VIDEO: H2 2024 Commercial Real Estate Investing Outlook

Amna Nawaz:

Hello everyone and welcome to CrowdStreet's H2 2024, Commercial Real Estate Investing Outlook webinar. My name is Amna Nawaz and I'm an investment analyst at CrowdStreet. I work closely with our investments and marketing team and with our chief investment officer on research, content, and analysis. Today we're going to give you a presentation on our latest market outlook, which we released a few weeks ago. This outlook report entails our research and analysis and intel from our investments team for the second half of 2024. Now, before we get into the presentation, let's go over a few disclaimers. CrowdStreet Inc. offers investment opportunities and financial services on its platform, (the "CrowdStreet Marketplace.") Broker dealer services provided in connection with an investment are offered through CrowdStreet Capital. This presentation should not be construed as an investment recommendation or advice or an offer to sell or the solicitation of an offer to buy an investment.

Also, keep in mind that this is an informational presentation on what we're seeing in the market, so that's based on our research, but we will not be speaking to deal specific information during the webinar, but rather on the broader market trends. So with that, let's jump into the agenda. We've got a packed agenda today and it's going to be an exciting one because not only are we going to speak to our outlook, we'll also have commentary on the fed's latest move, the fed's rate cut. So the fed reduced interest rates by half a percentage point yesterday, and that's the first-rate cut in over four years. So I'm really excited to dive into that discussion. Then we'll jump into the outlook section of the presentation. We'll be speaking on the big picture and then we'll dive into the five major commercial real estate asset classes, speaking to the outlook for the second half of the year, as well as our strategy for curating deals on the marketplace.

Then we'll jump into closing remarks and then we'll leave some room for Q&A. For Q&A please remember that as we're presenting, when you have a question, you can post that on the bottom of your screen on the Q&A box and then we'll get to those questions at the end of the presentation. A brief introduction for the speakers today, we're going to be joined today by Ian Formigle, the Chief Investment Officer of CrowdStreet, Anna-Marie Allander Lieb, Senior Managing Director, Investments at CrowdStreet, and myself, Amna Nawaz Investment Analyst at CrowdStreet. So with that, I'm going to kick off the presentation and give the stage to Ian. Welcome Ian.

Ian Formigle:

Thanks Amna. And thanks everyone for joining us today. We obviously got some good news from the market yesterday. And particularly for real estate capital markets, the news was a bit better than expected. And in general we would say that we view the lead-up of the activity in the markets over the last few weeks, culminating in the news yesterday and some the reaction today is a major positive shift for the commercial real estate industry going forward. So if we move on to the next, let's look at this next slide. And so here what we're showing is this is Green Street's projections of how they view over long-term corporate bonds, high-yield bonds relative to real estate returns. And so what I want to call out here is that with this move and as we're moving into this next phase and what we think is basically the beginning of a cycle, I'll talk about that more in a minute.

Now they're seeing that this is an inflection point where their expectations are real estate returns are now crossing over high-yield bonds from a return's perspective going forward. So just some overall positive news. And generally speaking, just over the last 25 years I've lived through watching the inverse correlation of interest rates and the commercial real estate values over that time. We just witnessed it happen again when we saw basically living through the run-up of real estate values inversely correlated to then the drop in real estate rates in interest rates in 2020, then leading to the tightening cycle that we've all just lived through and the headwinds that has imposed on the real estate cycle since then. And if we think about our last real estate tightening cycle, this one was hard for the industry. It's hard for a number of reasons. One, for partially what we saw, the rate of its ascent was difficult.

And two, the ambiguity and just this general uncertainty over inflation where it was going, the future prospects of inflation, we're imposing a large amount of uncertainty on the market. It's kind of somewhat easy for us to forget that a year ago, literally like September to October of last year, we were sitting here, the 30-year treasury was cresting over 5%. You had a lot of investors from high-profile ones such as Bill Ackman starting to project the expectations of the 30-year potentially going over 6% calls for inflation to remain sticky in the 3 to 4% range. And the likelihood that if that all occurred, that the fed would have to maintain its ... the fed funds rate where it was at five and a quarter to five and a half and potentially even increase it from there. So that was obviously a scenario that was putting a lot of headwinds on everything including the commercial real estate market.

So luckily that scenario didn't play out. And now we're sitting here at the beginning of what looks like a loosening cycle, and in my opinion that is the operative term. We are at the precipice of a new loosening cycle. If you look, going back and watching Powell's testimony. Yesterday his interview after the announcement, he stated that of the fed's 19, governors 10 were in favor of a total of 4 cuts in 2024, and 9 were in favor of 3 cuts. And if you look at the fed dot plot, it's now projecting roughly a hundred basis points of rate reduction in 2025. So we really are talking about a cycle that is beginning as of yesterday. And if we look at how that's playing out in terms of the risk-free rate, you'll see now that the two year is down roughly 140 basis points since it's 2024 peak, it sits at it now around 3.6%.

The five year is down over 120 basis points. Since it's 24 peak in April, it's now around 3.5%. The 10 year is down about 100 basis points. Since its peak in April, it's now sitting at about 3.73% of this morning. And what's really important here is the yield curve is normalizing. The 2 year, the 5 year and the 10 year are now all below the 30 year, which is right about 4.06% as of this morning. And that's big in my opinion because economic theory teaches us that a normal yield curve is part of a normal market. So the first thing I think that we get out of the announcement yesterday is that we get to lock in the transition in rates down in the last two or three months in anticipation of this news, the news is here. So I think we see short-term stabilization of the movements that we just saw in those risk-free rates.

And what we've also seen is we've now seen that in the last couple months the public REITs have seemed to run up in advance of the anticipation of this news. If you look at the broad index REITs such as in ETFs I should say such as VNQ and XLRE, those are up about 10% year to date. Multifamily REITs are up more. EQR is up about 24% year to date. AvalonBay up about 22.5%. Essex Property Trust up about 24.3%. Again, all of this morning. And from a sector perspective, if we think about what interest rates do and how the effects on commercial real estate, it's our opinion that if we look at the multifamily and industrial asset classes, we think that the rate move has the most pronounced move or effect, positive effect, on these two sectors because these were the two sectors that had the lowest prevailing cap rates going into the cycle. Enough so that when we would see going into the cycle, we saw what we would call positive leverage transitioning into negative leverage as rates rose and cap rates rose as well.

