What You Should Know About Blackstone Turning Bullish on Real Estate

There’s no way to ignore the stock market’s precent progress. Year-to-date, the market is up approximately 11%. That brings the trailing 12 month return to 26%. And that’s excluding dividends.

This impressive move is led by technology and communication service stocks, which are up over 20% in the past two quarters.

Both sectors have benefitted from the ongoing bull market in artificial intelligence (AI), with two companies standing out especially.

Since 2024 began, NVIDIA (NVDA) has advanced 128% and Super Micro Computer (SMCI) has gained 175%.

That’s the good news so many investors are focusing on. But there is bad news too. It’s important to recognize that the S&P 500’s price-to-earnings (P/E) ratio is now at 21x…

Which is 1.3 standard deviations above its 30-year average – and its third-highest valuation since at least 1994, according to the JPMorgan data below.

Fortunately, not everything is overvalued. Using State Street data, we see that three sectors remain attractive on an absolute basis: energy, real estate, and utilities.

‍

Take real estate, for example. When we look at last-12-month (LTM) earnings, next-12-month (NTM) earnings, price-to-book value, and absolute valuation composite score, we see favorable valuation z-scores. If you aren’t familiar with all these metrics, that’s okay. Each one uses different financial metrics to gauge if a company or sector is a good deal relative to the past.

I’ll explain how a z-score works. It denotes how many standard deviations away from the mean, or historical average, a data point is. Standard deviations follow the 68-95-99.7 rule.

One standard deviation includes 68% of past results. That’s a z-score of -1 or +1 depending on which side the data point falls on. Two standard deviations from the average include 95% of expected results. Now you can see why a data point outside of two standard deviations is rare. That only happens 5% of the time and includes circumstances when the investment is very expensive (-2 z-score) or very cheap (+2 z-score).

A z-score of +2 in the below chart is what we are most interested in. This score means it’s only been cheaper 2.5% of the time (the other half of the 5% is for the curve beyond -2).

Several scores for real estate and energy are above 2. That indicates these sectors are trading at a steep discount compared to historical averages.

This relatively attractive valuation makes sense since the Vanguard Real Estate ETF (VNQ), a real estate index proxy, peaked in 2021. The chart below compares it to the iShares 20+ Year Treasury Bond ETF (TLT), which gained downside momentum in 2021 thanks to accelerating inflation.

‍

The Federal Reserve’s decision to start hiking rates the following year only made it worse.

But buyers are now returning, including some of the world’s biggest asset managers. On March 14, for instance, Bloomberg interviewed Blackstone (BX) President John Gray, who made the case that real estate prices are bottoming.

“The perception is so negative and yet the value decline has occurred,” he explained. “So when you get into this bottoming period, that’s when you want to move.”

In other words, he’s expecting to see great properties start selling on the cheap. Very cheap.

Gray is referring to physical real estate in these comments. Publicly traded REITs may benefit from the same tailwinds since the underlying assets are the same. But there are significant differences between buying real estate at cost in the private markets versus buying publicly traded REITs that are more sensitive to ups and downs of the stock market.  

‍

Blackstone may be onto something about brick-and-mortar buys since commercial real estate (CRE) fundamentals are weakening. The way he sees it, there hasn’t been strong competition to buy discounted assets so far. But he expects to find a strong need for new capital from here.

Incidentally, The Wall Street Journal reported in February that global real estate funds operated by private equity companies amounted to more than $540 billion in cash as of 2Q-23. This is up notably from the $457 billion seen at the end of 2022.

Could they be saving up in anticipation of something significant?  

After all, some financial institutions are beginning to realize losses from loans they made when borrowing conditions were much lower. This could lead to a wave of buying opportunities, as some banks or even insurance funds may be forced to sell assets at a discount.

Just as Blackstone anticipates.

Consider Wells Fargo’s (WFC) latest 4Q-23 numbers, which show deteriorating CRE fundamentals. For example, vacancy rates are increasing in all areas except for retail.

The office segment continues to be the worst-hit, pressured by secular headwinds like work-from-home trends and decades of overbuilding. However, we’re also seeing a multi-year high in apartment vacancies and a meaningful upswing in industrial vacancies.

