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Sunshine Corner is SRR Consulting’s bi-monthly newsletter with updates, news, and Sara's views on the US economy and commercial real estate.
Sunshine Corner Issue 2024:4 noted that commercial real estate values are following market prices down.
For May’s full moon issue, let’s get into this further. There is more going on in the data than the usual suspect — appraisal lag — with core fund property type composition shifting dramatically since 2019.
Issue 2024:5
As measured by the Green Street’s Core Sector CPPI, core real estate market pricing in April 2024 is down 21% from its Q1 2022 peak. The index has flattened since November 2023 and is now in-line with its pandemic low in mid-2020.
The US core fund benchmark capital return (or market value appreciation/depreciation) has a similar trendline. As of Q1 2024, core fund capital values are down 23% from their Q1 2022 peak, bringing the index in-line with its Q2 2020 trough.
Appraisal lag.
Despite an alignment in trends for core market pricing and capital return, the market generally leads inflection points in values by two-to-three quarters because the capital return is appraisal-based. This causes a lag versus market pricing because property sales are a factor in appraisals. The chart below shows this lead-lag relationship since the GFC.
Appraisal-lag, however, does not explain why core capital values caught up to core pricing such that both measures are back to their mid-2020 lows in the same quarter. The lag also does not explain why the capital return index has corrected by a larger amount (23% vs 21% for the CPPI) since both indexes peaked in Q1 2022.
Property type composition.
The Green Street Core CPPI has an equal weight (25% each) of industrial, multifamily, office, and retail property prices. This makes the index comparable across time with the same composition.
The core fund benchmark composition fluctuates based upon acquisitions, dispositions, and performance. Core fund composition by property type has seen dramatic shifts since before the pandemic.
By market value, office holdings in the core benchmark have been cut in half since Q4 2019. Industrial market value soared from 20% of net real estate assets in Q4 2019 to 38% in Q1 2024. Retail holdings fell, while multifamily and ‘other’ (mostly self-storage) increased as a share of net assets.
Core office properties have not only declined in value, but core funds in the benchmark have dramatically decreased their allocation to the sector.
By property count, there are 105 fewer offices held in these funds since Q4 2019. Total core fund value allocated to office is down 45%, to $40.3 billion, from $73.5 billion before the pandemic.
So what?
Back to the central question of the day, are real estate values finding a trough?
As an economist, I am required to say, “it depends”, and it does. It depends on location, property type, asset quality, and asset management.
Market pricing has adjusted to higher interest rates. Allocation shifts are expediting the core fund value correction.
In aggregate, the winners and losers across these factors are emerging.
There is a dynamic shift occurring in how tenants utilize space, from doing office work in single-family rentals to warehousing same-day delivery retail goods in a power center. The retail-to-industrial trade-offs over the last two decades have largely played out, but the office-to-residential shift is only beginning.
From a fund perspective, the capital value correction is nearing an end and the reallocation of institutional investment holdings across property types will expedite this in appraisal-based data. The movement of institutional capital away from certain property segments leaves an opening for opportunistic equity and debt investors to fill.
Market pricing, on the other hand, has adjusted to higher interest rates and is unlikely to drop further. The concern for underwriting new acquisitions over the next 12-18 months will likely shift to determining operational assumptions (rent, vacancy, expenses, etc.). Locations vulnerable to new supply and/or insurance cost shocks will likely remain challenged.
☀️ Check out Q1 2024 SRR Real Estate Quarterly here ☀️
Thanks for reading!
Fun Facts: Sunshine marks the start and end of each day and illuminates the moon to mark the start and end of each month. New data covering the economic and demographic drivers of real estate performance are released at differing monthly and quarterly cadences such that an important data release occurs at least once a week. It is chaos. To build this newsletter's calendar, I chose to follow sunshine and release this newsletter twice per month, at the start (new moon) and end (full moon) of a lunar month. Problem solved. 🌞