Not Game Over, Just Different Rules: Reflections on the Real Estate Trends of 2023

In early 2023, Michael Kovacs embarked on a world tour. His schedule took him to Asia, the Middle East, Europe and the US in the space of a few weeks. While the travels took a toll on his body clock, they did give Mike a good opportunity to speak to investors across global markets and plenty of time in airport lounges to reflect on what they’d told him.

Only a few months earlier, back in late 2022, the global economic outlook had looked bleak. CEO confidence had sagged to near 40-year lows. Equity markets had just been pummelled by interest rate hikes. And with winter approaching in Europe, fears of energy shortages had intensified, as the war in Ukraine continued to drag on. The mood among investors was decisively negative.

Fast-forward to Mike’s trip at the start of 2023, however, and the picture had shifted dramatically. By January, Goldman Sachs was bullish in its outlook for 2023, with other major banks following suit and issuing similar predictions. While the first few months of the year would prove difficult for firms overexposed to long-dated assets (like Silicon Valley Bank and Credit Suisse), widespread financial distress never materialised, and equity markets rebounded.

As sentiment improved, institutional investors were relaxing their defensive postures and now looking to deploy capital once again. At the same time, however, it was clear—as Mike heard repeatedly during his meetings—that the rules of the investing game had fundamentally changed. On the back of a 500-basis point rate hike by the Fed, investors increasingly recognised that, going forward, they would no longer be able to make their returns by relying on the same strategies that had worked in the decade prior.

For one, the carry trade is not a viable strategy in a world where borrowing costs are now meaningful. It’s no longer possible to pay in 3-4% for an Amazon distribution centre, or a gateway office HQ or a city centre multifamily block, and then use leverage to get to a 6-8% cash return: either the now-shorter lease length reprices, a refinancing prevents positive leverage, or a general movement out in interest rates causes cap rates to move out.

Likewise, it will be more difficult to generate returns through broad, macro-driven bets on entire sectors. Higher interest rates will force investors to make tougher choices about how to allocate scarce capital, making them less inclined to plough cash into mediocre assets in high-growth sectors. Not every industrial property inside the M25 works for logistics, and not every shiny office building in Cambridge works for life sciences. As markets pay more careful attention to these differences, real estate investing will become more situational. Good and bad assets will exist across sectors and geographies, and investors will need to comb through markets to find the winners.

To achieve attractive returns in a more situational market environment, real estate investors have two options: (1) add value or (2) operate.

On the one hand, investors might accept that a larger share of their total return will now have to come from capital value growth rather than current cash yield. This means taking on value-added risk through specialist repositioning of a building or rent roll. Alternatively, investors could move some deployment away from lower-yielding, bond-like investments in core assets into more operationally intensive sectors that provide higher yields but have a higher degree of NOI volatility (like hotels or flexible offices).

Both strategies will require investors to take on greater operational or development risk. Under these circumstances, vertically integrated private equity firms like Castleforge are particularly well-positioned, with our operating capabilities and asset-management expertise. In short, amid sweeping changes to the old rules of real estate investing, we see compelling opportunities ahead.

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