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Market Update

Quarterly market review- Q1 2024

During the first quarter of 2024, we again observed strong equity performance with the S&P posting its second consecutive quarter of double-digit returns. However, private real estate, as reflected by the NFI-ODCE NR, saw another decline, albeit to a much lesser extent than last quarter.

Q1 2024 Benchmark Returns

  • -0.78% Bloomberg U.S. Agg Bond Index TR
  • 10.56% S&P 500 TR
  • -0.32% MSCI US REIT Index GR
  • -2.58% NFI-ODCE NR

Private real estate’s moderating negative performance resulted from cap rates and discount rates continuing to push a little higher. We continue to believe that, while frustrating, the performance of the fund reflects accurate marks of where commercial properties will transact when volume increases. We continue to observe other non-traded / NAV REITs that seemingly do not take valuation declines, which should be viewed with caution. Some of those funds may also have additional investment strategies within their portfolio (interest rate derivatives, debt, etc.) which provide risks and returns that do not correlate to the overall performance of core commercial real estate. We 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. This view is supported by a number of institutions that have allocated new assets to some of the NFI-ODCE funds during the quarter. To highlight this point, it is worth considering the NFI-ODCE posted a -12.73% in 2023 and experienced a drawdown of over 20%, while the average non-traded / NAV REIT posted only modest negative returns the same year and have experienced a total drawdown of ~5% based on average return data from individual REIT websites. 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.

We believe that the vast majority of the valuation write-downs are finally behind us. As mentioned, the driver of negative returns for the first quarter of 2024 was a continued increase in cap and discount rates, mainly across office and multi-family properties. Although the Federal Reserve acknowledged rate cuts were likely in 2024 after the December FOMC meeting, that optimism quickly dissipated as the inflation data and employment figures have not cooperated to the extent that the Fed had hoped. As such, with limited transaction volume and further uncertainty about when interest rates would meaningfully decline, appraisers continued to hold or slightly increased cap rates. However, we would note inflation is never perfectly linear and still believe the Fed will need to cut rates, although likely to a lesser extent than they initially indicated. Also, it is more important to note that inflation is otherwise a positive for real estate as landlords have the ability to re-price rents upward. The negative performance for private real estate over the past 18 months is a result of the Federal Reserve’s pace of interest rate increases rather than inflation itself. Moving forward, even if inflation remains sticky, it is below the levels that would warrant any further increases, which should allow for long term interest rates to stabilize and commercial real estate returns to normalize. Furthermore, when rates do start to decline, that has historically been a very favorable environment for real estate as credit becomes more available and owners can refinance debt at cheaper rates.

Source: YCharts

As we have written over the past year, operating fundamentals of the industrial, multi-family, 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 the building owners to extend the maturities, which should help mitigate widespread distress, although we will likely see some limited pockets of distress in the office market.

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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. In 2022, private real estate was one of very few assets that delivered positive returns (~7%) when every other major asset class had double-digit declines. Now that values have reset, this is the time to consider allocating towards the asset class.

5-year correlation

Benchmark 1 2 3 4 5 6
1 Private real estate 1.00
2 US stocks -0.28 1.00
3 DM stocks -0.40 0.93 1.00
4 EM stocks -0.36 0.90 0.94 1.00
5 Public REITs -0.09 0.90 0.83 0.75 1.00
6 US agg bonds -0.47 0.46 0.46 0.38 0.42 1.00

Data as of December 31, 2023. Private Real Estate: NCREIF ODCE Index US Stocks: S&P 500 Index, DM Stocks: MSCI EAFE Index, EM Stocks: MSCI EM Index, Public REITs: S&P US REIT Index, US Agg Bonds: Bloomberg U.S. Aggregate Bond Index.

Worth noting here as a reminder to us all are two points from Cliff Asness’ recent article titled “Cognitive Dissonance.” He lays out 13 points that are hard for investors to believe simultaneously, yet time and time again, we observe behaviors that would defy rational expectations. I include these quotes half-kidding, however, there is often truth in humor.

The point of those uncorrelated alternatives is to make money over the long-term while being, you know, uncorrelated…
…but we still evaluate these investments by comparing them to stock market returns, feeling extra good about them when the stock market is down, and extra bad when the stock market is up.”

Interestingly, most investors, even the most sophisticated, are willing to rebalance towards stocks after suffering a large drawdown but have less of a propensity to allocate back towards uncorrelated assets after stocks have run up.

“We believe in stocks for the long run, and we know they will have terrible drawdowns that we must stoically bear to earn their return premium…
…but if an uncorrelated alternative has a terrible period—even if you can directly point to its epic cheapness—we get out, as patience doesn’t apply here as it does with stocks.”

Performance by property type

  • Industrial — Industrial returns were flat across most funds. 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 in the second half of 2024.
  • Multi-family — Multi-family 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 (as shown on the chart below). These dynamics should help multi-family returns strengthen beginning in the second half of this year.

Source: YCharts

  • Office — Office properties continued their decline. Many office properties in the NFI-ODCE have now been written down between 30-40%, 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, NOI growth has been strong across many retail properties within the NFI-ODCE.
  • Specialty — The allure of specialty sectors like self-storage, life science, and single-family residential persists across many institutional buyers. Noteworthy performance in the life sciences and single-family residential segments underscores their strategic value in a diversified real estate portfolio.

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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.

About the author

  • Thomas Miller

    Managing Director
    USQ Interval Funds

    Kennett Square, PA