We're going to get into the scenario 1 in just a second and we're going to provide some context. So really what we're saying here is the shift. This shift has created a transition from what we would view as significant headwinds in the market to headwinds dying down and the potential for a small tailwind to begin to occur in the months ahead. It's big for the overall commercial real estate market and we think it's bigger for the multifamily and industrial sectors. So to provide some additional context for what really think that means and how that actually plays out on the street in the markets, we've created a hypothetical example, I'll walk you through, that displays what happens when you take a multifamily acquisition and you reduce interest rates by 100 basis points or 1%. So in the slide that you're now viewing, this is what we call scenario 1 and we call this one the potential for higher yield.

In this first example, it's very simple. We're taking a $60 million acquisition, we're leveraging it 60% with debt where the interest rate is going from 6% to 5%. And we're looking at what happens holding all else equal. If the rate declines, what does that do for net positive cash flow? It's important on this slide to note that we begin with a debt service coverage ratio. That's that DSCR in the bottom left of 1.39. Because here what we're depicting is an interest only rate and a 1.39 debt coverage ratio with a little bit of rent growth as it transitions to an amortizing loan could remain above a 1.25 debt coverage ratio. And that's meaningful because in our experience that's how lenders look at it and that's how they would size the loan. So this first example, dropping rates by a percentage point gives you roughly an additional $360,000 of net positive cash flow. Drops your debt service from here, from 2.16 million to $1.8 million.

It's going to increase the debt service coverage ratio from 1.39 to 1.67 and would take your yield on equity from 3.5 to 5% in this hypothetical scenario. So it's an increase in yield. It's a decrease in debt service. It's just objectively good for operating numbers, but it's holding debt constant. So let's go into the second scenario because this is the scenario that we think that the version of this, this is closer to what plays out in reality, it's not exactly, but I'll walk you through that. So in our second scenario, we focus on holding the debt service coverage ratio constant at 1.39. We get the 1% decrease in interest rates and now we explore what that means from a debt proceeds perspective. In essence, we assume now we can borrow more and we're looking for what is the maximum leverage we can obtain holding that DSCR constant at 1.39.

And what you see here now is that it's the potential for an additional $7.2 million of proceeds to come in, which would take the leverage ratio up from 60 to 72% LTC. And given that we're sizing to the same debt service amount, that cash flow remains relatively constant here. But what does increase actually here is actually the yield on equity does go up from 3.5% to 5% and that's because we've reduced equity required in the transaction, very substantially, from 24 million down to 16.8 million. And so what I would say here is that when we contemplate scenarios 1 and 2, in our experience when a buyer is weighing these two options in a good news scenario where they've maybe gotten a term sheet, where they've seen rates come down and they got an updated term sheet of which looks something along these lines. And in actuality we have actually seen instances on the street where borrowers have gotten this kind of good news in the last couple of months. Whether debating between scenario 1 or 2 depends upon the borrower and the borrower's objectives.

In reality, we would say that the borrowers are leaning more towards scenario 2, but not in totality. I would say roughly speaking from our general perspective, what you would typically see a borrower do is increase its proceeds but not from 60 to 72%, possibly from 60 to 66%, maybe 68%. Because in that scenario, from the borrower's perspective, what the borrower now sees is that I can increase proceeds, I can reduce the amount of equity required, hence hypothetically speaking, increasing the expectations for return on equity while at the same time actually increasing the debt service coverage ratio. Now maybe from something like 1.39 closer to 1.5, not 1.67, also increasing the yield on equity. So in their minds it's a little bit of best of all worlds.

And then the final thing to point out here is to illustrate how this effect played out on an asset by asset basis across the country affects the commercial real estate market. Because in this scenario, if the buyer is a bidder in this case, they're bidding against two or three other prospective buyers, they're projecting to pay $60 million for the asset, they receive this good news that they could increase proceeds, borrow a bit more and even get a little bit more cash flow than they thought previously and they want to win that asset. What do we think the probability is of that buyer? That bidder in this case is going to increase their bid from 60 to 61 million to maybe 62 million as a measure to try to ensure that it wins the asset and acquires it.

And from our perspective, we say that that probability is pretty high. And that's why as this phenomenon begins to play out across the country on an asset by asset basis is why we think this is the beginning of asset appreciation. As buyers step in, they receive this good news and they more competitively bid up at each individual asset. So now from here I think what we're going to do is we're going to move on and start looking about the strategy. So I hope that example actually provides some color. It is what we are seeing play out across the country right now on some deals. In the case of some refinances or term sheets that bidders are looking at and then they're receiving new, as I mentioned earlier, it is often tied to that movement that we just saw in the markets over the last couple of months and we expect to see some more of those types of movements and behavior in the months ahead.

So with that, let's move on to the macro strategy. We're going to talk about transaction volume and for that I'm going to pass it over to Anna-Marie.

Anna-Marie Allander Lieb:

Thanks Ian. So yeah, let's take a look at transaction volume. As you can see, we saw a steady quarter over a quarter decline in sales volume beginning in 2022 coinciding with that first-rate hike. Transaction volume somewhat stabilized in 2023 and then we saw another drop in Q1 of '24. This past quarter, however, we saw the first meaningful increase in transaction volume since the rates heights began. However, if we look at the data on a year-over-year basis, sales were almost flat coming in at about 2% below the year before. Now if you dive deeper into the data, it is notable that as you can see in the volume summary chart to the right of the screen here, that portfolio and entity sales increased by 24% year over year. This can be taken as an indication that institutional capital is returning to the market.

One notable transaction that took place in Q2 that attributed to this was Blackstone who completed its purchase of AIR apartment income REIT for $39 and 12 cents per share in an all cash transaction that was valued at approximately 10 billion. Now if you break it down by the biggest movers by asset class, office definitely stands out, for the largest decline in transaction volume down 20% year over year. However, per Collier's recent report, 13 of the top 25 markets for office actually reported increases in transaction volume year over year. And this included both core markets such as Washington DC, Chicago, and Seattle, as well as some growth markets like Nashville, Atlanta, and Phoenix. We look at industrial volume. We also saw a decrease there coming in at negative 17% year over year with only one major distribution market seeing year-over-year growth and that was Dallas. Now if you look at the positive side, multifamily saw a 20% increase in transaction volume year over year.

