Presented By: Kasowitz Benson Torres LLP
Morgan Stanley Exec Says Certain CRE Sectors Show Promise Despite Overall Headwinds
To evaluate the current and potential strength of the commercial real estate market, we must first acknowledge that CRE is not a monolith. It is an industry with different markets, asset classes, and even individual assets with divergent fortunes and promise, and a true analysis of the industry must recognize these key and massive differences.
This was just one of the significant takeaways from a conversation just released on video between Jennifer Recine, co-head of real estate litigation at Kasowitz Benson Torres, and Lauren Hochfelder, co-CEO of Morgan Stanley (MS) Real Estate Investing.
The discussion, which occurred at the recent Commercial Observer Spring Finance CRE Forum held at the St. Regis New York hotel, began with Recine asking Hochfelder for her thoughts on the industry’s prospects for the second half of 2023.
“We’re in a meaningful period of dislocation,” said Hochfelder. “We’re seeing risk and asset values repriced before our eyes, and I think that’s true across the entire investible universe and certainly across all of private real estate — every sector, and virtually every global market.”
But even with this massive level of dislocation, attempting to forecast the year ahead requires differentiating across CRE and “bifurcating between what is cyclical in nature and what is secular,” Hochfelder said.
The conversation then turned to individual asset classes, starting with U.S. office where, Hochfelder noted, utilization rates nationwide still hover around just 50 percent.
“The U.S. office sector is facing real cyclical challenges, economic softening, big tech layoffs, etc.” said Hochfelder. “But the reality is, what’s more powerful are these tremendous secular headwinds. Office, or real estate generally, is just a derivative as to how people use space. And the reality is, these hybrid working pressures have been stickier than I think any of us expected, and that’s material in terms of the long-term outlook.”
To emphasize her point about bifurcation, Hochfelder then noted that, doomsayers aside, she is far more bullish on other CRE asset classes such as industrial.
“This is a space that has the dual secular demand drivers of e-commerce growth and a supply chain reorientation,” said Hochfelder. “Greater focus on supply chain resilience and diversification of the supply chain increases aggregate demand for industrial space over the long run.”
Which is not to say that industrial is immune from current market forces, Hochfelder noted, just that its prospects seem to greatly exceed that of currently weaker sectors such as the office market.
“Is industrial immune from interest rate increases or economic softening? Of course not,” said Hochfelder. “Several of the factors that are weakening office also have to impact industrial. And frankly, the weakness in office, by virtue of how it affects banks’ balance sheets and capacity for credit, will also affect other asset classes. But the long-term demand drivers are still there. So even when you get cap rates gapping out, you can still have NOI that grows in excess of inflation and supports asset values.”
Recine followed this by asking if distress might lead to genuine opportunities for CRE investors.
Hochfelder believes that wherever you see this sort of asset value repricing and capital retreating, opportunities will arise. She also noted that the point is not to chase “value traps,” but rather to acquire the highest-quality assets with the longest-term value drivers. By way of example, she notes that Morgan Stanley has taken to acquiring repriced core industrial assets.
“Where we can buy really high-quality assets below replacement cost at substantial discounts to what they would’ve priced at in the first quarter of last year, we find that really interesting,” said Hochfelder. “We’re able to do that because many of the traditional buyers of those assets, be they open-ended core funds or public REITs or what have you, are sidelined for their own structural reasons. So we’ve been able to step in, at times over-equitizing those investments, but buying really high-quality assets at attractive bases.”
The conversation then turned to multifamily, which Hochfelder conveys tremendous optimism about long-term. Acknowledging the global housing shortage in general, she also said that there are markets where housing has been over-supplied, again emphasizing the need to bifurcate in any analysis between various markets and housing types. Between this and the COVID-driven migration from cities to suburbs, plus the different types of housing prevalent in each, it’s impossible to discuss multifamily without breaking it down by myriad essential factors.
The conversation then shifted to hospitality, with Hochfelder dividing the discussion between leisure and business.
“Business hotels are still experiencing real headwinds, but for leisure we’re experiencing a real rebound in travel,” said Hochfelder. “And while economic softening will surely impact that to some degree, the travel rebound feels very real and should propel RevPAR growth, which should propel asset value appreciation.”
Hochfelder also mentioned that shorter duration assets like hospitality or residential are best equipped to minimize the negative effects of inflation due to their ability to “reset your top line as quickly as possible in response.”
When Recine then asked Hochfelder what lessons we can take from prior market cycles, Hochfelder responded that her business has evolved over the years to increase its focus on long-term investing, and across their funds to invest in the sectors and geographies that have the longest term demand drivers.
They concluded the discussion on a optimistic note, with Hochfelder, reflecting on what’s happening within Morgan Stanley, saying she sees a potentially bright future ahead for investors with a keen eye on the market, even with unpredictable changes ahead.
“Generating outsized income growth for our assets [requires] betting on the right segments of the economy — sectors that we think have long-term secular tailwinds,” said Hochfelder. “That involves picking the right markets that have outsized growth because of migratory trends, demographic trends, etc., and picking assets we think are going to outperform or that we can asset-manage relentlessly to create that value. When your north star, so to speak, is growing income in the underlying assets, you can invest in any market environment and any rate environment. Given that’s always our biggest focus, it’s an exciting moment for us.”