Positive sentiment in commercial real estate is starting to build. Interest rates began to fall in the second half of 2024, transactional activity started to stabilize and tentative signs of asset-value growth returned to some slices of the market. But the recovery is still nascent and not everywhere all at once.
The recent market correction had been fueled by a mix of the familiar cyclical factors like rising rates and a reversal in overheated yield compression but compounded in some areas of the market by more serious and potentially longer-lasting structural factors like the change in office use. The move into a more sure-footed recovery will depend on several factors that may see some segments of the market race ahead while others lag for a potentially extended period, presenting both opportunities and risk for investors.
Historical and current weakness in the more traditional commercial-property markets of office and retail, combined with structural technological and demographic tailwinds for other markets, will continue to encourage some investors to tilt their portfolios further toward emerging property types. Meanwhile, other investors will see a value opportunity to get exposure to those more traditional sectors at cyclical lows. The combination of debt-refinancing stress with the structural weakness of commodity-office assets will continue to drive price discovery in that market.
In any event, it is likely that investors will not have significant yield compression at their backs and will need to drive returns through active management and selection. Market turning points are characterized by elevated dispersion in asset returns, and in such an environment, understanding the key factors driving performance through attribution will be vital.
If investors didn’t have enough to worry about with market-based risks, geopolitical and economic uncertainties persist, and the specter of climate risk has not gone away. The global economy is drifting further away from its net-zero targets, adding to concern that weather events induced by climate change will become more frequent and severe.[1] Such concern was heightened by multiple extreme-weather disasters globally during 2024.
1/ Recovery — not everywhere all at once
Two years on from the start of the slowdown in mid-2022, the global property market moved into a recovery phase in 2024, as transaction volumes and values bottomed out and interest rates peaked. In 2025, lower interest rates should allow buyers and sellers to move closer together on pricing, meaning liquidity will continue to improve from the current low levels. The recovery is in its infancy, however, and investors are more selective with regard to where they want exposure to real estate and the route to market.
Investor preferences remain focused on the living sector and industrial assets, as well as properties exposed to broader socioeconomic and technological shifts. One of 2024’s biggest deals was Blackstone Inc.’s USD 16 billion purchase of pan-regional data-center operator AirTrunk, and demand for assets like data centers and new energy infrastructure will blur the line between traditional commercial property and infrastructure.
Fundraising for property investment remains challenging, however, with distributions from closed-end funds stalling due to low deal activity. Moreover, the continued emergence of private credit and the outperformance of debt versus equity funds means debt has become a preferred route to market for many investors.
While the market has not yet been through a major distress cycle on par with that after the 2008 global financial crisis, distress levels have continued to grow. This may aid the recovery by providing opportunities for well-capitalized players to acquire assets at a discount. Unsurprisingly, data shows that the best-performing fund vintages tend to be those formed in the immediate aftermath of a market correction.
Office and retail have become dirty words for many investors as shifting preferences have meant huge value destruction for these property types. That revaluation is starting to tempt back some players, though, and there are pockets of outperformance in both markets. It is highly unlikely that aggregate deal volumes will return to their long-term average for these property types in the near future, however.
2/ Investment pendulum swings back to asset selection
As we enter a new investment cycle, industry conversations are increasingly focused on shifting performance drivers and the heightened role of active asset selection and management. The challenge for investors is clear: With market conditions evolving, the playbook for delivering returns is changing.
Picking the right assets has always been crucial for investors in commercial real estate. Every property is unique and, unlike in public equities, investors cannot buy the market. As such, investors must carefully balance top-down allocation strategies — determining exposure across geographies and property types — with the granular, bottom-up asset-selection and asset-management decisions. The interplay between these two approaches has grown increasingly complex as the real-estate market becomes more dynamic, influenced by macroeconomic shifts, technological disruption and evolving tenant demands. Understanding the drivers of performance — whether stemming from strategic allocation or asset selection — is paramount for investors seeking to optimize returns.
Attribution analysis can provide insights into the evolving nature of performance drivers in a rapidly changing environment. Evidence from the MSCI/PREA U.S. ACOE Quarterly Property Fund Index highlights this variability: Historically, selection accounted for around 63% of the deviation from the benchmark among funds, but the relative influence of allocation and selection has shifted over time as market regimes have changed.
As the real-estate market stabilized following the 2008 global financial crisis and its aftermath, secular trends such as the retail apocalypse and the (later) shift to remote work elevated allocation’s importance, with sector strategies shaping outcomes. The pendulum now appears to be swinging back toward selection, however. In today’s environment of higher interest rates, with less support from capital markets, fundamental asset-level performance has become a key focus for many investors. Without yield compression to drive growth, the unique attributes of individual assets are critical.
