Make no mistake about it, we are in the midst of an investment real estate bear market. A real estate recession? We absolutely had one, but it seems to be over now as activity starts to recover. A bear market refers to a drop in asset prices over 20%, while a recession is defined by a significant decline in economic activity. Starting in the second half of 2022, real estate transactions – and therefore reductions in new financings, purchases, sales, appraisals, etc. – hit a wall, with a sharp decline in activity in 2023 versus previous years, and that decline continued into 2024. But as we exit the fourth quarter, the markets appear to finally be adjusting to the new market realities (i.e., interest rates), with both transaction and refinancing activity increasing versus the same period last year.
If recessions are a decline in economic activity, then almost by definition, there is a limit to the length of the recession because activity can’t be negative. Once the market hits bottom, any increase is then growth and an exit from the recession. There is nothing about the definition of a recession or an exit from a recession that requires reclaiming economic activity levels equivalent to the pre-recession period.
Similarly, there is nothing about exiting a bear market that requires asset prices recovering to the pre-bear market levels. Bear markets, however, can last a long time – years even. The exit of a bear market is not defined by the termination of falling prices, but rather when market prices recover 20%, kicking off a new bull market. The most famous stock market bear market in the U.S. is probably the one that started in 1929 and lasted through 1932. Through the middle of the 1930s, even while the economy was in the middle of the Great Depression, the stock market experienced a bull market, though it didn’t recover to the 1929 market highs until 1954 – a full 25 years and 4 bear markets later.
If you are a real estate professional (you make your income from real estate activity), the real estate recession of the past couple of years was pretty painful. Reduced activity equals reduced revenue, which in turn equals reduced profits.
However, if you are a real estate investor, as are most readers of the Altus Insight, you are generally not impacted by fluctuating levels of real estate economic activity. You are impacted by changes in investment returns. Those returns are made up of four distinct components: 1. Cash flow, 2. Loan amortization, 3. Price appreciation, and 4. Tax benefits.
Real estate prices are impacted by multiple factors, but at the end of the day, it all comes down to the same factors that determine stock prices – net operating income (EBIT for stocks) and the cap rate (earnings multiple for stocks). Cap rates are influenced by interest rates, as cash flow and amortization (two of the four components of real estate investment returns) are essentially the margin between interest rates and cap rates. Those margins might expand and contract, even occasionally going negative, but over time higher interest rates result in higher cap rates (and vice versa).
Even going back to the inflationary environment of the 1970s, real estate price declines have been tied more to changes in the operating performance (NOI) than changes in the valuations assigned to that income (cap rates). An argument could be made that the early 1980s recession doesn’t fit the profile since interest rates increased so quickly, which is the same thing that happened again starting in 2022. Like the early 1980s, and unlike other real estate bear markets, the current bear market is tied far more to the change in interest rates than to the change in the operating income environment, because operating incomes have stayed relatively strong (certain types of hospitality and office notwithstanding).
The broad commercial real estate market, which includes multifamily, industrial, retail, office, and hospitality, was measured to have dropped just over 20% through June 30th of this year and has continued to fall over the ensuing 6 months. The resiliency of the industrial sector, which has benefited from enough increases in realized rent to mostly offset the impact of the increase in interest rates, severely skews the broader market weakness. Without the relative strength of industrial assets (only down 8–12%), market declines would measure closer to 25% (based on a very back-of-the-napkin calculation). Even within those steeper declines, property transactions with assumable financing are far outperforming the broader cash transaction market. Even multifamily, largely still considered a resilient market segment (especially when compared to office or certain types of hospitality), has seen pockets of weakness where prices are down 50% from their 2022 peak. For example, we have 1,200 units in contract to purchase at a price below where the seller purchased them 10 years ago. This is mind-blowing stuff.
And yet, this has to be one of the quietest bear markets ever. Even the proverbial back page of the news has rarely mentioned the carnage that is occurring, let alone it being front-page news. Why is this? I can only offer ideas:
- Despite commercial real estate being a substantial part of the economy, it is far less visible than other economic components. This is partially because the economic impact far outweighs the size of the employment. Most people don’t have family and friends employed in commercial real estate. Contrast this to residential real estate, where nearly everyone knows a real estate agent or mortgage broker, and two-thirds of the population owns a home. Pain in residential markets hits close to home. Pain in commercial markets is more likely to be viewed as something happening in a far-away land. News publications are in the business of selling ads and subscriptions. If few people care about commercial real estate, reporting on the bear market doesn’t attract eyeballs, and without it being reported on by the generic news sources, the general population isn’t aware of it.
