Lagging indicators

Summary of this week’s note:?

Performance of brokerage firms are a good barometer of CRE markets and are an effective lagging indicator. Private equity firms expectations are a useful leading indicator. Thus, consultancy and recurring revenue business streams bolstered large brokerage firms last year as transactional volumes slumped; expectations for 2024 are broadly positive and significant pools of capital are being raised and poised to be invested into CRE.?

In English, the verb “to lag” means to fall behind, and it usually appears with negative connotations. But in finance, lagging indicators are often just as important as leading indicators because they serve as confirmation that changes in patterns or trends have taken place. Unlike leading indicators, which are forward-looking, lagging indicators don’t predict trends. Rather, analysts use them to verify that a shift or change in the market has occurred.?

A prime example of a lagging indicator in the real estate sector is the global Bid Intensity Index by JLL. This index highlighted that, towards the end of 2023, bidding activity in the CRE market worldwide experienced a significant uptick, with the average number of bids per deal rising by 16% compared to the previous year. This momentum is primarily driven by private investors and institutional capital, with the United States being at the forefront of price adjustments, closely followed by Europe and the Asia-Pacific region. Additionally, JLL points out that the contraction in bid-ask spreads could activate a significant portion of the $402bn in 'dry powder' capital that is currently on standby.?

The UBS Evidence Lab's survey, which compiles insights from 100 US CRE Brokers, is a leading indicator. Nearly half of the brokers have a strong leasing outlook for the overall market in the upcoming three months, a figure that aligns closely with the 52% reported last year, yet significantly below the 85% optimism level seen in November 2021. The industrial segment showed the greatest signs of optimism, with 50% of brokers expressing a strong outlook, an increase from 35% in November 2022. Conversely, the office sector's outlook has worsened, with 53% of brokers now viewing it as weak, a substantial rise from 25% a year ago. A notable trend is the markedly more pessimistic sentiment among brokers from larger firms, with over 500 employees, compared to their peers in smaller and medium-sized firms.

The last survey was conducted in November 2022, amid a period when interest rates hovered near their peak. The quintessential forward indicator of sentiment, stock prices, suggests that this indicator is now lagging investor sentiment with a ~40% average increase in the stock prices of major CRE firms like CBRE, CWK, and JLL over the past quarter. The surge in stock prices presumably reflects the recent earnings results from Savills, CBRE, and CWK (Cushman & Wakefield) which offer clear evidence of the cost-cutting measures and slowdowns affecting the CRE brokerage industry but green shoots emerging.

Savills indicated that its FY23 results are expected to align with analysts' predictions. The company noted that high financing costs have impacted global transaction volumes, leading to a significant drop in profits within its transactional business. However, this downturn was somewhat mitigated by stronger performance in less transactional services, particularly in consultancy and property businesses which have shown resilience. The company is optimistic about underlying market improvements in the first half of 2024, setting the stage for a broader recovery across most markets in the latter half of the year.

CBRE reported earnings that exceeded expectations, with revenues and adjusted expenses both higher than forecasted, leading to a better-than-expected adjusted EBITDA margin of 14.2% versus the anticipated 13.0%. The Advisory and Real Estate Investments segments performed better than expected, while the Global Workplace Solutions fell slightly short. Looking forward, CBRE is optimistic about FY24 targeting a return to peak core EPS in FY25.

CWK reported a slight increase in fee revenue driven largely by the leasing segment, which showed year-over-year growth after four consecutive quarters of decline. However, this was offset by a significant shortfall, as above, in the capital markets segment. Looking ahead to FY24, CWK anticipates revenue growth similar to the 3% seen in FY23, expecting stability in the leasing market but no growth in capital markets until the second half of the year.?

