A possible reopening of the debt market next year? That’s one prediction PwC’s Deals 2024 Outlook report that should provide cheer to commercial real estate professionals struggling through the tail end of a challenging 2023.
International professional services firm PwC recently released its 2024 deals report highlighting future trends for the commercial real estate market.
And in some of the best news for CRE professionals, PwC is predicting that investment sales activity will pick up in 2024 as the Federal Reserve Board stops increasing, and maybe even begins cutting, its benchmark interest rate.
We spoke with Tim Bodner, real estate deals leader with PwC, about the report and what it means for the commercial real estate industry. Here is some of what he had to say.
The last 18 months or so have been tough ones for CRE professionals. From the information collected in the Deals 2024 Outlook, do you expect to see more commercial real estate sales activity in 2024?
Tim Bodner: When you think about the financing markets, there has been a significant pullback. A lot of that had to do not so much with the absolute level of interest rates, but more to do with the pace of those rate increases. That rapid pace of increases is what put the most pressure on investors.
Now, investors would prefer that the cost of capital be down. But folks knew that at some point those low interest rates that everyone was enjoying were going to change. Where we are at now with interest rates is not high by historical standards. As the macroeconomic picture becomes more favorable, I think we’ll see more investment sales activity. The measures of the economy are quite good today. That is good for real estate. And then the Fed made its announcement that it is done with interest rate hikes. That certainly helps.
I know you can’t predict the future, but do you think we’ll see interest rates not just stabilize in 2024 but fall, too?
Bodner: By everything that we look at, we do expect declines in rates. Whether that means three cuts by the Fed or five cuts, we don’t know. We’ll see where it lands. The more important point for the real estate market is that they are not going higher and that there is stability in the market.
What happens with that stability in the market is that a more constructive dialogue can happen between financial institutions and real estate investors. There can be more dialogue on how we can recap those assets and businesses. If there are cuts to interest rates, that will be great. But stability is arguably more important.
In addition to all that, there is a significant amount of capital flowing into private capital markets. There have been partnerships between financial institutions and alternative asset managers. We think that will continue. That will be helpful to commercial real estate activity, too.
For example, there is a lot of energy around insurance company capital. The large alternative managers have been building their insurance businesses. They are putting a lot of capital into real estate. Plus, there is the reopening of the CMBS market. There is more credit flowing into real estate. That will be helpful to transactions getting done. More importantly, we’ll see the existing assets being capitalized at a level that results in them being successful.
What types of assets are investors interested in?
Bodner: Part of the narrative in the market right now is that commercial real estate is just one thing. Part of what we have been focused on, though, is that commercial real estate is a lot more complicated than that. Commercial real estate includes a lot of different asset types, and some are doing better than others.
The office market continues to be quite challenged. It will continue to be challenged. The challenge in the office market are not the assets that are highly amenitized in gateway cities. That is not where the issue is. There is actually a growing concern among investors that we might have a shortage of high-quality office stock not just in the United States but around the world. It’s the lower-quality part of the office stock that is the challenge. That will take time to work through. There is a lot of appetite for the upper Class-A asset. But the lower-class office assets are where a lot of the negatives in the commercial real estate market are at.
What we are most focused on and spending the most time with our clients on is educating them that what is considered real estate is becoming much broader in scope. We used to think of commercial real estate as office, retail, multifamily, hospitality and industrial. When it came to student housing, single-family residential, medical office space and self-storage, we used to call those alternative investments. I think those are mainstream sectors right now. The core of what is real estate has become much wider over time. It is becoming even wider.
There is a lot of energy around data centers and other digital infrastructures today. Data centers will continue to be active. Demand for residential real estate will continue to increase. We still have an undersupply of housing in the United States. This is also a problem around the world. There is a lot of attention on the need for affordable housing. This is an issue that needs to be resolved. Investors will continue, then, to focus on multifamily housing.
We also like experiential real estate and mixed-use developments. The amount of money that is being spent on experiences, despite the country going through one of the most significant inflationary periods ever, is incredible. When you think about mixed-use centered around experiences, we like that type of asset.
The report also focuses on the challenges surrounding climate change and how that might impact commercial real estate. Can you talk about that?
Bodner: How climate change is talked about in the United States is very different from how it is discussed in Europe and Asia. There, climate-related matters have been a part of the mainstream investment decision-making process for a lot longer. But that is changing here. A significant reason for this is the fact that the number of loss events that we have had related to climate-related matters has doubled over the last five years.
The question ultimately becomes, at that level of cost inflation what happens if you don’t have a corresponding ability to increase rents or generate offsetting revenue or bill those costs back to the tenant? That becomes a real issue for deals when you get into the potential of returns. With that level of cost inflation, certain markets and certain assets aren’t investable.
This is more significant in some markets, but it is happening across the United States. Those are the kind of climate-related and ESG-related topics we are spending the most time discussing with our clients. Clients are also interested in issues surrounding complying with regulatory standards and certifying their buildings. Those things are important to the tenants. That falls into the category of amenities today. Getting your building certified is almost an expected part of the process at this stage.
There is still plenty of uncertainty in the economy, but from the deals report, it sounds like 2024 should be a stronger year for commercial real estate sales activity.
Bodner: The real estate industry is going through a period of transition. We have not had to operate in this kind of cost-of-capital environment for a long time. That transition needs to be worked through. When you think about returns on commercial real estate and the way they were generated in the past, a lot came through the accretive nature of financings. A lot of the returns were generated through compression and CAP rates. Moving forward, those two components will become less significant. The way assets are fundamentally operated will become more important when it comes to generating returns. That will require a lot of muscle. It’s an area that we are focused on and are clients are focused on. You are going to see more focus on value creation and overall operational efficiencies.
The reality is some market participants aren’t capitalized and don’t have the scale to address operating in this new environment. We do think that we will see more consolidations than we have seen in the past.