Han Dieperink: American real estate market is recovering
This column was originally written in Dutch. This is an English translation.
By Han Dieperink, written in a personal capacity
Despite the current economic uncertainties and geopolitical tensions, the American real estate sector is proving to be more resilient than expected. The doom and gloom scenario for commercial real estate that was painted a few years ago turned out to be exaggerated. The fundamentals were stronger than generally assumed.
Globally, commercial property valuations have fallen by around 20% since their peak. However, underlying rental growth remains positive in many sectors – a rare combination in the history of property corrections. This creates an attractive entry point for investors with a long-term view.
Never before have we seen a downturn in the property market while income growth continued to rise. Banks now recognise that the value of financed property is lower, but also note that the cash flows to service loans are still there.
Renewed interest in property equities
A few years ago, debt was preferred over equity, as debt outperformed equities when property values were falling. However, there are now reasonable growth prospects for equity positions in real estate. Real estate debt still offers good relative value compared to corporate bonds, with a premium for comparable credit risk.
The turnaround in banks' attitudes towards real estate is striking. After a period in which they actively sought to reduce their real estate exposure, banks collectively decided around the end of 2023 that they had reduced their exposure sufficiently. They are now willing to lend to real estate again.
Whereas financing was relatively scarce six months ago, there is now a broad group of lenders – including banks – that are once again lending to real estate investors. This is crucial for a sector that is heavily dependent on leverage.
A changing investment landscape
Ten years ago, real estate investors could be successful by simply investing in industrial real estate with a secondary allocation to residential properties. This sector approach yielded excellent results. Now, the historically usual differences between sectors and regions have diminished.
Industrial real estate, the best-performing sector globally over the past decade, no longer stands out as it once did. Success now requires a more nuanced approach, with asset quality and micro-locations becoming more decisive. The traditional distribution – with significantly undervalued industrial real estate and overvalued offices – is a thing of the past.
Working from home: a trend in reverse
Working from home, once seen as the death knell for office real estate, peaked in March 2020 and has been gradually declining since then. Although levels are still higher than before the pandemic, the trend remains downward.
In New York, there is even significant rental activity. Rents in prime buildings have risen to levels well above those seen before March 2020. Companies that can afford it see premium office space as an effective way to lure employees back to the office.
A clear divide is emerging: top-quality offices – perhaps 10 buildings in New York – have experienced this effect most clearly, but we are now seeing it filter through to the next category of high-quality buildings.
Needs-based real estate as a stable investment strategy
In a time of cyclical uncertainty, it pays to focus on structural themes that will survive this cycle. Smart investors are focusing on real estate that is in demand, driven, for example, by demographic changes such as an ageing population and family formation, and structural shifts such as the AI revolution, e-commerce and nearshoring. These segments are less sensitive to cyclical economic conditions and offer more predictable cash flows. Examples include rental properties, including single-family homes in the suburbs, essential retail such as shopping centres with supermarkets or pharmacies as anchor tenants, health-related real estate such as medical office buildings, and industrial logistics driven by the need for faster delivery.
Affordability as a key factor in a barbell strategy
Another crucial theme is affordability in a barbell strategy, with investments at both ends of the spectrum. On the one hand, there is affordable real estate for tenants with limited income, such as prefabricated homes, regulated affordable housing and affordable holiday homes such as campsites. These assets often perform well in different economic cycles. On the other end, there's high-quality premium real estate for wealthy tenants, including high-end office space, luxury rental homes where people rent by choice rather than necessity, and data centres. This two-pronged approach offers risk diversification and opportunities in different market segments.
Regional perspective: gateway markets versus the Sunbelt
In ‘gateway markets’ such as New York, Los Angeles, San Francisco and Washington DC, there has been little supply in recent years, but demand has been steadily rising (although Washington DC raises questions given the federal government's policy).
In the Sunbelt region, vacancy rates are currently rising due to oversupply. Nevertheless, assets valued below replacement value can be found there. In addition, new projects are being developed for 2027 and 2028, when competition is likely to be less intense.
The current vacancy peaks in the Sunbelt reflect oversupply, not weak demand. A recovery is likely to follow in the coming years. It is also interesting to note that the correlation between energy prices and real estate performance in Texas has been declining for two decades, making Texas increasingly dependent on the growth of the US economy.
In addition, input costs for real estate development have risen well above historical rates since 2020, both in terms of materials and labour costs. A high percentage of people in the construction sector are ‘illegal’ immigrants, which could limit supply in the future and improve rents and occupancy rates in the longer term.
Conclusion: patient investors will find opportunities
Commercial real estate remains a long-term illiquid asset class. Much real-time information is not immediately reflected in valuations, and the conservative real estate sector is slow to adapt to changing conditions.
The current situation is the exact opposite of mid-2022. At that time, interest rates were rising and a slowdown was likely. Now, valuations are 20% lower globally, borrowing costs have fallen over the past year, and financing is available. Tenant markets are still in reasonable shape, with vacancy rates around or below long-term averages.
Supply is likely to decline further in the coming years – possibly more than was expected a few months ago. For investors with patience, this combination of factors offers an attractive starting point. Those who can look beyond the short-term volatility and focus on structural trends will find ample opportunities in the US real estate market.