3/ Underwater assets come to light
Ongoing price declines and a regime of higher interest rates put in doubt the ability of some borrowers to repay or refinance their commercial-property loans. Concerns about borrowers and their lenders are global. In Europe, property prices and values have undergone substantial corrections since mid-2022, meaning that many properties sitting on investors’ books will likely be worth less than they were originally acquired for, especially those bought close to the peak of the market in 2021. When asset values do not meet or exceed loan obligations, prospects for refinancing become grim.
In the U.S., we estimate that nearly USD 500 billion of loans are set to mature in 2025 (based on data as of the end of Q3 2024). We marked to market each asset using our hedonic price indexes and found that if these loans were to mature at Q3 2024 price levels, approximately 14% would be flagged as underwater, meaning their current asset values have fallen below the outstanding loan balance.
U.S. offices will likely face the bleakest prospects for refinancing in 2025. Nearly 30% of maturing office loans, or approximately USD 30 billion, is associated with properties estimated to be worth less than the debt secured against them. The apartment market has USD 19 billion of properties worth less than the loans associated with them, accounting for 10% of maturing 2025 loans in that market. Given that loans made during periods of low interest rates and high property valuations are particularly vulnerable to asset-value shortfalls, it should come as no surprise that nearly 70% of these apartment loans have 2022 origination dates, when apartment values were at their peak.
4/ Investors get to grips with physical climate risk
Extreme weather events, which can negatively affect the value of real-estate assets through higher insurance premiums as well as repair and disruption costs, are predicted to become more common.[2] But is the risk being priced accordingly given the potential costs?
We examined data from the MSCI Real Capital Analytics transaction database to explore the relationship — or lack thereof — between transaction yields and physical climate risk, using the MSCI Climate Value-at-Risk Model. An analysis of multifamily properties located in the Southeast U.S., a region prone to extreme-weather events, found only a marginal spread in transaction yields between apartment properties with a high or very high physical climate risk and those with a low or medium risk.[3] Indeed, higher-risk assets traded at a premium to those deemed to be at lower risk.
As climate risks intensify, pricing should adjust to reflect the increased risk to property values from greater exposure to extreme-weather events. Therefore, the current market imbalance — where high-risk assets offer yields on par with lower-risk properties in a region susceptible to physical hazards — will likely not last indefinitely, especially as insurance costs continue to rise for higher-risk assets.[4] But investors can get a head start by factoring in the growing impact of climate-related risks on property values and reshaping portfolios to reflect the threat from extreme weather.
5/ Property investors seek a ride on the AI train
The rapid development and democratization of AI, through the development of tools like ChatGPT, has major implications for property. One is an explosion in demand for data centers to power this emerging technology.[5]
One of the biggest commercial-property deals in 2024 was Blackstone’s aforementioned acquisition of data-center operator AirTrunk. Moreover, billions of newly committed capital is targeting the development of new data centers, including GIC’s USD 15 billion joint venture with operator Equinix and BlackRock’s USD 30 billion AI partnership alongside private-equity firm Global Infrastructure Partners, Microsoft Corp. and sovereign-wealth fund Mubadala.
The rise of AI has resulted in not just an explosion of demand for data centers, but a different type of data center that features rack densities much higher than those targeted at cloud computing. In addition to computational intensiveness, these data centers are also capital-intensive.
The result of these changes is that the investment landscape for data centers is changing rapidly, with generalist property investors competing with the traditional infrastructure investors active in the sector. The arrival of this new wave of real-estate investors has brought with it a greater diversity of deal structures, such as those separating operator-focused “opcos” from the real-estate owning “propcos.”
Getting real-estate investors comfortable with this asset class has profound implications for the tradability of these assets and knock-on impact on market liquidity. In many mature markets like the U.S., U.K. and Japan, transaction yields have compressed significantly over the past 10 years, and as of today stand in line or even below the likes of traditional markets like industrial and offices. A similar trend is happening in markets at an earlier stage of the curve like those in continental Europe and Asia-Pacific.
Investors should be aware that the data-center market has its own set of idiosyncratic risks. For one, operating a data center requires many considerations and expertise that are unique to the asset class. Data transparency is also much lower than that for traditional property types, with information on rents and transaction yields typically harder to come by. Therefore, investors with a longer history in the sector, as well as those with a bigger portfolio, have a substantial informational advantage over new entrants.
The authors thank Benjamin Chow, Niel Harmse, Alexis Maltin, Benjamin Martin-Henry, Lynette Ng and Bryan Reid for their contributions to this blog post.
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