Again, this was in part attributed to that Blackstone's acquisition of AIR, but multifamily also did lead the way in overall investment volume with the sector accounting for about 43% of overall volume or 38.8 billion. Now as we look ahead to the second half of the year. Coming off the heels of yesterday's 50 basis point rate cut, we do believe as Ian indicated that we're going to see kind of that increase in transaction volume we witnessed in Q2 to continue. The cut rates and the fed's projection that interest rates will continue to fall to 4.4% by year-end and 3.4% by the end of 2025 should bring some more predictability and clarity to the capital markets. It's likely going to bring some buyers off the sidelines, which we expect may help to continue that quarter-over-quarter growth trend we saw in Q2. And with that I'm going to pass it off to Ian to discuss valuations and pricing.

Ian Formigle:

All right, thanks Anna-Marie. So from a broader pricing perspective, as many of you know, we track Green Street's commercial property price index on a monthly basis. It gives us a snapshot, a regular frequent snapshot of private real estate markets covering the top 50 MSAs. And what we've seen in Green Street's CPPI is that we now have about a year coming up on a year of stabilization. It's still actually down 3% for the last 12 months, but it's actually up 3% since November of 2023. And if we start to break out the CPPI on an asset class basis, we will see that apartments are now up about 12, I'm sorry, up about 2% over the last 12 months, still off about 20% from peak, so still down, but showing signs of stabilization. It's very consistent with what we've experienced in the market. More or less a flattening out of cap rates depending upon the asset class somewhere in the low to mid 5% range.

Price per door are very much stabilized. And we start to see a little bit of return, a little bit of rent growth, we'll talk about that more in a minute, but stabilization there. If we look at strip retail, it's up about 3% over the last 12 months, still down 13% from peak. Office is down 8% over the last 12 months, down 37% from peak, but it's very difficult to talk about office at a macro level. [inaudible 00:20:09] asset by asset, geo specific. We'll get into that later in the presentation. And then industrial is down 9% over the last 12 months, down 16% from peaks. From a broader level, what we saw in the industrial sector is that it did bounce back. It got knocked down in 2022 from '23. It did bounce back in '23, but it's given those gains mostly back. So it's still kind of almost relatively roughly flat relative to 2022. So with that, let's delve into the specifics of each sector and we're going to kick it off with multifamily and I'm going to pass it back to Anne-Marie.

Anna-Marie Allander Lieb:

Thanks Ian. All right, so let's talk some multifamily. When we look at today, we definitely are starting to see signs of an early recovery for the multifamily market following that deceleration that began in 2022. Again, we went from a record high with CoStar reporting 9.9% quarterly rent growth in Q1 of 2022 to an average annual rent growth of 1.1% in 2023. CoStar now forecasts an increase to 1.7% for 2024 in states that vacancy seems to have stabilized in around the 92% range. If we look at multifamily valuations, we can see that assets are beginning to appreciate as Green Street is reporting an 8% quarter-over-quarter increase in pricing, although this is again still down about 20% from its peak. Further, CoStar has reported about 460 units being absorbed during the first half of 2024. Now if we go to the next slide, you're going to see here from the chart on the right, that net absorption in the second quarter of 2024 actually outpaced supply for the first time since Q1 of 2022, indicating that we are moving towards a more balanced market from a supply and demand perspective.

However, despite these tailwinds that I've gone over here, it's still important to note that some markets are truly still facing the previous headwinds, particularly in the Sun Belt region. We're seeing this where oversupply is still a real issue. Markets like Austin, which per CBRE reported having about negative 7.7% rent growth in the second quarter are still being dampened by new construction, heavily outpacing demand. That being said, as the Sun Belt is still exhibiting strong population growth, coupled with the belief that current absorption trends may continue, and the fact that there are coming reductions in the new completions that are coming online in these markets, the Sun Belt sector should to also rebound.

It's just that it may end up stretching into the latter half of 2025 and into '26 before we start seeing the recovery in these markets. When we think of areas of opportunity within the multifamily space, again with pricing being 20% below peak prices and we're seeing also price appreciation on a quarter over quarter basis, these signs point that were coming out of the trough. Further, we're seeing rent growth that's beginning to accelerate forecasted upwards of 4% for 2025 and 2026. And per Green Street we're also seeing some relief on the expense side to go along with this.

These are all positive levers that is going to strengthen the yield on costs that you're able to achieve on these acquisitions, especially when we kind of couple this with what we're seeing on the interest rate front, that again, it's going to potentially continue through fall and through 2025. We're also seeing at this juncture that there is stress in the market, particularly for owners who purchased assets towards the peak of the cycle with a value add business plan in particular, which again provides opportunities for would be buyers. Again, these owners they may have taken on bridge debt that typically comes with a three-year term, has floating rates. They now likely have experienced kind of that rapid deceleration that we saw in rent growth, post peak in 2021. And they've also seen their expenses really increase alongside inflation. And along that have had, as I mentioned, their financing costs grow in tandem this with the rate heights that began in 2022.

All that to be said, really these owners, it could be very likely that they are seeing their debt come due, again with that three-year term associated with bridge debt. And as we mentioned, we have had a 20% decline in asset value. So these two coupled together with that, that strain on the properties may be putting these owners into positions where they become forced sellers. Lastly, we're selectively looking at developments. We expect to see construction costs improve as inflation cools. And as most construction financing is priced off of short-term floating rates, again, these drops in interest rates should further help bolster the economics moving forward. Clearly though the devil is in the details with us paying close attention to how construction costs are trending, along with what the forward-looking supply and demand balance resulting in net absorption numbers look like for individual markets. We definitely favor those markets that are seeing positive net absorption and that have experienced lower construction costs generally, specifically more on the supply demand balance side.

We're seeing that the Northwest and Midwest regions are standing out for potential development opportunities. And with that I'm going to pass it to Amna to dive into retail.

Amna Nawaz:

Thank you Anne-Marie. So let's jump into retail. Retail is a sector known for its adaptability. It's gone through many phases in the last decade facing changes from the eCommerce growth to the so-called retail apocalypse and then the sharp impact of the COVID-19 pandemic, and that led to numerous store closures and multiple reinventions of the industry. So therefore, our typical retail center of today, especially after the pandemic, is one of the most battle tested ones with tenants that have gone through a lot of iterations of that birth and rebirth, right? So over the course of the decade, that's also caused retail to experience a dramatic and consistent reduction in development. So I want to that into perspective for you to show you just how little is being constructed today for retail. So the total retail inventory today stands at about 12 billion square feet versus 25 trillion square feet for total CRE inventory in the US. So that makes about 4% of the total CRE inventory.

