With some key macroeconomic forces gradually shifting, what can real estate investors anticipate in 2024?

Principal Asset Management recently issued its annual Inside Real Estate forecast, offering its analysis of those and other issues. Among the report’s authors is Arthur Jones, senior director of real estate research and strategy at Principal Real Estate.

Your new real estate outlook report is titled Waiting for Godot, after the famous play by Samuel Beckett. Explain the relationship.

In a word, uncertainty. Since central bankers began increasing interest rates in 2022, commercial real estate markets have been subdued as investors waited for more definitive data on inflation and messaging on the direction of monetary policy affecting the cost of capital. The subsequent repricing of assets has also vexed investors who are trying to gain a clearer picture of the new interest rate regime and what it will mean for values. While the interest rate environment will be higher than the one experienced in the decade following the global financial crisis, it is important that investors can appropriately recalibrate their underwriting assumptions. If there is any good news on that front, we appear to be entering the end of the interest rate tightening cycle and may see some light at the end of the tunnel in 2024.

You observe that deals are scarce and selective. Which deals are still getting done and which are not?

Deals today remain scarce due to the lack of available debt capital and uncertainty mentioned earlier. On a sector-specific basis, residential and industrial warehouse remain among the most active due to the availability of debt capital relative to other sectors and sustained market fundamentals. Data centers also stand out due to strong structural demand, which will be bolstered by wider adoption of AI. We are seeing some high-net-worth investors enter certain sectors, in all-equity deals where they can take advantage of pricing dislocations. Deals that are capital intensive, such as offices, malls and hotels, remain the most challenged. New ground-up development requiring significant debt capital is also difficult to execute, due to more stringent lending requirements by commercial banks.

Given macroeconomic issues such as higher interest rates and inflation, what strategies do you anticipate will demonstrate resilience?

Commercial real estate has a reputation as an excellent inflation hedge. We believe that to be the case today even in a higher inflation environment. Higher interest rate environments tend to favor debt strategies. We continue to favor both the private and public (CMBS) debt quadrants, which are offering solid risk-adjusted returns in the current environment. Over the next 12 months we are entering a phase of the cycle where REITs appear fully priced and could present some interesting buying opportunities. Although private equity real estate remains in a corrective phase, we continue to believe that a focus on sectors with long-term structural drivers such as warehouse, residential and data centers will provide solid value for investors.

For which property type or types would you wave a cautionary flag?

Office clearly remains the most challenged sector as we enter 2024. The sector has suffered from remote and hybrid work arrangements that continue to frustrate corporate occupiers. Vacancy rates are as high as they have been since the early 1990s, when the market was severely overburdened with new supply, and capital values in the United States are nearly 25 percent below their pre-pandemic peak. While there are pockets of improvement based on region and quality of asset, we feel that sector will remain in a corrective phase over the next 12 months.

We also see challenges to the retail sector across several formats in 2024. While the sector has enjoyed a resurgence post-pandemic, it remains vulnerable to both cyclical and secular challenges. Ecommerce penetration globally is once again rising, and brick-and-mortar operators will continue to face headwinds from increased competition from online sellers.

What property type do you forecast being the best performer of 2024?

The data center sector is poised to be a top performer. As AI continues to experience an explosive growth phase, it will continue to drive increased demand for both computing capacity and data storage. Structurally, industrial warehouses and segments of the residential market, such as moderately priced housing and single-family rentals, will continue to do well on a relative basis.