September 17, 2024
Like many in the commercial real estate industry, I’ve been counting the moments until the Fed cuts rates. Barring anything catastrophic, that should happen tomorrow when the Federal Reserve lowers its target rate by 25 bps (or less likely 50 bps). Borrowers will rejoice! Markets will applaud! And I will be worried about the long-term impacts on institutional real estate capital allocation.
Why the doom and gloom? Commercial real estate should see positive implications from the rate cuts, but it will come following systemic losses.
In the global financial crisis of 2007-2008, we saw the collapse of “trophy” real estate assets, from the previously-impenetrable mall sector in particular. Then in the covid-era of 2020 and beyond, a similar collapse of the office sector. Today, we see softening in the “fortress” sectors of multi-family and industrial [yes, I know data centers are still awesome]. These are cycles, and we should be used to the cycle of winners and losers by now.
But what if your investing cycle isn’t 7-10 years but a multi-decade pension fund?
In 2023, after the last time the Fed hiked rates, I joined a local public pension board. Unlike a state-wide pension fund, local boards tend to rely on a combination of pensioners and appointees to safeguard and grow the investments along with the fund’s disbursement, giving the trustees a more hands-on approach to capital allocation.
Like many other pension funds that invest in commercial real estate, we have a similar target to the national pension fund average of 9%. In 2000 we invested in a private real estate fund and like others of this vintage, the returns were quite good for a long time. It served our purpose of steady income and low correlation to equities. It was even fine through the GFC…up until 2020 when the office exposure hit hard. But that’s OK—win some, lose some. It’s why there are redemption options, where we have been patiently waiting in the queue for four years.
Now, consider the mindset of pension trustees who allocate funds for the benefit of pensioners. While fund investments allow them to target specific assets, accessible in this vehicle only, they also require a long-term capital commitment and, potentially, the inability to divest in the future. Maybe they would rather try their hand at REITs instead so that they could get in and out in a hurry as needed; but then they have the broader equity market correlation to consider, which can run counter to other fund needs. There’s also a new(ish) medium-term option, popularized by Blackstone’s BREIT, to consider as well.
From the perspective of a pension trustee, it’s all pretty complicated, and there is real concern about not making a wrong move on behalf of the pension—they might even have the thought, What if we reduce our real estate allocation?
This is what I worry most about. For the last 12 months, capital has largely been on the sidelines. There are deals to be had for sure, especially now if you have dry powder. But what if the compounded pain of the prior cycles of commercial real estate have led you to reconsider how much to allocate to real estate as an asset class? Imagine if the trillions of dollars invested in U.S. institutional commercial real estate saw even a small percentage reduction in investment. The result would be disastrous.
So how do we fix it?
Real estate has a PR problem. I’m constantly amazed at how complicated we make an industry that has remained largely the same for hundreds of years. We build things, we buy things, we rent things, we sell things. Hopefully we build and buy them for less than we sell them. This isn’t to say that the nuances between sectors and assets within real estate aren’t important—quite the opposite. The nuance is the entire point! But, we haven’t done an effective job of communicating this within the broader non-real estate market. This leads to analysts and investment managers lumping positive and negative sectors together (and a pox on both their houses).
If all goes as planned, tomorrow at 2 p.m. the Federal Reserve will cut rates and end the tightening cycle. Let that end be a signal for a new cycle in commercial real estate—one with prosperity, but also one with increased education on the nuances of our industry.
Amen.