The CRE Analyst highlighted several key insights from the fourth quarter 2023 brokerage earnings calls. Firstly, after a challenging 2023 marked by job cuts, brokerages have streamlined their operations, positioning themselves as lean and prepared for a market rebound. Indeed they noted that profit margins had begun to show signs of recovery by the fourth quarter. Likewise, whilst leasing activity had stabilised there was a continued downturn in capital markets. Despite the challenges, they highlighted the widespread optimism among CEOs regarding a potential recovery in market activity in the latter half of 2024. As JLL CEO Christian Ulbrich said “We are beginning to see green shoots emerge in the commercial real estate market”. They also noted a focus on low-margin businesses, as evidenced by CBRE's $1bn investment in a government facilities management company, and the diversifying of revenues toward contract and management income to help weather CRE cycles. “CRE brokers have materially increased their exposure to recurring revenue streams in the past decade,” said Suryansh Sharma, an equity analyst with Morningstar Research Services in an email to Bisnow. “This is one of the main reasons why these companies have held up relatively well in the past year even though transaction volume has declined materially. “We believe the larger players will continue to gain market share in the brokerage business over time, and this is what we have seen in the past year.”

Ultimately the lead indicator for brokers is equity being mobilised and there are some promising signals. Blackstone, typically, described it well, and plans to step up its dealmaking before a rebound in markets drives prices higher. In his comments to the FT, Jonathan Gray predicted real estate values would begin to rise again soon as interest rates fell. “We really see real estate bottoming from a valuation standpoint,” he said. “The declining cost of capital with rates coming down and spreads coming down for real estate borrowing is very helpful” although conceded “we would acknowledge that this is not going to be some sort of a V-shaped recovery. There are going to be plenty of troubled deals in the market”. Sixth Street Partners Chief Executive Officer Alan Waxman said his firm is ready to capitalise as banks grapple with stress in their real estate portfolios. “The last few years, we haven’t really done that much because we thought valuations got way too speculative,” he said, adding that he now sees commercial real estate opportunities not just in the US, but also in Europe. “We’re sitting with a pretty clean portfolio”.?Lone Star Funds has raised $2bn thus far for its seventh opportunistic real estate fund, according to a filing with the Securities and Exchange Commission. For this vintage, Lone Star expects expected to capitalise on long term structural demand interrupted by short term factors the filing read. KKR also anticipates a significant uptick in CRE financing this year. The decline in commercial real estate values has eased enough that private investors are starting to fill in a financing void left by the pullback of regional banks and other traditional lenders to the industry, reported Bloomberg. Private equity funds that have spent the last 18 months in wait-and-see mode and are “awash in dry powder,” KKR’s head of real estate credit Matt Salem wrote in a note to clients. KKR’s own real estate credit pipeline has now swelled to $15bn, up from an average $10-12bn in 2023, he said.

The data bears this out. According to Macquarie, CRE is nearing fair value compared to corporate bonds, which is helping stabilise prices in leading markets and slowing declines elsewhere. In Europe, caution is advised due to cap rate spreads to bonds being below the 20-year average, particularly in weaker sectors. However, higher rates, construction costs, and tighter lending are reducing new developments, potentially boosting rental growth in the future by limiting supply. The UK and US markets are expected to lead the recovery, with the UK adjusting quickly due to proactive valuations and London's liquidity, and the US showing variability across local markets.

After releasing their 2024 Outlook for European private real estate markets in November 2023 and encountering scepticism, AEW conducted further analysis which reinforced their optimistic forecast. AEW examined real estate returns against broader market indicators, including stocks and bonds. Despite a significant downturn in real estate stocks a notable recovery occurred in the last quarter of 2023. The correlation between changes in real estate stock values and direct real estate returns, particularly with a two-quarter lag, bolsters their conviction for a recovery in real estate returns beginning in 2024, though there might be a delay of one to two quarters.

Some might read agents positive expectations for 2024 as wishful thinking and self-serving, and real estate private equity firms flush with cash as opportunist; so take both camps intentions with a pinch of salt. A study by George Loewenstein, Don Moore and Daylian Cain called "The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest" published in the Journal of Legal Studies, showed that disclosing a conflict of interest could be actually counterproductive. Most people think that if they know that their adviser (say an agent) has a conflict, they can take the advice with a grain of salt. But it turns out they can’t. For the simple reason that most people ignore the larger problem of ‘unconscious bias’. People extol their advice without actually knowing they are being partial to it. Notwithstanding, we have seen lagging indicators prove that cost cutting has been deep and non-transactional income streams be cash positive; and leading indicators show that valuations have declined sufficiently and large pools of money are poised to be deployed. Though as UBS noted in their broker survey, larger brokerage firms have been more pessimistic in contradistinction to their smaller and medium-sized peers, so take what we say with a pinch of salt.?