Midway through 2024, the economy is moderating, inflation is easing, and we could be en route to a soft landing. Fundamental turning points are beginning to emerge across real estate sectors, and investors are signaling a growing appetite to transact. We look at the macroeconomic and capital market conditions we see today and how they stand to impact real estate throughout the next cycle.

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In the face of higher rates, the U.S. economy has held up better than expected. GDP growth in the first quarter of 2024 stood at 1.4%, representing a welcomed downshift that, combined with a slowly improving pace of inflation, has fueled a resurgence of optimism regarding the potential for a soft landing. 

While avoiding a recession is the best-case scenario, today’s optimism is tempered with caution given the complexities and interconnectivity of the labor market, the U.S. consumer position, and as-yet unvanquished inflation. We believe the current slowdown is a good thing, as it facilitates a cooling off of the economy and inflation without throwing it into reverse; if conditions deteriorate more rapidly, however, that could create bigger bumps in the glide path. 

Macroeconomic Conditions 

Job growth has continued, with total nonfarm payrolls increasing by 206,000 in June; however, job openings have been contracting on a year-over-year basis for the last 18 months. While companies may be removing unfilled roles and achieving fuller staffing levels, normalizing the need to continually add new positions, this may eventually strain consumer spending power, as job switchers have generally been rewarded post-pandemic with higher earnings. Fewer open positions could mean fewer opportunities to increase earnings, though less-rapid wage growth would likely help remove some fuel from the inflation flames. The fact that most of the jobs being added have come from part-time jobs (as opposed to full-time) is also helping quell spending. 

Though these developments strained households’ ability to navigate today’s still-elevated inflationary environment (credit card usage since 2020 has increased at a 2x faster pace than the four years leading up to 2008), from a policy perspective it is the price required to weaken the last mile of inflation. 

At the beginning of the year, we outlined our take on how structural factors (de-globalization and re-shoring, demographics, decarbonization) were likely to keep inflation elevated relative to the post-Global Financial Crisis period, and how that backdrop would serve as the basis for setting a new floor for interest rates this cycle. Though we anticipate the moderation in the labor market will continue to support the gradual improvement in inflation, our earlier view – that neutral policy rates will settle higher – still holds. 

Capital Markets

In many ways, the conditions arising from the rapid rate hike cycle (a drawback in liquidity, decline in values and weakening fundamentals) have been like those typically associated with an economic recession when it comes to the real estate asset class. As a result, either of the two most likely macro scenarios (soft landing or modest technical recession) is likely to yield only mildly different outcomes for real estate.

That’s because capital markets have already adjusted to the new reality and effectively priced in the impact of modest economic volatility. 

More encouragingly, several indicators have shown progress in recent periods and seem to suggest capital markets are starting to move through their bottoms¹:

1. Distress: Net new commercial property distress (newly distressed less loans worked out) has been moderating for three consecutive quarters and was down 59% year-over-year in Q1;  
2. Pricing: The pace of real estate pricing declines broadly has plateaued in recent quarters as market participants have grown more confident on the outlook; 
3. Credit spreads: After peaking in December, lending spreads (measured as the difference between the 10-Year Treasury yield and fixed-rate, 7-10 year commercial real estate loans) compressed by 35 basis points over the first quarter back to levels on par with late 2022; 
4. Commercial Mortgage-Backed Securities: CMBS issuance in Q1 represented nearly half the amount recorded in all of 2023, offering another source of lending for borrowers.

ARA’s proprietary measure of market liquidity reflects the cumulative improvement in capital markets conditions from last year’s bottom. In the past, pivots in ODCE returns have tended to trend with turning points in this measure. Today’s capital markets recovery, though nascent, is fueling optimism that core fund returns could move back into positive territory before too long. 

Investment Implications

Given our view of a higher-for-longer interest rate environment, we believe the upcoming cycle places even greater emphasis on the ability to select the right assets and enhance value through operational business plan execution. We believe the ability to do so successfully in the next 18-24 months has somewhat less to do with the “big picture” trajectory of the economy and rates, and more to do with localized exposure to supply relative to demand. 

Softer fundamentals and tighter financial conditions have prompted a dramatic pullback in permitting and new construction starts across sectors, which should help set up a potential fundamental recovery in 2025. How meaningfully supply recedes, and how resilient demand remains, even in a more modest growth environment, will play a major role in the relative winners and losers in the coming few years, and is why sector subtype, market, submarket and asset selection remain a critical focus for all our investment strategies. 

• Industrial
  • Current oversupply impacting rent and occupancy rates but expected to rebalance by 2025.
  • After a pause in 2023, major occupiers are shifting back into expansion mode.
• Residential
  • 2024 marks peak deliveries for many markets, with steep declines in 2025 - 2026 offering a much-needed reprieve for the sector.
  • Despite supply headwinds, persistent demand stemming from affordability issues in the for-sale market should support sector fundamentals for several years.
• Office
  • Pre-pandemic lease expirations could trigger further downsizing as companies reassess their space needs amidst slower office-using employment growth.
  • Decline in new space should help stabilize headline vacancy and further insulate demand for prime buildings by virtue of lesser competition. 
• Retail
  • Hybrid work has shifted consumer behavior, driving neighborhood retail to outperform urban.
  • Consumer spending remains steady despite stubborn inflation, though higher prices may mean a softening in discretionary retailer sales. 
• Specialty Sectors
  • Varietals of primary industrial and residential property types such as cold storage, data centers, and SFR positioned well on the supply-demand spectrum.
  • 28 of 30 top self-storage markets show positive monthly growth despite new supply in many markets.

Print Charts and Figures PDF

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More to Explore:

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Sources

1  American Realty Advisors based on data from MSCI Real Capital Analytics, Macrobond and Green Street Advisors as of June 2024.

Disclaimer

The information in this newsletter is as of June 30, 2024, and is for your informational and educational purposes only, is not intended to be relied on to make any investment decisions, and is neither an offer to sell nor a solicitation of an offer to buy any securities or financial instruments in any jurisdiction. This newsletter expresses the views of the author as of the date indicated and such views are subject to change without notice. The information in this newsletter has been obtained or derived from sources believed by ARA to be reliable but ARA does not represent that this information is accurate or complete and has not independently verified the accuracy or completeness of such information or assumptions on which such information is based. Models used in any analysis may be proprietary, making the results difficult for any third party to reproduce. Past performance of any kind referenced in the information above in connection with any particular strategy should not be taken as an indicator of future results of such strategies. It is important to understand that investments of the type referenced in the information above pose the potential for loss of capital over any time period. This newsletter is proprietary to ARA and may not be copied, reproduced, republished, or posted in whole or in part, in any form and may not be circulated or redelivered to any person without the prior written consent of ARA.

Forward-Looking Statements

This newsletter contains forward-looking statements within the meaning of federal securities laws. Forward-looking statements are statements that do not represent historical facts and are based on our beliefs, assumptions made by us, and information currently available to us. Forward-looking statements in this newsletter are based on our current expectations as of the date of this newsletter, which could change or not materialize as expected. Actual results may differ materially due to a variety of uncertainties and risk factors. Except as required by law, ARA assumes no obligation to update any such forward-looking statements.