The Glass Half Full

Happy Thanksgiving! We hope you are finding occasion to enjoy some down time with friends and family.Regarding interest rates — the financial press seems mired in a misconception. The narrative now seems to go “interest rates went up, real estate values went down, REAL ESTATE: BAD.”?

Let's consider the "glass half full" perspective.

On the one hand, rising interest rates increase cost of capital, potentially reduce cash flows, and create stress for operators. Not ideal for (some) individual operators who already own assets and are ill-positioned to hang onto them. (This also creates opportunity in the form of private lending and distressed asset opportunities.)?

On the other hand, the typical narrative misses something very fundamental: asset valuation does not equal performance. Yes, interest rates have an inverse relationship on real estate values. But the glass-half-full side of this story shouldn’t be ignored: when rates go down, values go up. This means investors today can potentially get in at a better cost basis, and have better future return prospects because interest rates now have the potential to drop. In more jargony terms, we now have potential for cap rate compression whereas two years ago there was hardly any.?

Looking Ahead Towards 2024?

While real estate may be getting short shrift, other narratives around market forces are rosier. The correlational flip that sunk the 60/40 portfolio in 2022 has eased. Inflation is not such a big deal anymore. The stock market is on the upswing and the “soft landing” scenario looks increasingly likely. These are welcome trends, should they remain intact for the next phase of the cycle.?

However, there’s some reason to cast a sideways glance at each:

Stock/bond correlation and the 60/40 portfolio:?

With recent gains in the stock market, it’s easy to forget that 2022 was the worst year for the 60/40 portfolio construct since at least 1937. Seven companies are responsible for 72% of the growth of the S&P 500 this year, while the other 493 stocks are up only 7%. And most of the gains of those seven stocks have been buoyed by enthusiasm for AI. While the potential of AI is truly groundbreaking, the pace and breadth of innovation are a matter of speculation, and arguably the highest-profile business leader in the space was just sacked by his board under mysterious circumstances. Not quite a recipe for stock market stability.????

Also, the stock/bond decorrelation effect doesn’t seem to have come back. While the CPI has trended downward, rolling 24-month stock/bond correlations have hovered around 60%, considerably higher than pre-2022 (when this correlation was negative in some periods). In other words, if the stock market dips, bonds may not be there to break the fall. Private real estate debt, on the other hand, potentially provides a less correlated, income-focused alternative.

Recent analysis from KKR shows (again) that allocating meaningfully to private-market alternatives can boost risk-adjusted portfolio returns vs. a traditional 60/40 construct. While the analysis suggests this is the case across market cycles, the spread is most acute during higher inflation periods. As the recent Blackstone study put it, perhaps the “set it and forget it” days are over and “simply owning the market won’t get it done anymore.”? Private-market alternatives, and the potential alpha thereof, may be a key piece of the puzzle moving forward.??

What Inflation??

Recent CPI numbers are encouraging, but it’s not a done deal. There’s reason to believe sticky inflation may stick around for some time. For one thing, consumer expectations of forward inflation have remained persistently high. Inflation is partly a reflection of our collective psychology; it tends to be a self-fulfilling prophecy. Should inflation stick around, private real estate (where operators can “capture” inflation in the form of rents) may hold appeal.?

Have We Landed the Soft Landing??

Maybe, maybe not. In many ways, the effects of higher rates have not made their way to the core drivers of economic growth. Job numbers and consumer confidence remain high. However, we may be starting to see some cracks form. In six prior recessions dating back to the late 1960’s, the lag from peak interest rate to recession was, on average, 10 months. This means that if rates have peaked, or will peak in early 2024, we still may be a ways out from the onset of a recession. Should a recession come to pass, our thesis remains that private commercial real estate can offer a uniquely favorable investment thesis, particularly sectors that offer a counter-cyclical strategy (such as Class B multifamily, student housing, and self-storage) and those that are supported by durable sectoral trends (such as data centers, last-mile industrial, and medical office buildings).?

Far be it from us to be economic doom-sayers. We aren’t alone, however. Recent modeling by the NY Fed (using the yield curve as the main forward predictor) put the probability of recession by mid-2024 at about 70%.?

This fork in the road forms the basis of our current asset selection focus.

• In the positive (soft landing) scenario, we enter into a “higher for longer” interest rate environment, which prolongs the opportunity in private real estate debt and credit. (Our Ascent Income Fund was established to provide investors access to this once-in-a-cycle opportunity.) Meanwhile, longer dated equity investments may offer the opportunity for cap rate compression.
• In the negative scenario, allocation to potentially counter-cyclical and non-cyclical sectors, particularly multifamily (which bears the strongest risk-adjusted returns in NCREIF Property Index data since inception).

EquityMultiple’s three pillars —?Keep, Earn, and Grow — were devised to support investors in uncertain times. No matter what the future holds, you can easily allocate to tailored diversification options across cash management, debt (fixed-income), and private equity real estate.

Oh and by the way, we're offering up to 1% boost on new investments made between now and November 30th, 20231 as a token of our appreciation during the holidays. Happy Investing!