Moreover, prices continue to be weak. All segments, except for industrial real estate, are seeing year-over-year declines of 5% or worse.

Wells Fargo noted that, over the past eight months, prices have been flat. Yet even that non-negative news was mainly due to industrial strength offsetting weakness everywhere else.

‍

Wells Fargo’s numbers also support Blackstone’s comments regarding low demand for assets. CRE transaction volume has declined to levels not seen since the early years after we began recovering from the Great Financial Crisis (excluding the 2020 pandemic).

Year-over-year, transactions are down by double digits, led by a 50% decline in apartment transactions and a 40% decline in both industrial and hotel transactions.

The Trigger That Could Cause Investors To Jump In

The only thing missing here is a “trigger” that causes transaction volume to increase. While this could come in many forms (if it comes at all)…

We are aware that the Fed may not be close to cutting rates aggressively as previously expected.

According to CME Group’s (CME) Fed funds futures tool, market participants put the odds of a >4.50% Fed funds rate on December 18, 2024, at roughly 80%. That’s up from less than 5% in January. And the odds of a >5.00% rate are now close to 50%.

While markets enjoyed expectations of a dovish Fed in 4Q-23 and early 1Q-24, these hopes are now fading as inflation turns out to be “stickier” than previously expected.

Multiple factors contribute to this, with two of the biggest being:

1. Oil prices are rising again. As we can see below, NYMEX WTI crude oil is gaining upside momentum. Historically speaking, this is very bullish for inflation.

The chart above compares year-over-year (all-item) inflation to the price of oil.

2. Economic indicators point to higher inflation. The ISM Manufacturing Index is gaining upside momentum. While this bodes well for economic growth, it comes with a rebound in the “prices paid” component, signaling further inflation to come.

Although the economy is still in good shape in so many ways, momentum is moving in the wrong direction regarding inflation. This could damage credit stability and trigger foreclosures, especially if the Fed maintains a higher-for-longer approach.

For now, credit quality in the commercial real estate industry remains very safe. Delinquency rates were at just 1.4% going into this year.

However, the trend still matters. And looking at other indicators, including credit card delinquencies, we’re starting to see a deterioration in overall financial conditions.

These are likely to increase if the Fed has to keep rates elevated for longer.

Data firm Trepp certainly made the case that analysts expect distress rates to keep rising. It notes that more than $2.2 trillion in commercial mortgages will have to be refinanced through 2027.

In which case, there are two benefits to private equity building a massive war chest:

• It allows these companies to buy great assets at subdued prices if credit quality continues to deteriorate.

• It provides much-needed liquidity for distressed firms that need to service their debt.

In the meantime, we should be prepared for potential headwinds in CRE if inflation doesn’t come down quickly. This could include increasingly troubled debt conditions that major funds like Blackstone will use to their advantage.

In fact, even if the Fed decides to protect debt quality over fighting inflation, we could easily see a second wave of inflation or elevated inflation on a long-term basis. This, too, warrants a bigger focus on high-quality assets.

In Closing

Blackstone's bullish stance on real estate signifies a potential shift in the market's dynamics. And its strategic move to capitalize on discounted assets indicates a unique opportunity that may become even more attractive still in the quarters ahead. Blackstone hasn’t become the largest alternative assets manager in the world by making more bad bets than good.

If Blackstone’s Gray is correct, the real estate sector is at a turning point. In which case, well-capitalized CRE investors are in store for favorable conditions.  

With private equity firms building significant capital reserves, the stage is set for potential real estate acquisitions. In light of rising inflationary pressures, prioritizing high-quality assets becomes key – a strategy that Blackstone’s approach underscores.

But you don’t need to be managing a trillion dollars in assets to capitalize on these developments. Private investors have several options. One is to purchase physical real estate outright. That has it’s own set of pluses and minuses. Diversification is minimal, but you can borrow a large percentage of the purchase price. The other is publicly traded REITs. These stocks usually own hundreds of assets so diversification is excellent, but their prices can be volatile and are sensitive to the broader stock market. The last option is investing in private real estate through private funds. These range in strategy, investment minimums hold periods, and fees, among others. No matter which route, always do your due diligence and study the risk factors closely.

Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.