Quarterly market review- Q2 2024

During the second quarter of 2024, equity markets continued making historic highs with the S&P posting another strong return. Fixed income also delivered positive returns, albeit to a much lesser extent. Private real estate, as reflected by the NFI-ODCE NR, saw a modest decline and we now believe that we have seen a bottom in pricing for many of the property types and anticipate strengthening returns for the remainder of the year.

Private real estate’s negative performance resulted from cap rates and discount rates continuing to push out a bit more. While transaction volume remains low, we have seen a few notable transactions within industrial and residential that achieved stronger pricing than appraisal cap rates had implied. This is a positive sign and gives us more confidence that valuation declines are now behind us for those property types. As we mentioned last quarter, we continue to observe other non-traded / NAV REITs that seemingly do not take valuation declines, which should be viewed with caution. We strongly believe this drawdown—for those that have recognized the losses—has created a compelling opportunity to re-balance or enter the private core real estate equity asset class. As investors re-allocate or enter the private real estate markets, understanding valuation and choosing the right vehicle is very important and will greatly influence prospective returns.

It is worth highlighting that several NFI-ODCE funds delivered positive returns for the quarter. Although the overall index was negative, we believe more funds will deliver a positive return in Q3, and that the index will continue to build momentum for Q4. From a macroeconomic perspective, quite a bit has changed since the last quarter. Labor markets have continued to soften and inflation has continued on a downward trend after pausing in the first quarter. The Federal Reserve has now indicated they believe that the labor market is in balance and they do not want to hold interest rates high for longer than needed as it may cause an unnecessary rise in the unemployment rate. This change in tone has the futures market now predicting at least two rate cuts coming in 2024, which would be welcomed news for real estate investors. As the Fed starts to cut interest rates, we anticipate a large amount of capital will flow towards private real estate. That, coupled with the fact that declining interest rates will reduce the cost of debt, could set up commercial real estate for a period of strong returns.

As we have written over the past year, operating fundamentals of the industrial, residential, and retail property types remain strong, and rents are growing. Office fundamentals continue to deteriorate, which is where the majority of write-downs again occurred, but that is not the same across all markets and properties. The highest quality office is seeing leasing strength, although that is not typically reported in the mainstream media. Additionally, lenders for many of the troubled office assets continue to work with building owners to extend maturities, which should help mitigate widespread distress, although we will likely see some limited pockets of distress in the office market.

As a reminder, commercial real estate is not correlated to other asset classes, as shown below. But more striking in this chart is the high correlation among other major asset classes. While this has largely benefited investors over the past few years, it is important to remember why diversifying assets are critical. Given that equity markets are at all-time highs and are primarily being driven by a narrow subset of stocks, having highly correlated assets may not benefit investors in coming quarters if the market retreats. Private real estate is a great diversifier as demonstrated in 2022, being one of the few assets that delivered positive returns (~7%) when every other major asset class had double-digit declines.

5-year correlation

Performance by property type

• Industrial — Industrial returns were flat across most funds, but we did see a decline in select parts of the country, namely southern California. As construction starts are down significantly as a result of higher interest rates, and demand remains strong from onshoring and online shopping trends, we expect industrial returns to normalize moving forward.
• Residential — Residential experienced slight declines as cap rates pushed higher. As previously mentioned, quite a bit of new supply came online in 2023, which moderated rent growth in the short term. However, new construction starts are down and purchasing a home continues to be less attainable across the U.S. with higher interest rates, limited supply, and high prices. These dynamics should help residential returns strengthen from this point forward.
• Office — Office properties continued their decline. Many office properties in the NFI-ODCE have now been written down significantly, in many instances more than 50%, while some are down even further. With such declines already factored in, we expect office returns to have a much less meaningful impact on overall core real estate performance moving forward.
• Retail — The retail sector, after seeing valuation declines for the previous decade, is benefiting from a strong economy and consumer spending. As a result, net operating income (NOI) growth has been strong across many retail properties within the NFI-ODCE.

Outlook

The commercial real estate markets are evolving with notable resilience across most property types. While equity markets continue their historic highs, the private real estate market is beginning to show signs of recovery and potential growth, particularly in industrial and residential properties. Despite ongoing challenges in the office sector (office only represents ~20% of the overall market), the fundamentals across the other property types remain strong. We do not believe we need to see interest rate cuts to start to see positive returns in real estate, however the anticipated interest rate cuts could further enhance the attractiveness of real estate investments. As we navigate these dynamic times, staying informed and strategically diversified will be key to capturing the potential benefits and mitigating the risks in the quarters ahead.

Definitions

Cap rate represents the annual rate of return on based on the income that the property is expected to generate.

Bloomberg U.S. Aggregate Bond Index is an unmanaged market value-weighted index for U.S. dollar denominated investment- grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities with maturities of at least one year.

MSCI EAFE Index is a free float-adjusted market capitalization index that measures the equity market performance of 21 developed market countries.

MSCI EM Index is a free float-adjusted market capitalization index that measures the equity market performance of 24 emerging market countries.

NCREIF Fund Index — Open-end Diversified Core Equity (NFI-ODCE) consists of private real estate equity funds that meet certain criteria with respect to such things as leverage (less than 35%), operations (at least 75% invested in properties that are 75% or more leased), sector and geographic diversification, and investment in core real estate (at least 75% in office, industrial, apartment and retail properties).

S&P 500 Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

S&P US REIT Index measures the investable U.S. REIT market and maintains a constituency that reflects the market's overall composition.

Past Performance is no guarantee of future results. One cannot invest directly in an index.

Risk Disclosures

Union Square Capital Partners, LLC is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Past performance does not guarantee future results.

There are a number of significant risks that should be considered when considering an investment in real estate or real estate related securities. No amount of diversification or correlation can guarantee profit or prevent losses. This website is neither an offer to sell nor a solicitation of an offer to buy any securities. An offering is made only by the applicable offering documents or Prospectus and only in those jurisdictions where permitted by law. This website must be read in conjunction with the applicable offering documents or Prospectus in order to understand fully all of the implications and risks of the offering of securities to which it relates and a copy of the offering documents or Prospectus must be available to you in connection with any offering. All information contained in this website is qualified by the terms of applicable offering documents or Prospectus. Neither the United States Securities and Exchange Commission nor any state regulator has approved or disapproved of the merits of any offering described herein. Any representation to the contrary is unlawful.