Now for retail development, currently that's only five 50 million square feet of new construction, so that's roughly 0.4% of retail's own inventory. Now if you were to visualize it, the total retail construction in the US is roughly 1.3 times the size of Central Park. So hopefully that helps you visualize it a little bit. It's very little being developed, right? So what makes this even tighter is that according to CoStar, the national retail availability rate hit its record low of 4.1% in 2024. Now all of that is showing ongoing demand for retail. With that record low availability. As you can see on the graph on the screen, that rent growth peaked at about 4.2% in 2022, though it's since moderated into about 2.3% today. Landlords today, according to CoStar on average maintain relatively strong pricing power, but as you can see reflected in the numbers to the top right of the screen, it's expected that rent growth will cool down in the next few years and it's going to go closer to the pre-pandemic trend almost, and that's partly due to an expected moderation in consumer spending.

Now just to add a little color on rent growth, rent growth varies by region. Of course, CoStar and CBRE data show that rent growth is strongest in the Sun Belt region. Cities like Dallas, Houston and Phoenix have seen increases over 22% since 2020 for rent growth, partly driven by population growth and buying power. Meanwhile, cities like New York, Los Angeles and then markets in the Midwest and Northeast including Milwaukee and Chicago are seeing slower growth due to population declines. Lastly, Green Street data shows retail's price volatility has been relatively low as compared to other sectors, and this is partly due to the fact that retail has been in a price discovery mode for over a decade as it adapted to shifting consumer trends. Now we expect this trend to continue in 2024. So with that, let's jump into the strategy section.

Okay, so although retail's opportunity set is limited, we do consider a few things. Firstly, we consider daily needs centers, particularly those anchored by grocery stores. These centers are resilient to shifts in consumer spending generally due to their stable foot traffic and a focus on non-discretionary spending. While we remain generally market agnostic, we're especially drawn to regions like the Sun Belt where there is strong growth in the population for traffic and income. Secondly, we emphasize the importance of a solid tenant base with strong financial health, especially. I suppose especially as consumer spending is expected to moderate, we will remain cautious about centers catering to lower income areas because they're expected to have potential financial pressures on these centers. Also, due to their higher demand, we will consider retail that's more catered to experiential, lifestyle malls, and also like I mentioned, grocery anchored centers over traditional malls or secondary big box stores.

Additionally, we will also consider generally opportunities around shadow anchored spaces, which generally means that when major retailers are nearby, they drive traffic to the project area without being part of the tenant mix. So that's also a consideration. An example of that is a location near a big box retailer like Costco and that can benefit local businesses. Thirdly, we're also focused on leveraging retail cap rates, which tend to be higher than other asset classes that provides the potential for positive leverage in some cases even in a high interest rate environment. And just to end my section for retail, I'm going to speak a little bit about what we're monitoring as we consider these areas of opportunity. A survey by McKinsey reveals that while overall spending growth is moderating, consumers are prioritizing essentials like groceries and household items due to inflation and they're cutting back on discretionary spending.

So as you can see on the graph to the right, eCommerce spending, it peaked close to 18% in about Q4 of 2020 were total retail sales during the pandemic because there weren't a lot of places where you could shop. So a lot of people were going online to shop and that is stabilized if you can see close to around 15%. According to CBRE, foot traffic though in stores is expected to fully recover to pre-pandemic levels by Q3 2024 and exceed them by 2025. The holiday season is also coming soon, which is also going to provide a boost most probably to categories like travel and dining, despite expected cutbacks, which will also be monitoring. So that's all on retail for today and I'm going to pass it on to Ian to speak about office.

Ian Formigle:

Thanks Amna. So as we kick off the office section, I thought there was one data point that was interesting and I think relatively illustrative and where the office sector sits overall from an outlook perspective. And is that in a year where I think a lot of us could agree that the most famous stock for its performance is Nvidia. Over the last six months, SL Green, which is a publicly traded office REIT, has outperformed NVIDIA. Now I will definitely say if you go back to year to date, year to date, NVIDIA is absolutely outperforming SL Green. The point being is that I think at the beginning of the year the prospect of any office REIT outperforming NVIDIA for any period of time in 2024 seemed like a near zero probability.

And really what that tells me is that I think just from an outlook perspective feels like we're reaching a point where so much bad news is already baked into the office sector that continued bad news is mostly muted at this point, still will play out on an asset by asset per basis in terms of affecting where it trades relative to where it used to trade, but that also the prospect for any good news could be significant for the sector.

And it's not just SL Green on the public side that's up. If we look across other office REITs, Piedmont Reality Trust is up roughly 35%. For Nato is up about 35%. BXP was formerly called Boston Properties, it's even up 12.75% and it has concentrated holdings in west coast markets like LA, SF, and Seattle, which are still struggling immensely. And so overall I do think that what we're seeing that activity in the publics could be a leading indicator for us in terms of what might happen going forward in the private markets. And it's also important to note that we are reaching a point where we have data, for example, like Kastle Systems that is showing that we're somewhat flattening out, very incrementally increasing are the return to office and office utilization rates. But that we also just received an interesting announcement this week. We all saw Amazon when it publicly declared that its employees are expected to be back in the office five days a week starting in January 2025.

And that the expectation at this point is of utilization rates to mean remain relatively flat to where they currently are. A lot of groups, even Green Street was essentially calling that, hey, office utilization rates are probably flattening out from here going forward. And to the extent another few Amazon type users come forth start to increase their office usage, that could be a leading indicator. It's a bigger, you know, these are major employers that could be a leader in the return to office. So this is something that we're going to pay attention to. One thing that was interesting is if you look at, there's a website called the Flex Index. It tracks office usage across a bunch of companies, about 13,000 nationwide. If we look to the percentage of companies that it notes as 5 days a week per required in the office, it's about 3000 or about 22% of them.

