Q&A: The Macro Regime Shift Driving Commercial Real Estate in 2024

• While a slowdown may still be in the offing, 2023’s “recession obsession” has not panned out. In fact, growth is accelerating, and inflation is still high if cooling. What did prognosticators miss? The scale of global investment needs, for one – related to the green energy shift, supply chain adjustments, and defense spending – and the lagged impact of fiscal stimulus, especially in the US.

• We believe interest rates will not return to the lows of the previous cycle. US rates will perhaps settle around 3.0%-3.5% (versus 5.5% now). Rates in Europe could go a bit lower than that, but the era of free money is over.

• As long as yields remain high, institutional investors can meet their return objectives without taking on as much risk; thus, we expect them to continue gravitating toward fixed income and credit in the short term. Once yields have normalized lower, we believe the need for higher-risk assets will resume, which could set the stage for a recovery in real estate and other risk assets.

Marc Mogull: We had a conversation this time last year where we spoke about a regime change post-pandemic and the implications of that. So, how did that pan out? And how did we do?

Hani Redha: So far so good in terms of what we thought was going to happen and how it’s played out. Not so far so good in terms of returns in markets. But at least we anticipated what was going to happen and positioned ourselves accordingly.

You’ll recall, we saw clear signs that we were going through a major regime shift from the last cycle, which was the one starting after the financial crisis and extending all the way up to the pandemic – and was characterized by low growth, low inflation, low rates, low, low, low – to pretty much the opposite of that. And that’s what we’ve seen.

This time last year people were expecting a recession. There was almost a “recession obsession,” at least in my corner of the markets. But that never panned out. In fact, we’ve seen an acceleration of growth. The US last quarter had above-5% GDP growth. That’s an insane level of growth. Inflation has come down, but it’s still high, and central banks have jacked up interest rates.

Mogull: It’s funny you talk about it as an obsession. I remember a story that said there was a “100% chance of a recession in the US in the next 12 months.” So, that “100%” was clearly the wrong number. But what are the key drivers that so many people missed, and why do we think they’re going to be with us for several more years?

Redha: There are a few. First, there are some large-scale investment needs going on in the world that were not there in the last cycle. Think about things like the green energy transition. This is fully underway now. Trillions will need to be spent. We’ve got companies restructuring their supply chains because they realize it’s too risky to be so concentrated in China. All that needs to be built out. And we’ve got a lot of defense spending, unfortunately, that also needs to happen. All these things will absorb capital and lead to higher growth as they’re built out, and to higher interest rates because there’s now a real cost of capital.

And there’s another factor that has become very prominent in our thinking, and that’s fiscal policy. Why didn’t we get a recession that was ‘’100%’’ sure? A lot of it, especially in the US, came down to a huge amount of deficit spending through programs that the government put in place to stimulate the economy and invest in infrastructure. All good stuff. But it’s come at a time when inflation was already high. The central bank was putting its foot on the brakes, trying to cool the economy down. Meanwhile, the federal government was slamming its foot on the accelerator. And when you pump that much growth into the economy, it's hard to create a recession.

Mogull: Let’s flip to interest rates. Talk me through the rate outlook for the next 12 to 24 months.

Redha:  One of the main takeaways from this regime change is that interest rates are not going back to where they were in the previous cycle. In the US, for example, we could end up at around 3.0%-3.5%. We’re at five-and-a-half percent now. So, we have some room to cut, but the era of free money is over.

Mogull: How much latitude do the Bank of England and the European Central Bank have in their ability to diverge from that? Or has the Fed kind of become the central bank of the world?

Redha: That’s a tough one. It’s a self-correcting mechanism where the BoE and the ECB cannot deviate that far from what the US is doing, even if the US has faster growth. Because otherwise their currency weakens. Then that creates inflation and forces them to increase interest rates anyway. That said, in Europe, rates will stay a bit lower. What that means, I think, for our markets, is that eventually there will be more of a ‘’search for yield’’ phenomenon than in Europe.

Mogull: I often use the expression that real estate is a hybrid instrument that has fixed income and equity features. So far, we’ve mostly talked about the fixed income-like perspective. So, what are some of the observations you’d make about equities that at some level drive our sector as well?

Redha: Keep in mind that on the whole growth is going to be more robust over the full cycle ahead. Things are just less fragile. That said, right now we’re at the top of the monetary cycle. The central banks have rapidly increased interest rates, and the lagged effects of those rate hikes are still on their way, still pushing growth lower and inflation lower towards its target. And that’s not a great setup for equities in general, and especially equities that are more sensitive to interest rates, like cyclical types of equities. But once that adjustment process is over, I think there’s a lot of bright light at the end of this tunnel. This is going to be a world where growth is healthier. Yes, it comes with higher interest rates, but it’s backed up by higher cash flows. It’s a no-pain, no-gain situation. The pain yesterday and today is going to create nice gains later.

Mogull: One more question: You spend so much time with investors. What are you picking up in terms of their risk appetite?

Redha:  Even if they have appetite, institutional investors know they can hit their return objectives right now without taking as much risk as they did before. So, we see them gravitating towards fixed income and credit – to begin with. But we don’t think yields are going to stay this high. When yields are this juicy, they become irresistible and get eaten up pretty quickly. After yields have normalized lower, we think the requirement to go into higher-risk assets will come back. At the same time, by then we think that this next slowdown phase – which could end up with maybe a mild recession – would also be behind us, and that sets you up quite nicely for a risk recovery.

Mogull: Brilliant.