The commercial real estate industry is experiencing a structural reset triggered by steep interest rate hikes beginning in 2022 that have led to sharp repricing across sectors and regions. According to a DavidsonKempner white paper, the U.S. CRE market is seeing record dispersion among the best and worst performing sectors and geographies in rent growth and cap rates.
Since peaking in 2021, asset values have dropped about 18% in the United States, fueled by higher risk-free rates, said the report. Unlike during the Global Financial Crisis, when price decreases were driven by declining net operating income and widening cap rates, the industry today is experiencing growth in NOI and compressed cap rate spreads. Construction costs are rising due to inflation, tariffs and immigration restrictions, while replacement costs are elevated due to the higher cost of capital. These dynamics will slow new development activity, which should support continued rent and NOI growth, according to the report.
Industrial has been the top-performing sector since 2020, with an annualized return differential between the top and bottom 50th percentile of 12%, while office has been the worst-performing sector with a differential of -4%. Even within sectors, performance can vary significantly. For example, California’s Inland Empire industrial sector had a 15% differential, while Chicago’s differential was 9%.
Sector selection has become a more powerful differentiator for CRE investors since 2020 than market selection, according to the report. The differential between top and bottom sector performers in the past five years is about 12%, more than twice the historical average.
“In such an environment, we believe a nimble CRE investing mandate supported by deep research is crucial to capture alpha opportunities,” said Davidson Kempner.
With the cost of capital expected to remain elevated, the firm said it believes the most compelling CRE returns will come from asset selection, entry price optimization and the operational know-how to drive excess income growth and maximize free cash flow.
But sector selection can be a moving target. Since 2012, the best-performing sector has shifted from self-storage to industrial to data center, with the second-best performing sector varying among multifamily, retail, senior housing and self-storage. In today’s high-interest-rate environment, the firm expects sectors with excess demand to be able to capitalize on a supply/demand differential for longer, and sectors with high occupancy and supply/demand imbalances will be best positioned to drive rent growth.
Greater cap rate dispersion is typically observed during periods of high interest rates as sectors with strong supply/demand differentials benefit from increased rent growth and investor capital flows, according to Davidson Kempner. The current cap rate dispersion is near or at the 25-year high, with industrial at the 94th, hospitality at the 98th and office and retail at the 100th percentile. Multifamily is an outlier due to its relative stability, government-supported financing markets and long-term structural factors such as underperforming supply.
The firm attributes the current wide cap rate dispersion to increased sector and market performance dispersion, which has resulted not only in elevated interest rates, but also rapidly evolving structural and secular trends, including increasing demand for distribution centers as e-commerce becomes ubiquitous, the reshaping of office use due to the pandemic and the growth of data centers fueled by a surge in artificial intelligence.
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