If you look at employees that are 1000 or greater in employees, that number actually goes up to 28%. So checking out the Flex Index, if that number starts to tick up, we think that could be a positive indicator for the market. Give us the opportunity to have maybe just a substance, a sliver of hope of what actually could be the beginning of a little bit of absorption if occupancy rates flat. Now, and really what the slide here is noting is that that now the expectations from CoStar's perspective is that we're reaching the flattening out part of the cycle. Occupancy is kind of remaining flat in the 80 point something percent range. Rent growth now flat, not really going down anymore. We're also noting that on the street level. Essentially rents have mostly flattened out. What hasn't flattened out yet is the size of the footprint that the tenants want.

Tenants might be coming back for renewals, but when they do so they're typically still giving back space. That's still something that we think has to continue to play out. But it does seem that we were getting further into the innings of the office game, so to speak. And when we think about this. So let's go to the next slide and talk about what do we think, what does this mean and what could potentially make sense? Well, anything that might make sense next year from a regular office perspective is going to be massively discounted basis relative to its peak. So what does basis reset look like? Well, it depends a lot of where the asset is even within the market, even within the sub-market. And if we think about what's holding up the best right now or what's showing some signs of life, you probably say that looks like an asset that's in midtown Manhattan. It's very close to Grand Central Station and it's new.

So newer, nice assets, close proximity to transit. On East Coast markets, those are typically assets that are holding up the best. We are ceding some of those trade. The trades look roughly upwards of half off of prior peak. If we are moving around the country, if we go to Chicago and we look downtown the loop, we're going to see much more higher reduced basis. A lot of assets in Chicago are a little bit older. We're seeing 80s and 90s vintage assets. They're starting to trade. They look like anywhere from 60 to 80% off-peak depending upon the quality of the asset. Moving further west. If we look at Salt Lake City, one recent asset that's coming to market was interesting to me. It's a 750,000 square foot class, a suburban office portfolio. It's really just one cluster of buildings. It's located in Silicon Slope, it's coming to market. The expectation is $220 per square foot at a 10 cap with a 4.75 year weighted average lease term.

That one stands out as notable to me because the asset's new. It was constructed between 2016 and 2019. It's fully stabilized, it's got a stellar rent roll and that's over half. It's well below half of replacement cost. Finally, out in San Francisco, we are seeing heavier, steeper discounts in the financial district. We've seen a handful of trades on California Street. Financial District, even a little bit higher up on five 50 California. So overall, I think what's interesting is when we say we are starting to see a little bit of price discovery emerge, these data points are starting to look more and more similar as the months ensue. Now when we think about asset class, it's obviously anything that might make sense going forward is really going to look more class A.

It's going to have higher ceiling heights, it's going to be in the best locations. We continue to believe that commoditized class B office still at this point should be trading for potentially a discount to land basis because you literally might have to demolish it or repurpose it in the years ahead to turn it into something viable. So the jury is still very much out in our opinion in terms of the future viability of class B. But it's interesting to note heavy discounts on class A, We might be reaching a point where there might be an asset or two that might make sense. The other opportunity that we see is interesting in this market, it's almost like you would say an adjacent way to approach the market is to look at stabilized assets that have different types of uses in them and really focus on flex office use.

Now, flex office uses, they have a blend of traditional office space, but then they have a heavy component which looks like either R&D or manufacturing. And these are types of uses that literally must be done onsite. They have maintained greater occupancy levels over time. They aren't, I'd say the poster child for office vacating is a heavy tech use in a market like San Francisco. So this is almost the opposite end of the spectrum of this.

These are types of uses that continue on, they occur onsite, they're done by oftentimes companies with long tenure the properties. And so in a market that overall we're seeing a massive increase in cap rates correspondingly a massive decrease in price per square foot costs. And we can find assets where we're finding stabilized that have heavy flex use in them. We have confidence in that, in the tenant base, the weight average weighted lease term. And we think we're getting it at an attractive cap rate relative to where it would've traded in a pre-COVID market. To us, that's an interesting adjacent way to approach the market and potentially get some upside yield. So with that, I'm going to pass it over to Anna-Marie. We're going to go, I think we're going to talk about hospitality next.

Anna-Marie Allander Lieb:

All right, thanks Ian. So yeah, let's discuss hospitality. The sector definitely has been a state of recovery since the pandemic in 2020 and it's still playing catch up. When we look at revenue per available room on an inflation adjusted basis, we can see that although growing on an inflation adjusted basis, we're still behind numbers from 2019. As you can see from the chart showing ADR or annual daily rate and RevPAR revenue per available room, these have both been trending upwards since the pandemic with ADR hitting approximately $160 in July of '24 and RevPAR coming in at about 115 for the same period. Looking ahead, ADR and RevPAR growth are expected to continue through 2024 and into 2025. ADR is expected per STR to trend at about 2% for both '24 and 2025. Meanwhile, RevPAR is expected to trend at about 2% in 2024 and shows a slight increase to 2.6% in 2025.

If you look at what's been driving the recovery in hospitality. Per STR between 2020 and 2022, leisure hotels generally outperformed business hotels. However, if you fast-forward to 2024 and where we are today and we are seeing that group ADR, which is generally associated more so with business travel has shown some positive growth through the past 19 months through to July. Whereas transient ADR, which sometimes can be more so associated with leisure travel has leveled out over the same period with July actually coming in at negative 1.1% growth. CBRE also noted in its hotel state-of-the-union, which was released last week that it expects 2024 revenue per available room to be driven by growth in both group and business segments with RevPAR growth for urban and airport locations outperforming. We've also seen a bifurcation within the hospitality market when we look at kind of the chain scales with the top three chain scales.

So that would include luxury, upper upscale and upscale hotels. They've actually been outperforming in terms of occupancy and recording increases. Meanwhile, kind of the lower scale economy chains have seen declines. As the economy scales, chains generally cater more to lower income households that have become more cost constrained and are pulling back on travel. This trend is not unexpected from our view. And then if we go to the next slide, we can talk a bit about strategy. All right, so when we think of our strategy for hospitality, we currently are favoring acquisitions over development for this asset class. As assets pricing is still declining in the hospitality sector, we do believe there's opportunity to purchase assets with attractive yields. Just in our pipeline we've had some kind of interesting views into this. We've seen assets located in core markets that we looked at approximately 12 months ago, kind of cycle back to us, but with pricing that shows cap rate expansion north of 150 basis points and with improved operating numbers to what we saw 12 months ago.

