A Commercial Real Estate Reset
The Commercial Real Estate (“CRE”) market has continued to capture a lot of attention in the years following the global COVID-19 pandemic and, more recently, given the Fed’s precipitous hike in interest rates and mounting concerns surrounding regional bank exposure to CRE risk. It’s no surprise that these factors, along with other structural shifts, have resulted in a steep decline in transaction volumes as market participants paused to digest and reassess asset values.
While there is likely still more pain to play out in the office sector, which Ares has long been underweight, we believe there are signals that the CRE market may be turning a corner as a clearer interest rate picture emerges. While rates may stay higher for longer, attractive supply/demand dynamics in certain sectors and significant dry powder waiting to be deployed are driving an improvement in overall market sentiment.
Looking at U.S. CRE transaction volumes, Q1 2024 has marked the smallest year-over-year decline since Q3 2022, suggesting that the market is getting closer to a bottom. While this move is trending in the right direction, we are not expecting the path ahead to be smooth as the macro picture is still evolving given a recent sharp jump in the 10-year Treasury yield as inflation is proving stubborn.
U.S. Transaction Volume Down 16% YoY in Q1
Sector Deep Dive
The industrial sector continues to outperform the broader commercial real estate market. Fundamentals within the sector remain strong as powerful demand tailwinds from high growth areas such as e-commerce and onshoring persist. Meanwhile, the development pipeline has thinned significantly over the last year as new starts plummeted by 54% year-over-year in 2023. Finally, strong net operating income growth in the sector has largely offset the impact of higher interest rates in 2023, with property prices declining by just 3% year-over-year as of Q1 2024.
In contrast, multifamily and office transaction volumes and property values have declined the most on a year-over-year basis, relative to other sectors – but their underlying fundamentals tell different stories.
While multifamily has experienced an 8% price decline year-over-year as of Q1 2024, taking a closer look, it’s important to keep in mind that the sector is coming down from an elevated basis after experiencing a significant run up in pricing in 2021 with prices peaking in Q1 2022. The multifamily sector is also facing a sizeable supply wave, delivering nearly two times as many units as pre-pandemic and elevated supply is likely to continue into early 2025. While the supply wave presents near-term challenges, we continue to believe in persistent and robust long-term demand for multifamily units and that in two to three years, the supply wave will again turn into a supply shortage given a significant decline in new starts. Additionally, with U.S. home-buying currently at historically low levels of affordability amid the large run-up in home prices and the surge in mortgage rates, we believe that more households will choose to remain renters for longer.
Office prices have led the downward trend, reflecting a 16% year-over-year decline in property prices as of Q1 2024. Price declines in this sector have precipitated from major structural changes in office use that were brought on by the global pandemic. Today, office utilization in the U.S. remains stuck well below the pre-pandemic norm, with certain markets showing greater signs of recovery1. For comparison, the European office market has exhibited better health relative to the U.S. One reason for this is that the European market had less supply growth heading into the global pandemic and therefore fundamentals have not been hit from both the supply and demand sides of the equation. Additionally, post-pandemic, office tenants in Europe are exhibiting greater demand for office space relative to the U.S. as the shift to work-from-home did not gain as much traction in Europe. Compared to 2019 levels, tenants in Continental Europe are occupying approximately 1% more office space vs. a decline of just over 2% in the U.S. This gap is expected to further widen through 2028, with office space demand in Continental Europe rising well over 7% above 2019 levels, while overall office space demand in the U.S. is anticipated to further decline to nearly 5% below 2019 levels2.
Property Prices Stabilizing
Data for the Healthpeak acquisition has been excluded.
Outlook
We remain cautiously optimistic that CRE transaction markets may build upon a string of recent larger portfolio transaction announcements and thawing debt markets to generate momentum for the balance of the year and into 2025 as upcoming debt maturities and expiring rate caps compel sellers to approach the market. Furthermore, with greater clarity on the direction of travel for interest rates and improving market sentiment, we expect buyers, who still sit on ample dry powder, and sellers to gain greater confidence in determining realistic pricing, narrowing bid-ask spreads and ultimately driving improved transaction volumes in 2024.