U.S. Real Estate: Risk or Opportunity?

Doomsday headlines may persist, but do not be fooled: The outlook for real estate is getting brighter.

Nearly a year after the demise of Silicon Valley Bank and Signature Bank, bank tremors have resurfaced in the U.S., Japan, and Germany, rekindling fears around property and its perceived threat to the financial system. We believe that these concerns are not only overblown; they obscure an improving outlook for U.S. real estate. Consider the following:


1. U.S. banks appear well positioned to withstand real estate stress.

About $930 billion of U.S. commercial real estate (CRE) debt is slated to mature in 2024, nearly half of it held by banks.[1] In some cases, borrowers will struggle to refinance at higher interest rates and lower collateral values. Non-maturing loans could also default where rental income has dropped (e.g., a tenant vacated) or not kept pace with leasing, debt-service, or other expenses. Still, U.S. banks appear positioned to weather the storm. CRE represents 13% of bank assets.[2] If they suffered a 9% haircut (consistent with the Federal Reserve “stress test” of large banks), the hit to capital ratios would be about 120 basis points.[3] Though significant, an impairment of this magnitude would be manageable, in our view, against tier 1 capital ratios that are near record levels (14%, or 40% above Global Financial Crisis (GFC) levels), particularly when offset with retained earnings over time.[2] In actuality, losses may be much less severe. The Federal Reserve’s stress tests assume CRE prices fall 40%.[3] This might be realistic for office properties, but these represent less than 20% of CRE loans (2%-3% of assets).[4] Prices in other sectors have dropped about half as much, and losses there are likely to be much smaller (since loans are typically buffered with an equity cushion of 40%-50%).[5] True, smaller institutions have greater exposure to CRE, and some of the more than 4,600 banks in the country could fail.[2] Yet in our view, this does not rise to the level of a systemic problem.


2. Interest rate pressures may have peaked.

Surging interest rates were a formidable blow to real estate valuations. Yet they have declined markedly since October 2023, and with inflation receding (albeit haltingly), even lower rates may be on the horizon.[6] In our view, stabilizing interest rates will relieve upward pressure on cap rates, the primary source of valuation pressure. Loan defaults may force more sales, but history shows that stress can coincide with a market recovery, as fresh capital looks to exploit emerging opportunities. In 2010, after the GFC, bank real estate delinquencies soared to 9% (they are just over 1% today) and nearly 20% of all transactions were “distressed” (per Real Capital Analytics), yet core diversified real estate funds produced a 16% total return.[7]


3. Real estate yields are approaching their highest levels in a decade.

The negative effects of rising interest rates are subsiding, but the benefits are only beginning to be felt. These include an increase in cap rates to their highest levels in a decade, as cash flows have remained resilient even as prices have dropped.[8] Higher yields deliver stronger income returns. They also provide greater protection against any future interest-rate shock (since a given increase in cap rates is less impactful from higher levels) and provide scope for value gains should yields track interest rates lower over time.


4. Construction is plummeting.

Another salutary effect of higher interest rates (and lower prices) is a sharp construction slowdown. While the industrial and residential sectors (62% of the core real estate fund index) are experiencing record levels of supply, total construction starts have dropped 67% from their 2022 peak (see Exhibit).[9] Projects already underway will come to fruition, but industrial supply is poised to slide precipitously in the second half of 2024, followed by residential supply in 2025. Fundamentals in these sectors, already quite healthy (vacancies are at or below historical norms), may therefore tighten materially, supporting robust rental growth.[10]


Exhibit: Construction Starts

Note: Weighted Industrial (35%), Residential (30%), Office (20%), and Retail (15%)
Source: CoStar and DWS calculations. As of December 2023.


5. Demand drivers are compelling.

While the economic outlook is uncertain, recent momentum arguably reduces the likelihood of recession, which would otherwise undermine leasing activity. Meanwhile, structural drivers — household formation and prohibitive homeownership costs (residential rentals), e-commerce and supply-chain resilience (industrial) — remain firmly intact. Make no mistake: the office sector is structurally challenged and unlikely to recover before 2025, but it represents a shrinking slice of the real estate pie (18%).[11] Meanwhile, the retail sector has quietly emerged from its own structural “apocalypse”, boasting the highest returns of all major sectors in 2023 on the back of strong service-driven demand.[10]

Doomsday headlines may persist, but do not be fooled: The outlook for real estate is getting brighter. Banks appear well positioned to address troubled real estate loans. Interest-rate pressures have likely peaked. Income returns are at their highest levels in a decade. Fundamentals are essentially sound, and with construction slumping, they will likely tighten. In short, we believe that 2024 will provide an attractive entry point to capitalize on the next real estate cycle.

 

Additional Resources

Retail sector shines as the U.S. consumer remains resilient

We believe that structurally tight labor markets and robust household finances — together with low current vacancies and limited new construction — will continue to underpin healthy retail fundamentals for the foreseeable future.

2024 Real Estate Outlook

We believe that 2024 will mark a turning point for U.S. real estate, as easing financial conditions offset a soft patch for fundamentals.

Residential: 2024 Outlook

While there has been a resurgence in renter demand to levels consistent with strong pre-pandemic years, the nation’s apartment market is still expected to see rising vacancies as it continues moderating into the close of 2023.

1. Mortgage Bankers Association. As of February 2024.

2. FDIC. As of September 2023.

3. Federal Reserve, 2023 Stress Test Results. As of June 2023.

4. Federal Reserve, Financial Stability Report. As of May 2023.

5. GSA (prices); Federal Reserve, Financial Stability Report (equity cushion). As of May 2023.

6. Federal Reserve. As of February 2024.

7. Real Capital Analytics (distress); FDIC (delinquencies); NCREIF (returns). As of December 2023.

8. NCREIF and DWS. As of December 2023.

9. NCREIF ODCE (fund index); CoStar and DWS (starts). As of December 2023.

10. NCREIF. As of December 2023.

11. NCREIF ODCE. As of December 2023.

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An investment in real assets involves a high degree of risk, including possible loss of principal amount invested, and is suitable only for sophisticated investors who can bear such losses. The value of shares/ units and their derived income may fall or rise.

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