So this improved pricing and projected kind of performance that's expected to continue to grow, makes acquisitions attractive at this juncture. In terms of development, again, as pricing is still decreasing and financing is still very challenging, it's very difficult to find ones that pencil. Again because construction costs are still very elevated. And when we look at RevPAR projections on an inflated adjusted basis, we are still kind of falling further behind where we were at pre-pandemic levels. In terms of markets, we really favor those that, again have been exhibiting the recovery within their performance indicators, leaning more so to primary markets. We've seen that secondary and tertiary markets tend to have a higher concentration of mid-scale and economy oriented inventory that caters more to budget conscious travel, a consumer base that again has been disproportionately impacted by the high inflationary environment, which as I noted again has led to that bifurcation that we've seen in the chain scales.

In terms of areas that we're monitoring, one will be operating expenses. We've seen an increased pressure on wages, real estate taxes and insurance along with other areas that really has put a lot of pressure on operating margins within the hospitality sector. That being said, SDR is forecasting that this should begin to ease as we move towards 2025. As you can see in the chart to the right here, that as inflation continues to cool, gross operating profit margins are projected to improve to 39.3% in 2025.

Lastly, as we look at acquisitions, we really are going to pay a lot of attention to deferred maintenance and CapEx requirements. From conversations we've had with industry experts, we've heard that some owners have neglected these expenses, especially through the pandemic and as they're moving through the recovery, which now have come up and need to be addressed and are causing some of them to kind of capitulate to buyers in terms of pricing to some degree. However, again, it's just paramount to understand these needs when looking at assets and budget appropriately before transacting. And with that I'm going to pass it to Ian to discuss industrial.

Ian Formigle:

All right, thanks Anna-Marie. So on the industrial sector from a broader perspective, we are approaching almost two years of flat pricing from Green Street's index perspective. It hit an all-time high of 253.9 in April of 2022, and then it dropped about 17% by the fall of that year. And in our perspective that relative flatness since then is mainly attributable to two things. First, we saw a supply demand and balance tick up some. Essentially, we saw deliveries increase particularly in the bulk distribution space, and we saw a pullback in absorption in that sector specifically that led to a moderation in rent growth, which came down to 2.3% in 2024. And we saw an uptick in vacancy from 4% to 6.6% and that's according to CoStar. And then finally over that period we saw cap rates expand. So again, in a market where we actually did see some rent growth in the sector, but we have expanding cap rates, well then we're getting more yield for every dollar and that's what's creating that flatness in pricing as well.

And we add this all up. And so the market has remained relatively strong. You know from, it's held up relatively well I would say, but it hasn't remained so strong that it could continue to appreciate in pricing over this period. And so interesting thing about the industrial sector, just to point out in terms of the longer term trajectory. Last year I published an article with Amna and we called it the Discerning Relative Value in Commercial Real Estate. And one of the conclusions of that paper was that as an asset class, if we go back to 2015, we saw that sector break out from the pack forcefully and accelerate away from it as eCommerce became more and more popular, as the trend and the mindset around what the future of eCommerce would mean for the industrial sector. And it's still actually above, it's well above the pack today and it's even still above its own trend.

So what we've seen over the last year, now we've seen the industrial sector down 9%, we've seen cap rates tick up a bit. In my mind it's fair to argue that perhaps we're now reaching the point where some of the specialness that used to be attributed to the industrial sector is beginning to wear off a little bit and it's looking a little bit more mainstream from a go forward perspective. And so let's move on and talk about our industrial strategy because here is where we actually, we start to get into the specifics of what does make sense to us right now. And really in a word we're focused on small bay, light industrial projects. These are potentially both acquisitions and developments. We'll focus on them in locations where occupancy levels have remained relatively high, 95% plus not more in the 94% range that we saw.

And also where we think that new supply coming in does not look to outpace the rate of absorption going forward. And in general, we think there's a lot of factors which make small bay light industrial stand out to us within the broader sector right now. And the first is that its uses are highly relevant to their surrounding communities. When you think about the uses in these small bay industrial properties, they include things like manufacturing, packaging, potentially last mile distribution, and some warehousing. The tenant profiles in these properties include uses such as HVAC vendors, material suppliers, subcontractors. And the formats can vary, but they usually, when we look at these properties, they usually have some office, a little office in them, and they could even contain a small retail component in them from a service perspective oriented.

They're generally more located in infill locations. They want to be closer to their end users. And when we think about size, these are more in the 100 to 300,000 square foot range. They are typically multi-tenant in nature. So that gives us the ability to diversify some of the lease role risk on a go forward basis. And when we look at those users, the HVAC vendors and potentially the contractors, the flooring contractors, we generally see today that they have thriving businesses. They've been in place a long time. They're positioned in a thriving business. Now they view that that location is geographically strategic to them. It might sit in the center of their market service area.

If you have trucks coming and going, you typically want to be about a 15- to 20-minute drive. You don't want to be a 45-minute drive because that takes a material amount that adds up over the course of the day. So these are all factors that play into the decisions of the tenants. And when we see tenants in these buildings, when they seem to be stable, they seem to have a growing business and we view their location as important, we can also see that they have the ability to handle moderate normal increases in rental growth rate over time. And that would give us confidence that we think the renewal probabilities, our market rate are better, and it creates an opportunity perhaps in an acquisition of what we would call a mark to market scenario. Maybe there is some lag in rents that the new owner is going to come in and move towards market over time. And if they do that in a good location with tenants that are thriving, then we think the opportunity for those tenants to stay in place is relatively high.

And so, the final point here is that as a low overall in the sector, we've definitely seen as this slide depicts, a lot of the supply really has been in the larger bulk distribution space. We've seen supply ramp up in a number of markets. They looked really attractive to us, relatively speaking back in 2020, '21. And now we're watching those markets. We do view them as, in some cases, relatively oversupplied. And to the extent that that supply-demand balance and changes, that would be something that we would watch going ahead. Overall, we are watching absorption rates, supply and so forth. Overall, I don't think the market is necessarily on sale at down 9%, but it's on average just a better deal than it was a year ago and that could create some opportunities.

So from here, I guess we're going to move on to some of our closing remarks. And as we do, and we're going to get into Q&A in a second, I thought what was interesting is that to go back and look at our H1 outlook and revisit the four overarching key themes that we highlighted in that outlook in the closing statement that we thought would be meaningful for the rest of the year. The first was reset cost basis. This has been and continues to be a defining theme in how we approach the market throughout the year, today and going forward. We have greater confidence in the future outlook of assets given what just happened in interest rate market and now the beginning of what we think is a loosening cycle, but we're still searching for that reset basis in our acquisitions.

