Winds of Change

If you’ve ever had the pleasure of riding in or navigating a sailboat, then you know any shift?in the wind can turn a pleasure cruise into an upwind battle. The fascinating thing about?sailing is no matter what direction the wind blows, by turning the sails the right way, you can?get where you want to go. But when the direction of the wind changes, there is that moment?of transition. The sails flap?helplessly?and the boat loses all speed. It’s noisy, it’s chaotic, and?you are directionless until the sails find the new wind’s direction and snap into place. In one?moment, silence returns, the boat picks up speed and all is calm again. We are in a moment of?transition like that now in the investment cycle. We need to adjust our sails and set course to?find new winds, but soon things will snap back into place for our new journey forward.

?CHARTING OUR COURSE

The strong 40-year tailwind of declining interest rates is over, and it ended quite dramatically.?For example, last year had an unprecedented breakdown in the paradigm between bonds and?equities. The global financial system remains quite fragile, with most of these losses hidden in?plain sight due to the required accounting treatment – there is no mark-to-market if the intent?is to hold bonds to maturity. If a bank is forced to sell them to meet obligations, the losses?are realized. The market is still digesting the extent of these losses which are likely to increase?with any further slowing of the economy. And we believe bank consolidation is a trend that?will continue.

Even if rates do come down later in 2023 (which is likely given the unfolding banking crisis),?we believe a new era of investing has begun, and rates will be trending upward for a long?period. Interest rate super-cycles are nothing new. Before this 40-year run, we had 35 years?of rising rates (1946-1981), 26 years of falling rates (1920-1946), 22 years of rising (1898-1920),?37 years of falling (1861-1898), etc. Each were in response to broader economic or geopolitical forces that impacted financial policy.?

This wave will be a combination of stubborn inflation due to a lack of political will to truly slow?the economy,?combined with a reversal of globalization. Geopolitical instability will be the?opposite force. Lastly, many major economies with debt-to-GDP levels at historic cycle highs?have historically used inflation to bring these down. All these forces strongly suggest while?rates will likely have their ups and downs, they will generally be on the upward march, and?4-6% inflation expectations are likely to replace historic 2% expectations.

?REAL ESTATE RECALIBRATIONS

What does all of this mean for real estate? The first point is to acknowledge that over the last?40 years, but especially the last 15, all asset classes have benefited from declining interest?rates. Much of the economy has shaped itself around this reality which is now over. Therefore,?the system needs to be recalibrated and reworked, which will take time. It’s important?for investors to look back at previous outcomes (and do the return attribution analysis) to?really understand what?was Beta?versus what was Alpha generation. Where did they miss?on execution, but were saved by cap-rate compression? In this new era of investing, good execution will truly be the prize, especially in a world of high interest rate risk.

Second, we must avoid recency bias. Nearly everyone working in the industry today has only?worked in one era of investing. Few have experienced any other way. Market selection needs?a new lens as the global economy is reworked. But also, how will the removal of low-cost?capital impact the number of start-ups, e-commerce expansion plans and continued demand?for new spaces? More fundamentally, how real estate is held also needs to be reexamined.?Longer-term structures with more moderate leverage are likely to outperform the highly levered “fix and flip” ones. The days of holding real estate for cash flow are likely making a?strong comeback.

Third, there will be winners and losers in the ‘future of office’ debate that’s raging in the?United States. But with a global lens, it’s fascinating to see how much this is limited primarily?to a U.S. issue, making it very different than the e-commerce/industrial wave we saw the last?decade. No doubt U.S. office is overbuilt and underinvested due to tax laws of the ‘80s, and?then ownership structures thereafter. But we are seeing high-quality office leasing perform at surprising levels, yet capital markets are painting too broad a brush. Investors will simply miss?some generational pricing-entry opportunities if they short the entire asset class.

Finally, it’s important to focus on potential new levers of value creation that the built?environment can produce. A zero-carbon economy is the ultimate destination. It will take a?long time for this reality to be achieved, but it does represent an economic opportunity. This?shift offers something future generations will strongly value, but it will also help find ways to?lower operating costs and generate new revenue. We believe that the road to outperformance?will be paved with decarbonization, greater flexibility and personalized offerings curated?for occupants. Our best advice is to get close to your customers, as having an operator?mindset will be essential.

TACKING FORWARD (INTO THE WIND)

It’s important to remember that this cycle began to turn March 17, 2022, when the U.S. Federal?Reserve first raised rates, and questions around office began to emerge in earnest. What is?happening now is more the second and third order effects that occur close to the end. We?would not be surprised to see increasing government regulation in the banking system, which?could impact liquidity. Nonetheless, we believe we’re closer to the end of the current repricing?than most realize and expect conditions to improve later this year.?

That said, the smart real estate investor is ignoring those near-term dynamics and focusing on?constructing portfolios based on all the new realities described above. It is our belief that real?estate will perform well in this type of environment; you just?have to?align your sails in the right?direction to catch these new winds.