Trends that will impact real estate funds this year

We discuss five trends that will have an impact on real estate funds and investment throughout the year.

Executive summary

• With a new year upon us, we see some key trends that will affect real estate investment activity.
• Current trends shaping the industry include increasing sustainability compliance requirements, new investment technologies and a historic election.
• Some possible tailwinds include easing inflation and lower interest rates.

To prepare, companies should focus on the process of collecting and analyzing the data; evaluate existing board oversight and risk management over environmental, social and governance (ESG) risks to determine whether any changes might be appropriate in advance of reporting on these processes; and evaluate existing oversight and risk management over ESG risks to determine whether any changes might be appropriate in advance of reporting on these processes.

A focus on investment advisor fees and expense practices

Real estate fund managers have heightened risk factors related to affiliate fees and expenses as these advisors often utilize affiliated personnel and companies to provide a variety of services to real estate investments under management. The SEC recognizes that real estate investments require specialized services (e.g., property management, leasing, asset management) for which fund managers may have relevant, in-house expertise. In some cases, affiliates can provide specific services more effectively and economically, compared to an external service provider. However, given the increasing use of affiliates by real estate fund managers and the significant growth in real estate funds in recent years, the SEC continues to expand the number of real estate investment advisor examinations with a primary focus on fairness of affiliated pricing arrangements and appropriate disclosure of conflicts of interest arising from affiliate arrangements.

In response to the SEC’s increasing focus on transparency around affiliate fees and expense reimbursements, real estate investment managers should ensure that adequate policies and procedures are in place to regularly confirm affiliate fee structures, perform analysis (e.g., benchmarking) to validate fairness of pricing and ensure that appropriate controls are in place to identify and disclose new and updated arrangements.

Due to the lack of published surveys on real estate services pricing, there can be difficulty in obtaining market pricing for a wide range of different real estate services across a range of real estate asset types.  Often, this information is obtained through a fee survey, where current market pricing (including both fee structure and allowable reimbursable expenses) is gathered from third-party service providers. Surveys are generally performed annually or biannually and typically account for asset type and geographic differences in pricing. Investment managers can, in turn, leverage the fee survey results for both internal market intelligence and investor reporting purposes. Investors often seek to understand whether the nature of arrangements with affiliates are market-based before placing capital with an advisor. Furthermore, real estate fund documents often require that an independent market study be performed on a periodic basis to ensure that related-party fees continue to be structured at market terms.

The elections will have an impact on real estate investment

While the US presidential election will take center stage, 2024 will be a pivotal election year, as all 435 House members and 34 Senate seats will be contested. A number of economic issues will be decided, including tax policies, budgets and various government funding. Additionally, policy on clean energy regulations will also be debated before the elections. Robust consumer spending throughout 2023 has helped keep the economy stable; however, time will tell if wallets become tighter due to cost fatigue and tighter credit. 

Other forces that will affect the US economy are the continuing war in Ukraine and conflict in the Middle East. The current administration has sent aid to help keep those country’s governments running and address their humanitarian needs. Looking forward, there is additional global trade tension including issues facing container logistics in the Red Sea.

With the Federal Reserve continuing to a show tight monetary policy, the economy continues as one of the most important issues facing the country. In the last meeting of 2023, the Fed kept the federal funds rate unchanged at 5.25%-5.50% while signaling peak rates. If progress is sustained, lower inflation will favor policy recalibration in 2024. The labor market ended on a strong note, with the unemployment rate falling to 3.7%, which may give some pause to reducing interest rates during the front half of the year. However, according to EY-Parthenon Chief Economist Gregory Daco’s forecast, the unemployment rate will likely rise during the year. In turn, the Fed is expected to cut interest rates later in 2024 for the first time since 2020.

Investors need to plan for a wave of loans maturing

While the American economy has slightly improved through the second half of 2023, interest rates remain elevated, which continues to pressure the real estate market. This has caused the total CRE transaction volume to fall sharply compared with last year. Capitalization rates across most asset classes have increased through most of 2023 as investors perceive greater risk in CRE.

Looking into the new year, borrowers are hoping for a decline in borrowing costs as EY analysis points to approximately $1.5 trillion of commercial loans maturing between now and 2025. According to the EY article How Buyers Should Position To Win Distressed Real Estate Deals, the overall share of asset exposure to CRE is 26.3% for regional banks and only 6.8% for the larger banks. Due to lower asset values and heightened risk, some properties coming up for refinancing today may have trouble obtaining a new mortgage sufficient to replace the one that is maturing. With interest rates remaining elevated over the near term, banks are working toward a range of outcomes with borrowers, including loan extensions and modifications. Heading into 2024, there are concerns, including increasing bond yields; however, there are also some reasons for optimism, including interest and inflation rates staying steady.

With occupiers continuing to utilize hybrid work, demand for office space has been softening, resulting in higher vacancy rates and higher volumes of sublease space. These trends are notably evident in older, Class B office properties. However, according to the third annual EY Future Workplace Index, while the hybrid work model is still being used across all industries, we are seeing a large decrease in the amount of fully remote workers. This trend is good news for the corporate real estate sector, which is targeting growth in both the demand for office space and its utilization.

To navigate the uncertainty ahead, owners of impacted real estate assets must plan ahead for multiple possible outcomes. There can be multiple consequences of potential actions, including legal, financial, valuation and tax outcomes, that could all affect asset portfolios, which all must be carefully vetted, with various scenarios thoughtfully considered. Most importantly, keeping the lines of communication open is an essential factor for success. Lenders, borrowers, occupiers and investors must work toward mutually beneficial outcomes to optimize the interests of all parties involved.