The second thing we called out are more capital calls and recapitalizations. A loosening rate cycle can now potentially provide some relief for certain legacy assets, but overall legacy assets are not out of the woods. We still expect more capital calls to occur and/or the infusion of more rescue capital for many legacy assets and we expect that to continue into 2025. To the extent there's some upside there, I think that in those scenarios, the existing owners in those assets could probably have a bit more optimism over what a refinance or it might look like in 2026 or perhaps what the demand for that asset on a sale basis might look like in the market in 2026. And that's what we see as the upside there. But there's still more pain to come in that sector for legacy assets. It just is what it is.

The third thing we pointed out was the 10-year treasury. Our thesis at the outset of the year was that a 10-year treasury that was sustained at a sub 4% yield could serve as a catalyst for recovery in real estate values. But we now have that arrived. It took until the last couple months or so. But with this interest rate reduction and the guidance going forward, we now think we are in a sustainable sub 4%, 10-year treasury yield range. And I think my previous thoughts on this stand, I think this sets the stage for recovery in asset values.

And the final thing we point out, the fourth thing here, was expect some interest rate relief. So we entered 2024 with the belief that taking Powell roughly at his guidance, namely that we would see 3.25 basis point rate cuts in 2024 that would be weighted towards the second half of the year was a logical approach for the market. The market proceeded to price in six to seven cuts. The pendulum swung by mid-year. We were talking about zero cuts, but right back here at three to four rate cuts in 2024, that will look like roughly 100 basis points from where we entered the year. And so as we move into 2025, I continue to believe that taking Powell roughly at his word is the most logical way to approach the coming loosening cycle. And so that's what we're going to do. And so, with that, I'm going to pass it to Amna and Anna-Marie to cover a few CrowdStreet updates.

Amna Nawaz:

Yes, so I just wanted to let you all know where the market outlook can be found. If you go to CrowdStreet's main website, crowdstreet.com, you'll go to resources and you'll find the CRE outlook under resources. Also, this report also has niche classes, so student housing and self-storage if you'd like to read further. But I'll pass it back to Anna-Marie now.

Anna-Marie Allander Lieb:

Yeah, I just wanted to make sure everybody's aware. We're excited that we have rolled out our new project status reports. Again, many CrowdStreet investors have requested additional insights over the years in terms of ongoing performance of their investments. And with our new project status reports, which can be found in your invest rooms. We're hoping to provide some of this. These reports are going to aim to provide standardization across deals as sponsors are now required to fill out specific data points when submitting their quarterly reports and updates, which is going to help ensure that key data is available for you, the investors, in a standardized format.

These reports are going to include both projected figures and actual outcomes where applicable. So it's going to provide a clear view of your investments performance over time. Also included are new charts for occupancy, NOI and debt yield that will help enable you to easily compare your investments performance across quarters. So we're excited to roll that out. And now, Ian, let's jump into some Q&A.

Ian Formigle:

Okay. All right. So I'm going to start jumping into questions. I may pass them around or may answer them. Let's just roll through them as quickly as possible. We are at the top of the hour, but we're going to go into overtime to get some of this done. First question here from Andreas. Appreciates the scenarios and the impact of the interest rate cut on the hypothetical investment. Unfortunately, majority of his investments still have negative income. Would need 100 to 200 basis point reduction to cover debt service, let alone provide a return to investors. What will happen to those investments? The answer is, Andreas, it depends case by case.

So in those scenarios, this is where I go back to the 2026 example. If the scenario now, if we look at the forward curve, forward curve now projecting that SOFR will trend below 3% to the high 2s by 2026. That would now stand as well over 200 basis points from where we are. And so, in my mind, sometimes some of these assets that have been subject on the downside to the floating rate debt, the question is, can the asset get into 2026 and still be viable? If the answer is yes, then that is the scenario where the asset could now actually get into a positive coverage scenario, that would turn into scenarios where maybe potentially this is not a big return on capital, but it is a return of capital in that range. If a property can now cover its debt, probably has equity in there and there's probably asset value. That's how I would look at it. Really stress in that individual scenario. What does it look like getting from today into 2026? If the operator has a credible business plan for doing it, that's how I think that equity is restored over those ensuing months.

Okay. Oh, Anna-Marie, I'm going to pass this next question to you. This is an anonymous attendee who asks, "Please describe how the Fed's apparent current plans through the end of next year will affect the recent slow rate of new starts."

Anna-Marie Allander Lieb:

Sure. Yeah, I think definitely the proposed rate cuts and then the rate cut that we just saw is going to have an impact on construction starts going forward. Is it going to be immediate? No, it's going to take time for this to work through the market. I think you got to look at it in terms of A, when you look at a loan, there's the rate, but there's also proceeds and lenders still on specifically construction loans still have pretty high standards that are more conservative than what we've seen in terms of proceeds available for costs. So groups that are looking to develop are looking to circle more equity. There's still things along with rates that are going to come into account as we're looking at these new starts.

Similarly, as I discussed, there still is that supply-demand imbalance in many markets. It's starting to shift in some, but we still need to absorb a lot of new units before it's going make sense to be moving into development. Similarly, construction costs are going to be taken into consideration. We're starting to hear from developers out there that they're seeing movement and those are coming down and that definitely is something that we're watching as well. So it's not going to be immediate like, "Hey, we got a 50 basis point rate cut, new starts are now going to start." My expectation is that it's going to slowly start to increase. Ones that have been in the pipeline but have been stalled due to financing may start coming back around and getting looked at again now as financing is starting to ease, but probably more so, it's going to be '25, '26, I think, where we're going to see more of that big uptick and new starts coming.

Ian Formigle:

Yeah, totally agree. A couple of data points to help frame this. Peter Linneman does a good job of tracking multifamily starts over time and relative also to absorption. So if we look back to what was the start of rates or rate starts that would create oversupply short-term in the market, that's when we started to hit 600,000 units on an annual basis. That was too much for the market to absorb and we saw those 600,000 starts concentrated into Sun Belt markets. We saw those markets get oversupplied and now those markets are dealing with low levels of absorption, but they are beginning to absorb.

