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Market Update

Quarterly market review - Q1 2023

April 1, 2023
  • Thomas Miller for USQ


    Thomas Miller

    Managing Director
    USQ Interval Funds

    Kennett Square, PA


The story of volatility continues yet again this quarter. However, after a very difficult 2022, returns for public equities and fixed income were positive for Q1 2023.

Keeping it in perspective, the negative return for core private real estate (as measured by the NFI-ODCE NR) was after a strong 2022 annual net return of +6.55%. We believe the vast majority of negative returns are now behind us as the operating fundamentals of the asset class remain strong. The negative returns were primarily a function of cap rate expansion, given higher interest rates and the expectation that rates would continue to rise. However, market expectations have quickly changed regarding interest rates, with peak rates in the 10-yr Treasury seemingly behind us as long as the inflation data continues to ease.

Speaking of interest rates, the Federal Reserve continued its quest to bring down inflation at all costs, almost without regard to anything else. What became clear over the quarter was that the Federal Reserve did in fact break something: the regional banking sector in the U.S. (and perhaps across the world, given other central bank actions as a result of the Federal Reserve’s moves). While there has been much press regarding the collapse of certain banks, we won’t cover that in this commentary. However, it is worth noting that central banks increasing rates by 500 basis points in thirteen months will have consequences. Ironically, the Fed’s actions of taking rates so high so quickly—not giving regional banks time to increase savings rates for their clients—created competition and instability in the very banks the Fed is supposed to oversee. The increased competition from high money market and short-term Treasury yields, coupled with the technology that allows almost all bank customers to move money within seconds, creates a recipe for far faster and perhaps more frequent bank runs than we have ever had to deal with in the history of the U.S.. The good news is that the economy seems to have stabilized. However, if the Fed continues on its path of higher rates, this stabilization may be short lived. As long as the Federal Reserve honors its promise to be “data dependent,” we believe rates will not go much higher from here. Inflation is coming down (and is lagged so this trend is likely to continue), the labor market picture is weakening, and wage growth is moderating. This may be enough for the Fed to pause, although they may just as likely try to get one last 25 bp increase in before doing so.

As it relates to private commercial real estate, the highest quality real estate is likely to win in this environment. Values did decline for the second consecutive quarter, albeit to a lesser extent than last quarter, primarily because cap rate expansion continued. Cap rates and discount rates have been rising over the past 12 months. Therefore, we believe the vast majority of the negative returns are now behind us, especially now that interest rate increase expectations have moderated. We are not seeing distressed selling in the commercial real estate market, and default rates remain low. We still expect that many parts of the commercial real estate market will see returns normalize by the second half of this year, as we previously suggested.

We have received a number of questions regarding some of the headlines that many media outlets have published over the past quarter, and which we want to address in this commentary. The media continues with its irresponsible reporting using “commercial real estate” and “office properties” interchangeably. In fact, since the regional banking issues surfaced, many media outlets have reported that “commercial real estate will be the next ‘shoe to drop’”. The fact they seem to miss, or perhaps intentionally omit because they prefer click-bait fear tactics, is that commercial real estate is much broader than just office! While office was historically the largest subsector in the NFI-ODCE, it is only about 20% today and lags both the larger industrial and apartment sectors, which total over 60% (the remaining 17% is Retail/Other). Apart from office, most sectors within commercial real estate are experiencing robust operating results. The most notable sectors that continue to experience rent growth are industrial, multi-family, life sciences, and, as of late, retail. Furthermore, even stating that all office properties are in trouble is simply not the case. Class A office continues to be well-leased and is experiencing increased leasing activity in some markets. As a reminder, the NFI-ODCE’s exposure to office is generally Class A.

Below is a brief summary of performance by property type:

  • Industrial properties’ return was negative for the quarter. Cap rates continued to expand as a result of higher interest rates. However, we believe further value declines are likely over in this sector. Rent growth continues in the sector, and we have seen many funds report 20-30% increases in rents as leases renew.
  • Multi-family returns were also negative as cap rates pushed higher in this sector as well. Rent growth persists but it has moderated from the historically high levels experienced last year. The supply-demand dynamics for housing in the U.S. continues to make this sector attractive from a longer-term perspective.
  • Office properties were negative for the quarter as cap rates continue to expand, keeping with the trend for the sector going back to 2020. The NFI-ODCE has written-down their office values by about 25%, on average, over the past year.
  • Retail properties continue to experience meaningful increases in net operating income (NOI). Retail has now posted the best returns of the four main commercial property sectors over the past two quarters.
  • Specialty property sectors such a self-storage, life science, and single-family residential continue to be in strong demand from institutional investors. Notably, life sciences and single-family residential experienced strong relative returns over the quarter.

What will be the impact of regional banks on commercial real estate?

While it is too early to determine what the impact will be on commercial real estate, we do expect some ripple effects from the recent regional bank issues. Regional banks do play a large role in commercial real estate financing, especially for smaller deals and construction loans on smaller projects. The good news, perhaps, is that lending standards had been tightening for the past year, and regional banks were already pulling back on commercial real estate lending. They were also requiring more conservative loan-to-value ratios, meaning property values would have to significantly decline before their loans were in jeopardy of not being repaid.

In summary, the impact from the recent regional bank issues on real estate values may be more limited than is being suggested. That said, we may see some distress in Class B/C office if they are required to refinance in the current environment. While we have not seen this actively play out, there are valid concerns that we may see a greater number of operators walk away from low performing assets.

It should be noted for the larger real estate owners that capital is available from other sources such as larger banks and insurance companies. As it relates to the NFI-ODCE, with just 24% leverage, most debt having fixed rates, and the vast majority of debt maturities not coming due until after 2026, refinancing risks are much less concerning.

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Cap rate represents the 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 U.S. REIT Index is a free float-adjusted market capitalization index that is comprised of equity REITs. With 126 constituents, it represents about 99% of the US REIT universe and securities are classified in the Equity REITs Industry (under the Real Estate sector) according to the Global Industry Classification Standard (GICS®). It however excludes Mortgage REIT and selected Specialized REITs.

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.

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