities and Exchange Commission (“SEC”). An adviser’s status does not represent any endorsement of the SEC or any expertise simply by having the status as a registered investment adviser.}

^{This content is provided for informational purposes only and should not be construed as financial or investment advice. The information presented in this piece is based on historical data and current market conditions as of the date of writing, which may change without notice. Investing in real estate, whether public or private, involves inherent risks, and individuals should carefully consider their own financial situation and consult with a qualified investment advisor before making any investment decisions.}

^{This educational piece does not constitute an offer or solicitation to buy or sell any securities or investments. The content should not be relied upon as the sole basis for investment decisions and does not take into account the specific objectives, financial situation, or risk tolerance of any individual.}

^{The performance of real estate investments is subject to various factors such as economic conditions, interest rates, market volatility, and tenant occupancy. Past performance is not indicative of future results. The information provided in this piece is believed to be reliable, but no representation or warranty, expressed or implied, is made regarding accuracy, adequacy, completeness, legality, reliability, or usefulness.}

^{Investors should be aware that investing in real estate, both public and private, involves risks, including but not limited to market fluctuations, illiquidity, concentration risk, regulatory changes, and property management challenges, layers of fees, lack of transparency, and conflicts of interest to monitor. There is no guarantee of investment returns, and the value of investments may fluctuate. Investors may lose some or all of their investment. Additionally, investing in private real estate may have different diversification benefits and correlation characteristics compared to other forms of real estate investing.}

^{Individuals considering investing in real estate should conduct thorough research, carefully review the prospectus or offering documents, and consult with their financial advisor to assess the suitability of any investment based on their individual circumstances and investment objectives.}

^{This content serves as an overview of the state of the real estate markets and should not be considered as a comprehensive guide. Investors are encouraged to seek professional advice and perform due diligence before making any investment decisions. Please consult with a qualified tax professional before making any tax decisions.}