Right now, in 2024, to Anna-Marie's point, we've seen starts drop off precipitously. So we do have some ability to supply the market, we just can't supply it too fast. So that's why we're going to be taking a look at those markets which markets have are seeing new supply. We're starting to see, even in our deal flow, new supply start to pencil better than it has. So we do expect that it will tick up next year, but as long as it maintains in that three, 350,000 units per year range, we think that's sustainable supply going forward.

So we have a question from Diego and, "In the CoStar chart on industrial development focused on larger properties graph, if I add up the percentage from under 25,000 to 500,000 plus, they do not add to 100%. Why is that?" The answer, Diego, is that you are looking at a percentage. I don't know if, Cyrus, you want to go back to that slide to show it, but on that slide, what we're showing is the amount of stock that has been produced in that size class as a percentage of existing stock. So the point is that chart is not intended to sum to 100%. It's intended to show you that in that 500,000 plus square foot sector, that's how much growth of ... The numerator now is 25%. It's 2.5 over 10 in terms of the supply relative to the existing stock. You have to look at each bar individually. It will not add to 100%. You're showing you what is the rate of supply of that size.

The point of that slide, and the reason why we show it, is that when we say when we've seen supply come in industrial, it really has been weighted towards those bigger bombers, bulk distribution spaces, right? We've seen the growth in stock over the last five years equal to 25% at the top, and we've seen it in low single-digit percentages in the very small projects. The reason that we're really focused in that two 50 and undersized is that you can see that it just hasn't had the same level of new supply as a percentage of existing stock. And so that's why we think there's greater probability of maintaining tenants or to the extent new ones are coming to attract them to your properties because there just aren't simply on a relative basis as many options out there where there are options in the bigger distribution space. So I hope that answers that question. It's not intended to add to 100%.

Let's see. We're going to go... Anna-Marie, I think I'm going to throw this one back to you. It's on the multifamily sector. "From your perspective, how many fixed rate loans versus floating rate loans are you seeing being executed? Are assumable loans still the most coveted and attractive right now?"

Anna-Marie Allander Lieb:

Yeah, sure. So speaking of numbers, probably can't throw those out there, but I think when you think of loans, especially in the multifamily sector, you're typically going to see a floating rate associated more so with bridge financing or construction financing. You're looking at a stabilized asset that's typically going to have a fixed rate through an agency lender. So again, it's looking at is the loans being on acquisitions that are stabilized or again, that value-add construction. So with that in mind, we know construction starts and development is quite hampered right now. There's a lot of lending requirements on that end. So we're not seeing a ton of those loans getting done.

Similarly, maybe not as much on the heavy value-add deals. We're definitely seeing some of those come through with fixed rates, but probably my guess is that some more stabilized fixed rate loans are getting underwritten by the banks. I would say that from our perspective, assumable loans, if there's term left, are still attractive, especially again on that agency sign side. We're seeing assumable debt come through in that 4% range on some deals in our pipeline that we've seen. Whereas if you're getting fresh new debt, that's more so in the 5% range. But I don't know, Ian, if you have some more thoughts there.

Ian Formigle:

No, I think that sums it up. I want to get through a couple more questions here before we call it a wrap. Linda asks, "Does the lowering of interest rates indicate the economy is softening or heading towards a recession?" So Linda, while I'm not a macroeconomist, I think what I'm looking at or scenarios is that Goldman Sachs still today projects the probability of a recession in the next 12 months at 20%. Powell yesterday in his comments noted... His comments were very clear. "Hey, the economy's doing okay. Unemployment is 4.2%. We think it goes to 4.4% by the end of the year, and in their minds, 4.4% is still very close to full employment."

So the Fed reversing course is an acknowledgment from what Powell is saying, and I believe also, is now that we have seen inflation come down close to its long-term target, it no longer needs and feels the reason to keep the Fed funds rate at 5.25 to 5.50. I mean, again, economic principles say if you want to create disinflation, you raise the risk-free rate to above the inflation rate and you'll incent disinflation over time. Now, with the risk-free rate at 5.25 to 5.50, but inflation coming down into the 2s, it's well above the risk-free rate.

It probably trades its stabilization somewhere in the 100 to 150 basis points above the risk-free rate. So now if you want to think about the 10-year treasury, if we can keep inflation in the 2s, probably means that the 10-year is somewhere in the 3s, upwards of 4, but three and a half or so until we get down to 2. Then you might see the 10-year come down closer to 3%. That's our expectation going forward. It really is more of the softening kind of soft landing scenario. I personally don't see a recession coming. I just haven't seen data that supports why we would be scared of something right around the corner.

And let's see. Let's do one more question. Anna-Marie, I'm going to pass this to you. Our thoughts on build-to-rent space.

Anna-Marie Allander Lieb:

Build-to-rent space. Again, I think, we are in a place where affordability for cost of living, especially when purchasing a home is still high. So I think definitely we like build-to-rent as an alternative to those high cost to own. But again, it comes down to understanding the individual markets, understanding the supply-demand similar to other multifamily, and making sure when we're looking at this space that we're A, looking like I mentioned multifamily, but also looking at what we would call the shadow market of single-family homes that may be rented out to make sure that we believe that the demand is there for the product.

Ian Formigle:

All right. We are 12 minutes over the hour. I think we're going to call it a wrap at that point. We've got a few more questions that came in. Thank you, everyone, who submitted them. We will follow up with you individually. Wish we could get to all of them during the webinar, but I think we're at the end of our time slot. I think that's a wrap. I just want to say first, thanks for everyone for joining us today. I hope you found the information helpful. We're obviously reasonably encouraged by what we're seeing today in the market. We do think it's going to take some time to further play out and really materialize into things that actually show up on our marketplace, but we're out there hunting for those opportunity sets that we think are now starting to marginally expand. Pass it over to Anna-Marie, Amna, any last thoughts or comments?

Amna Nawaz:

Thank you all for joining us. Yeah.

Ian Formigle:

Okay. All right. Well, again, thanks for everyone for joining us. We look forward to doing this again in the future. We'll do it for the first half outlook next year, and stay tuned. As Anna-Marie and Amna pointed out, we will put out more content regularly. We have some thoughts. This is going to be a changing, interesting market. There will be things to talk about and to the extent that they occur and we see things that are interesting out there, then we definitely intend to bring those thoughts to you and share our opinion on them. So thanks again for everyone for joining us. Have a great day.