Real Estate Outlook – US, Edition May 2024

Although one quarter does not make a trend, positive real estate returns in some sectors leaves us optimistic that improvement in 2024 remains on track.

Tiffany B. Gherlone, Head of Real Estate Research & Strategy – US

After more than two years of adjusting to higher interest rates, private market real estate results were mixed during 1Q24 (see Figure 1), with value declines offset by income in several sectors. Returns for retail and industrial warehouse turned slightly positive. Self-storage returns were flat. Apartments and office buildings experienced negative total returns; though niche segments of the sectors, like medical office, manufactured and student housing outperformed.

One quarter does not make a trend, and one-year total returns remain negative across most of the industry. However, even small positive returns mean our expectation for recovery begin later in the year – for all but the troubled office sector – remains intact.

Commercial real estate conditions will not improve materially until transaction volume increases, creating comparable sales and pricing confidence. During 1Q24, transaction volume was USD 78 billion, well-below average and 16% lower than 1Q23. Facing uncertainty in portions of their existing loan portfolios, lenders remain reluctant to accelerate the pace of new originations. Property owners can resist the discounted prices demanded by buyers as net operating income continues to grow across most sectors.

However, buyers face the daunting task of assembling capital in a higher interest rate environment. After reaching a peak near 5% in October 2023, 10-year Treasury rates are near 4.5%, signaling that market conditions may be improving. While the timing of rate decreases is uncertain, recent commentary from the Fed raises investor confidence that they are likely done raising interest rates.

Downturns are rare in private commercial real estate. Since NCREIF began in 1978, total returns were positive about 90% of the time. Periods of depreciation are difficult, but repricing and reduced buyer pools create opportunities for investors willing to accept more risk today for higher reward during recovery. Sectors with the highest rent growth and lowest capex burdens, like industrial, residential and self-storage, should continue to attract increased buyer interest, especially if expectations for a soft landing in the economy come to fruition. Current market dislocation offers a rare opportunity to improve portfolio diversification by adding niche property sectors at a discount to historical pricing.

Figure 1: Appraisal-based total NPI- Plus returns (%)

Source: NCREIF Property Index, as of March 2024. Past performance is not a guarantee for future results.

Apartment
Apartment demand reached higher-than-average levels in 1Q24 but still fell short of the amount of supply delivered during the quarter (see Figure 2). Apartment demand was 33.4% above its five-year historical first-quarter average, but even higher supply drove occupancy rates lower. Occupancy fell 10bps over the quarter and 60bps over the year to 94.5%. Apartment rent remained unchanged over the quarter but increased marginally by 0.4% YoY. Transaction volumes remained 25.3 % below 1Q23 levels, as capital market volatility continued to weigh on activity. The apartment sector delivered an annual total unlevered return of -6.5% in the year ending 1Q24 with negative, but less severe capital returns dragging performance.

Industrial
Industrial fundamentals continued to soften in 1Q24, even as rents grew at a solid pace. Tenant demand turned negative for the first time in fourteen years, as sustained economic uncertainties discouraged occupants from expanding their footprint. New deliveries stayed elevated and pushed the availability rate up by 70bps over the quarter and 230bps over the year to 7.8%. Despite weakening market fundamentals, industrial rents still rose by 4.9% YoY. Transaction volumes remained slow during the quarter, down 20.2% from a year ago. The sector’s total unlevered return turned moderately positive in 1Q24, as income return offset capital depreciation. However, over the trailing four quarters, total annual return was -3.2%.

Office
Office sector fundamentals remained challenged in 1Q24 due to ongoing occupancy losses. Net absorption experienced a sharp decline during the quarter, as occupiers continued to downsize their office footprint. Completions slowed to the lowest quarterly level in over a decade and were 59.7% below its five-year historical first-quarter average. Office occupancy fell by 40bps over the quarter to 81.0%, marking the lowest rate in nearly 32 years. Ongoing capital market challenges and work-from-home headwinds weighed on transaction activity, which was 27.5% below 1Q23 levels. The office sector delivered an annual total unlevered return of -16.7% in the year ending 1Q24, a slight improvement from last quarter’s performance.

Retail
Retail fundamentals continued its steady streak in 1Q24. Solid demand for retail space, combined with minimal new development, kept occupancy at a record high. Occupancy remained unchanged over the quarter at 93.5% in 1Q24 and was 30bps higher than a year ago. Transaction volumes were 14.3% below 1Q23 levels, as high borrowing costs continued to drive sluggish activity. Retail total return turned positive during the quarter, with income return outweighing moderate value declines. However, over the trailing four quarters, total annual return was -0.7%.

Figure 2: Sector fundamentals

Source: CBRE-EA, as of March 2024, Apartment Occupancy is Real Page, as of March 2024. Note: Completion and absorption rates shown are the total supply delivered and absorbed within the year as a percentage of inventory. Past performance is not a guarantee for future results.

Self-storage¹
Self-storage fundamentals remained stagnant during 1Q24 compared to the previous two quarters. The primary driver of rent growth is currently existing customers, as move-in rents declined 15% YoY. Same-store occupancy for Public Storage (PSA), a self-storage REIT, was 92.1% in 1Q24, down 80bps from a year ago.

