Three reasons we see a potential comeback in commercial real estate

We are optimistic on the potential opportunities during this pullback. Here are three reasons:

I. This CRE drawdown is unique

Property values have fallen, but cash flows have remained resilient.

Capitalization rates (cap rates) are the standard CRE market metric for comparing relative value across real estate investments. (A cap rate of 5% means a property is expected to generate annual income—or cash flow—equal to 5% of its purchase price⁴).

An investor would have paid 20 times that cash flow (called a multiple) for the property.⁵ Higher cap rates (or lower multiples) suggest potentially greater returns.

The question for investors is: Have cap rates risen enough, or is cash income high enough to justify the risk?

A common way to assess the risk-reward balance in CRE is comparing real estate cap rates with Treasury yields. Today, this comparison might lead investors to think that CRE is overpriced.

The spread between Treasuries and CRE cap rates is currently at one of its narrowest levels since the 2008 global financial crisis (GFC). This suggests that investors are receiving too little compensation for the additional risk they take on by buying real estate versus Treasuries, which are considered a risk-free security.

But much as you would not decide to buy or sell equities based purely on their price-to-earnings ratios, you would not decide to invest in commercial real estate based on the cap rate alone.

We believe cash flows can remain resilient

Let’s consider the fundamentals in the CRE market: cash flow versus valuation.

Cash flow, known as net operating income (NOI), is rental income after expenses. Today, the returns from cash flows are robust. Despite the dramatic headlines, cash flows are in line with prior cycle peaks. Historically, CRE cash flows have fallen with, or even ahead of, valuations. That has not happened this time.

Will cash flows fall to meet valuations, or will valuations rise to meet cash flows? We expect the latter, where cash flows remain resilient and valuations gradually rise. Rental income is based on the supply of properties and the demand from tenants. CRE supply and demand currently point to higher prices moving forward.

Supply is connected to anticipated demand (construction takes time) and the cost to develop. The most aggressive hiking cycle in decades made those costs surge, dramatically slowing new property construction. New single- and multi-family residential construction projects are now 13% below their 2022 peaks⁶. Retail, industrial and office are down 75% from their peaks⁷. Supply will likely be crimped for a few years, which should support prices charged by property owners and translate into higher cash flows.

Demand: The U.S. economy has been strong despite the Fed rate hikes; in fact, the economy is near full capacity, given a ~4% unemployment rate. Employment and income drive demand for housing, and ~5% CRE vacancies are near the lowest levels of the last 25 years (Figure 9).

Valuations should improve following Fed rate cuts

A property’s price, or valuation, is based on a transaction or an appraisal (an estimate). CRE valuations are driven by the cash flows that properties generate. They are also affected by two other components: the discount rate on those cash flows (derived from interest rates), and leverage (how much the owner borrowed). Leverage and credit availability can make or break real estate investments. Typically, these three components move together, but a unique feature of this market is that they have not.

We’re seeing fewer buyers and sellers in the market today as a result of high interest rates. The volume of CRE transactions has dropped well below pre-COVID levels. As for credit availability, lenders are shortening loan terms, raising the proportion of loans expiring in the next two years. This has led to more delinquencies, particularly in office.

So amid resilient cash flows, these other two components should improve as the Fed initiates its rate-cutting cycle in the back half of 2024.

II. The CRE market is not a monolith

There is significant variation across asset types, locations and property qualities. One useful metric we track⁸ shows widening dispersion between the office, industrial, retail and residential sectors. Vacancy rate dispersion and NOI dispersion are also widening. 

Different regions also tell different stories. For instance, office real estate in Southern New Jersey is thriving, while Seattle is taking a hit.

The quality of the asset matters, too. Despite office vacancies of around 18%, the One Vanderbilt office building in New York City is 99.4% leased and grew NOI by 150% in 2023.⁹ The market is all over the place, and that could be where the opportunities lie.

III. Non-listed REITs are no longer mismarked

One of the strongest narratives for the CRE market has held that investors should avoid investing in non-listed (private) real estate investment trusts (REITs).¹⁰ The popular belief has been that these investments’ net asset values (NAVs) do not fully reflect current market conditions. The narrative says that they’re overpriced, and as a result, they will begin to underperform their listed REIT counterparts, which have declined in price.¹¹

We disagree. At the moment, we see minimal to nonexistent valuation differences (measured by cap rates) between listed and non-listed REITs, despite their divergent performance.

We did a study to understand theoretically cap rate dispersion over time between a popular non-listed REIT and its listed equivalent REITs.[4] If the non-listed REIT were mismarked, we would expect the actual cap rate to differ from the cap rate we simulated by using listed REIT proxies.

While the gap was wide in 2022 and parts of 2023 due to valuation adjustments by the non-listed REITs and strong relative performance by listed REITs, that gap has closed. Therefore, we think differences in total return between listed and non-listed REITs will be driven primarily by differences in the NOI growth of the assets owned.

This means it would make sense for interested investors to consider owning both.

Conclusion: Consider adding CRE exposure

We believe the recent sell-off may be complete, and that investors should consider adding CRE exposure. REIT values are driven by cash flows and multiples. We expect a soft landing in the U.S., meaning lower interest rates without a meaningful decline in growth.  NOI growth is likely to remain resilient. Financing difficulties are expected to ease as interest rates fall, which should prevent further decreases in multiples (increasing cap rates) and stabilize property values.

We believe investors should consider adding both listed and non-listed CRE markets, as their transactional cap rates are similar. We emphasize that an investor’s decision to add exposure should be based on their liquidity needs, interest in and ability to use leverage and risk tolerance, not on valuation, as these look similar.

In CRE investing, REIT manager selection is critical. Since 1989, the average listed REIT manager in the top half has posted performance more than 35% better than an average manager in the bottom half.¹² With a greater range of fundamentals and cap rates in properties of different types and in different regions, we believe manager alpha will be even more important this cycle.

Speak with your J.P. Morgan team to explore whether investing in commercial real estate makes sense for your portfolio and supports your long-term financial goals.

¹Ariel Zilber. “U.S. Office Prices Headed for ‘Severe Crash,’ Investors Say.” New York Post, October 2, 2023

²Tobias Hill. “Wall Street Braces for Commercial Real Estate Time Bomb.” The Hill, March 21, 2024.

³Jeanna Smialek. “‘Zombie Offices’ Spell Trouble for Some Banks.” New York Times, February 8, 2024.

⁴This metric is called net operating income (NOI).

⁵Twenty times multiple is derived by dividing one by NOI. In this case, 1/.05 = 20x.

⁶Haver Analytics; Census Bureau. Data as of March 31, 2024.

⁷Wells Fargo; CoStar Inc. Data as of March 31, 2024.

⁸Implied cap rates from listed REITs.

⁹J.P. Morgan Asset Management; Costar. Data as of December 31, 2023.

¹⁰Real Estate Investment Trust. Non-listed REITs are not traded on an exchange, and they do not have daily liquidity like listed REITs.

¹¹Non-listed REIT proxy created through a weighted average cap rate of listed REITs with the same asset class exposures. Weights are based on % of rental income. Net operating income is from public filings.

¹²Net asset value (NAV) is the total value of a REIT’s assets minus its liabilities, providing a snapshot of the REIT’s intrinsic value.