- There are real estate investment companies being completely wiped off the map. Unfortunately, investors’ equity in their projects is being lost along with them. But in relation to the point made in item #1, they aren’t companies that are well-known within the broader economy or even the broader real estate world. If Blackstone, Related, or KKR were to blow up, it would be newsworthy. Smaller companies, even those having hundreds of millions of investment dollars under management, don’t have household names; therefore, their failures don’t make waves.
- At the risk of sounding like a broken record, this bear market is mostly caused by the increase in interest rates. Large real estate companies like those mentioned above generally are more well-funded or have access to cheaper rescue financing than smaller real estate investment companies. Large companies have also taken losses (especially in office), but they are mostly able to work through their problems.
- At the risk of sounding like a broken record, this bear market is mostly caused by the increase in interest rates. Large real estate companies like those mentioned above generally are more well-funded or have access to cheaper rescue financing than smaller real estate investment companies. Large companies have also taken losses (especially in office), but they are mostly able to work through their problems.
- Banks, which hold the general population’s cash accounts, haven’t (yet) blown up from the real estate distress. The bank failures of 2023 weren’t tied to real estate losses. The structures of financing leading up to the bear market were largely either balance sheet lenders (debt funds, CMBS) or long-term debt. Unlike banks with their fractionalized lending, balance sheet lenders generally experience a dollar-for-dollar loss when real estate collateral falls below the loan balances. Painful, yes, but not systematically dangerous. And similar to the comment that few people know people invested in commercial real estate, fewer people know the investors that are bearing the losses on the loans that are going bad.
- Because this bear market is mostly caused by interest rates rather than operating performance, there are huge bifurcations within how people (investors) are experiencing the bear market. Altus is extremely fortunate to have a portfolio that is mostly on the right side of that bifurcation. While our operating company felt the impact of the real estate recession (we went two years with no transactions), our portfolio stayed pretty darn solid, with most properties continuing to produce distributions. While several of our investors also have substantial investments through other investment groups, and therefore we hear the horror stories of those investment experiences, many, if not most, of our investors aren’t widely invested and haven’t experienced the crushing losses incurred by so many others. Without the direct experience, the losses aren’t personal and don’t matter. This bubble of relative ignorance truly is bliss, until there is a bit of turbulence, at which point the shock of the situation is far outsized compared to the relative reality within the larger real estate investment world.
While all the above is true and accurate to the best of my understanding, there are a couple of additional clarifications that should be made to paint a more complete picture. First, while the distress being felt across real estate segments is mostly attributed to the changes in interest rates, there have been a variety of fundamental impacts to the various real estate segments as well. Operating costs have increased rapidly in multifamily and hospitality, even while rents have mostly flatlined. Vacancy in multifamily has skyrocketed in some markets where previous overexuberance led to overbuilding. In commercial real estate, landlords are able to pass on most of the increase in operating costs, but many tenants are not able to bear the increase on their end. While our commercial portfolio (light industrial and retail) vacancy has stayed relatively constant, we have had far more tenants going dark and space turnover over the past year or two than we had in the years previous.
Second, even while I am truly thankful for the stability of the Altus portfolio, I can’t say that we have had no impact from the real estate bear market. We had one industrial lease-up deal that mostly went according to the business plan, but on which we still took a large loss due to the adjustable rate financing we had in place and the inability to refinance to permanent debt even with the property fully leased. We are also invested in a hotel deal along with several of our investors that is severely struggling, with the most recent appraisal indicating a value almost 50% below where it was in 2019. In some areas, multifamily operations have been under pressure despite great financing. All these things are painful, but across the larger portfolio, they are manageable and mostly resolved.
Over this same time period, Altus – generally a company that doesn’t like to sell – has sold off quite a few properties, not because of distress, but because we have been able to obtain sales prices higher than we imagined possible, even while much of the market is experiencing weakness. A few months ago, we sold a small bay industrial property we had owned for several years with a 20% outperformance to proforma – despite selling in a down market. We sold another industrial building earlier this month at a 100% return on investment in only two years, build-for-rent land at 3x our investment basis in three years, an apartment property at a substantial profit, and we have two more multifamily properties in contract to sell, and, and, and…
Meanwhile, we are actively buying properties that we feel are wonderful purchases because of the intrinsic value of the purchase along with cash flow possibilities despite the elevated interest rate environment. This is the dichotomy of the current bear market. We are somehow able to both sell properties at prices producing great returns and make purchases at a cost basis that makes us giggle with disbelief. One of the hardest things for the human brain is to believe two seemingly diametrically opposed things to both be true. But when those things in seeming opposition are in fact both true, the belief reconciliation is where true opportunity lies.
Happy Investing.