First quarter results for CubeSmart and Extra Space tell a similar story as occupancy levels have returned to pre-COVID-19 levels. Overall, rents for PSA grew by 0.8% after existing customer rate increases. The economic backdrop leaves self-storage in a tight spot as existing customers will likely be less able to absorb rent increases and interest rates remaining elevated dampens mobility and home sales. Supply remains the greatest headwind for the sector, but elevated construction costs, supply chain bottlenecks and labor shortages continue to push back the incoming pipeline.

Cold storage²
Cold storage net operating income (NOI) growth continued its solid performance in 1Q24. Americold, a global cold storage REIT that holds 86% of its inventory in the US, reported a 10.1% YoY growth in NOI. This performance was helped by a moderate 0.8% YoY growth in revenues combined with a 3.5% YoY decline in expenses.

Economic occupancy declined by 350bps YoY to 80.9% due to unusually high production in 2023 leading to comparatively lower results this quarter. Throughput volume remained low, down 760bps YoY, while consumer demand held steady. Food consumption indexes turned positive in 4Q23 for the first time since 2022 and grew at a faster rate during 1Q24.

Senior housing³
The senior housing sector – defined as the combination of the majority independent living and assisted living property types – continued to make positive gains in 1Q24. Occupancy rates in primary markets rose by 50bps to 85.6%, marking the eleventh consecutive quarter of occupancy increases. Occupancy is now only 150bps below pre-pandemic levels.

Solid demand combined with muted inventory growth helped drive occupancy gains. Quarterly net absorption was 0.7% of total inventory, outpacing new deliveries at just 0.3%. Occupancy rates are expected to make a full recovery back to pre-pandemic levels by the end of 2024.

Life sciences⁴
Life sciences fundamentals continued to soften in 1Q24, despite improvements in capital funding. Vacancy rose by 1.7% over the quarter to 14.8%, due to a 2.0% increase in supply and a 0.3% decrease in absorption.

Despite a slowdown in market fundamentals, capital funding saw some improvement during the quarter. Venture capital (VC) funding, a major driver of demand, increased above quarterly levels seen in 2019. Even as capital funding picks up again, the sector still faces an elevated supply pipeline ahead, with 26.9 million square feet or 13.4% of stock currently under construction. We expect the supply pipeline to weigh on market fundamentals over the near term.

Economic viewpoint
The US economy slowed during the first quarter of the year. Real GDP growth moderated to an annualized rate of 1.6% during 1Q24, below consensus forecasts of 2.5%. Consumer spending, the main driver of growth last year, came in slightly below consensus but contributed nearly 1.7% to first quarter GDP growth.

Net exports were a 0.9% drag on the first quarter GDP figure, but this was due to an increase in imports, a good sign for domestic demand. Fixed investment grew but was helped by an unsustainable 14% increase in residential investments. State and local government spending slowed as fiscal support for growth began to wane. Expectations for the second half of 2024 vary (see Figure 3), but a soft landing is becoming consensus.

Figure 3: Real GDP quarterly annualized forecast (%)

Source: Actual Moody’s Analytics, as of 8 April 2024; UBS Investment Bank forecast, as of 6 May 2024. Note: Shaded area indicates forecast data. Past / expected performance is not a guarantee for future results.

Nonfarm payroll employment posted a 175,000 increase in April, below consensus and lower than the average monthly gains of 251,000 in 2023. The unemployment rate increased slightly to 3.9% and wage growth rose by just 0.2%.

Notable weakness was seen in professional and business services, which declined by 4,000. This reduction was primarily due to a 16,000-job decline in temporary workers, a segment which typically sees the first job cuts. Employment in the services sectors increased by 153,000, led by 95,000 gains in the health and education sector.

The Fed has signaled that they plan on cutting interest rates this year but emphasizes the need for data dependence in future rate cuts. The Fed has also cited a lack of confidence that inflation is maintaining a path towards their 2% target due to the most recent data coming in hotter than expected. In March, the US economy recorded a 2.8% YoY increase in the Fed’s preferred inflation metric, the personal-consumption expenditures index which excludes food and energy. As a result, consensus forecasts have postponed expectations of rate cuts from the first half of the year to the second. All else equal, the impact of lower interest rates will improve values, as the cost of borrowing becomes less expensive.

Expectations between economists for the remainder of 2024 became muddied from the stickiness of inflation, the resiliency of job numbers and consumers, and comments from the Fed citing a lack of confidence in curbing inflation. While this led to speculative headlines, such as potential rate hikes, our view is that current rates are sufficiently restrictive.

As a result, we expect growth to continue to moderate in 2024, leading to rate cuts during the September and December meetings. Further rate cuts are anticipated in 2025, followed by renewed growth. Our base case is for GDP to increase by 2.0% during 2Q24 before slowing significantly during the second half of the year. Growth is expected to rebound in 2025, as the Fed would lower interest rates. In this soft-landing scenario, investors should benefit from the durability of income in real estate and stabilization of prices in 2024, followed by a return to growth in 2025.

Source:
1. GreenStreet, as of October 2023;
2. Americold Company Report, as of 3Q23;
3. NIC Map, as of October 2023;
4. CBRE, as of October 2023.