The Gap Between CRE's Winners And Losers Keeps Widening

While high demand and constrained supply have boosted returns for some commercial real estate owners, the underperforming property types and locations are falling further behind. 

The difference in values across CRE sectors and geographic markets is experiencing the highest levels of dispersion since the 1980s, according to a new white paper from Davidson Kempner Capital Management.

With higher interest rates, inflationary pressures and supply-demand imbalances, some sectors are seeing rising income, but many CRE investors are feeling financial pain. 

“In a higher-interest-rate environment, you should expect higher absolute levels of rent growth,” said Josh Morris, partner and head of global real estate at DKCM. “But in addition, you should expect more of a rent growth differential between winners and losers.”

The repricing of commercial real estate values that began with rising interest rates in 2022 represents a “structural reset,” according to DKCM's white paper.

Higher construction costs and borrowing costs have led to a development slowdown that has created greater returns for owners of assets in areas with high demand but supply constraints. These could fetch higher returns than they have in decades, DKCM predicts.

But the difference between those winners and the worse-performing sectors and locations has widened. The divergence of returns follows trends that emerged in 2015 and that have only grown more dominant since, reaching highs unseen for the last 40 years, DKCM found.

“There's been greater dispersion in a post-Covid world,” Morris said.

Overall real estate values have fallen from their 2021 highs by around 18% in the U.S. and by 22% in Europe, according to Green Street.

This change in asset values isn’t a blip, DKCM’s white paper says. Instead, it predicts the trend will continue over the next five years — even for asset classes seen as healthy, said Suzanne Gibbons, the firm's head of research. 

“Rapidly evolving structural and secular trends have caused greater dispersion between sectors and rates just amplified those differentials,” she said in an emailed statement. “As those differentials have become clearer, investor capital has followed, and cap rate dispersion has been created.”

Persistently sticky inflation and fiscal deficits mean that borrowing costs and 10-year Treasury yields will likely remain higher for longer, DKCM predicts. Meanwhile, a blend of political and macroeconomic factors, including labor inflation, supply chain disruption, deglobalization trends, tariffs and changes to immigration policy, mean deliveries are poised to slow over the coming years. 

That combination of factors will further boost rent growth for in-demand assets while keeping cap rate spreads in a fairly tight range, but it will likely exacerbate differences in investor returns, according to DKCM.

Returns on industrial assets are up by 12% over the last five years, while returns on office were down 4% over that period. 

The firm also found dispersion among the same asset class across different markets. Industrial properties in California’s Inland Empire saw a 15% increase on returns over the last five years, while returns on Chicago’s industrial properties grew by 9%.

Although there may be a floor to how far the lowest-performing asset classes can fall, these dispersions will continue and likely widen, Morris said. 

“If it's the case that you have higher rent growth in periods where you have higher interest rates and you therefore have more likelihood of a sector continuing its outperformance, when you put those together, those sectors that have strong supply-demand tension, you will ultimately have this continuing outperformance,” Morris said.

Opportunities exist for investors that can acclimatize quickly and deploy capital on properties that are selling at a discount, especially in markets where demand is high and supply is low. That combination will become the biggest driver of excess returns, according to DKCM.

“In the higher-interest-rate environment, that complexity is more likely to rise to the surface and create more situations where you're able to buy assets below its as-is value,” Morris said.

Investors that put cash into asset classes like industrial, data centers, self-storage, senior housing or retail may have seen their returns outperform the overall U.S. CRE market by between 13% and 17%, according to DKCM.

That isn't lost on REITs, which are already sniffing around for opportunities to buy below market value, zeroing in on asset classes including senior housing and industrial where demand is significantly higher than supply.

Data centers are another real estate asset poised for staggering rent growth, thanks to demand from tech firms building out artificial intelligence infrastructure, DKCM’s experts said. Data center demand is six times higher than it was in 2021, with the limited availability of capital acting as the sector’s only obstacle to further growth.

“We believe that between now and 2030 that demand will triple from here,” Morris said. “We believe that that demand is quite sustainable, based on the combination of demand growth from AI cloud computing and large language model development.”