An in-depth look back at 2024 and the start of 2025
It’s hard to believe that it has been five years since the world effectively shut down with the COVID-19 pandemic. It’s even harder to believe how dramatically the pandemic transformed global economies and financial markets, which had enjoyed a decade of relative calm and stability following the Global Financial Crisis of 2008-2009. Since 2020, financial markets have been on quite a rollercoaster ride, and investors have had to navigate a myriad of variables and dynamics.
The start of 2025 has been no different. Capital markets initially celebrated Donald Trump’s second term with stock indices rallying and credit spreads compressing. However, the enthusiasm has seemingly been checked in recent weeks with investors now questioning what impact the administration’s actions will have on the economy and capital markets. But this situation wasn’t unexpected. In our annual letter published a year ago in March of 2024, we wrote the following:
“…there’s also the matter of the U.S. Presidential election this year. With Donald Trump having all but locked up the Republican nomination, he seems to have a very viable path to winning a second term, further complicating the outlook for commercial real estate. It’s hard not to believe that a Trump presidency would have an inflationary bias – tax cuts, “stock market to the moon,” tariffs, and trade disputes. There’s also a possibility that an anti-interventionist approach to current geopolitical crises creates more issues and higher treasury issuance in the medium term, keeping upward pressure on treasury yields. These policy positions would further complicate the Fed’s ability to reduce interest rates (something Chairman Powell is probably already very focused on) and would likely maintain upward pressure on interest rates and cap rates for a period of time.”
Folks who have attended our in-person events the past couple of years will recognize this theme of “higher interest rates for longer” – we have repeatedly emphasized this house view given a host of structural forces, and this view has heavily influenced our investing and portfolio construction strategies. In this letter, we’ll provide a snapshot of how we see higher interest rates impacting property and investing markets over the medium-term, and we’ll also touch on our early thoughts for the new administration’s economic policies and actions.
The Impact of Higher Interest Rates on Property Investment Markets
Another theme we’re fond of at Ohana is that we try to focus on the “middle distance” of the investment horizon when investing – roughly 2-5 years out. The concept of “middle distance” comes from learning to drive a car as a teenager and being told where to focus your eyes to scan for risks and to know where you’re going – don’t focus immediately in front of the car and don’t focus miles out; focus somewhere in between: the “middle distance.” Applied to investing, it means that we’re not trying to make “calls” on what markets will do in the year, for the year. That’s too short-term in nature, especially for investing in private illiquid assets. In fact, we believe that type of extreme short-termism is exactly what led to bad decisions during the past five years for some investors who decided that immediate-term spot market dynamics were the “new normal” forever – e.g., everyone will live and work from home forever, consumers will spend 50% of their income on vacations forever, interest rates will be 0% forever. On the other hand, while long-term trends absolutely shape our overall investment philosophy and the properties we focus on, a 30-year macro trend can be less relevant for an idiosyncratic property or loan investment with an expected duration of 2-5 years. Lately, however, it feels like property investors are wrestling with a new issue altogether. To apply the driving analogy again, that issue is driving using the rearview mirror – in particular, it seems that many investors have been anchored to ultra-low interest rates of the not-so-distant past. But that finally seems to be changing, and that dynamic has major implications for property markets.
In the decade before the 2008 Global Financial Crisis (“GFC”), the 10-year US Treasury Yield averaged 4.7%. In the decade following the GFC, the yield averaged 2.5%. And in the pandemic period from March 2020 to March 2022, the yield averaged 1.2%. Over these three periods, major sector real estate cap rates[1] averaged a spread of ~250-320bps to the 10-Year U.S. Treasury Yield. As of the last week of March, the 10-year U.S. Treasury Yield is back up to ~4.4% and the cap rate spread is only ~110bps.
A lot of variables can influence the cap rate spread to treasury yield at any given point in time – economic forecasts and credit spreads, yield curves, technical factors such as capital flows, and expected trends in property / sector income growth, to name a few. However, even accounting for these types of variables, cap rates for major sectors still feel very low to us and more anchored to the past than today’s reality.
This cap rate disconnect is not just data on a screen either – we’ve been experiencing it out in the field. In our sourcing and negotiating activities out on the “front lines,” the disconnect between buyer and seller spot cap rates is probably the biggest obstacle for owners being willing to transact. Many have chosen to throw good money after bad to cover debt financing deficits and buy time in the hopes that rates come down. Owners / sellers are understandably pointing to sales comps from just a few years ago when a mostly stabilized property might have traded for a 5% cap rate, for example. Because of bloated debt structures, it’s difficult for them to acknowledge that a 5% cap rate doesn’t make sense in a world where borrowing costs for that property have nearly doubled, and the proxy risk-free rate is nearly 200bps higher than it was before the pandemic. The problem is more pronounced in ultra-low cap rate sectors, which have experienced significant valuation volatility since 2019.
In our view, this bid-ask gap in cap rates and valuations is a principal cause of the much lower transaction volume across U.S. property markets. But that seems to be changing. In our closed-door meetings and conversations with other property investors in recent months, we were intrigued by how many started to (finally) acknowledge that they are meaningfully increasing exit cap rates in their underwriting models. That, of course, flows back into their spot market valuations for assets, pushing up spot cap rates (pushing down spot valuations). It seems folks are starting to recognize that the decade after the GFC is not the best anchor point for cap rate and valuation expectations. This realization will be a growing theme in the coming 12-24 months.
This wholesale recalibration of cap rates and valuations is coming as the U.S. CRE debt maturity wall swells, which we also discussed in last year’s annual letter. According to Mortgage Bankers Association, nearly $1 trillion of U.S. CRE debt will mature in 2025 – that’s roughly 20% of the ~$5 trillion in total U.S. CRE debt outstanding. Notably, the dollar volume of NTM maturities has increased each of the past two years, as loans have matured and been restructured / extended, resulting in a snowballing effect.
As you might expect, this confluence of valuations declining and loan maturities spiking is creating a steady drip of stressed and distressed investment opportunities, as borrowers finally run out of time on their overleveraged debt stacks. The challenge is that while we can recognize a problem capital stack pretty quickly given our daily involvement throughout our sectors, we don’t always know when a property or borrower might wave the white flag or when a lender might finally call time. As a result, we might stalk an opportunity for months or years before it finally hits a wall and then a borrower and/or lender might want to move quickly and discreetly to resolve the problem. That has been the case with many of our investments over the past couple of years. We still don’t expect a massive wave of distress like we saw during the GFC, unless asset values become 1:1 correlated again (like with a deep recession). So, our house view for now remains that there will be a steady flow of opportunities for the next few years.
Another positive consequence of the “higher interest rates for longer” theme is that supply growth across most property sectors is grinding to a halt, and that will benefit owners of high-quality properties in coming years as even modest demand growth will get compressed into a stagnant inventory base and drive income growth. Elevated materials costs, higher labor costs, and the lack of construction financing have been challenging for a few years now. As we note below, the new administration’s posture is only likely to exacerbate these issues.
Lastly, higher interest rates could influence capital flows in coming years, with investors allocating less to generic and lower-returning real estate strategies and reserving their real estate allocations for higher yielding opportunities. It’s easy to forget that the mega-fund thematic sector-driven investment trend didn’t come about until the post-GFC era, when ultra-low interest rates resulted in a flood of capital into private real estate vehicles from investors seeking an alternative to fixed income. Now that investors have attractive alternatives in fixed income, will that reverse the flow of capital into some of these strategies? And how might that dynamic ripple across various property sectors?
These dynamics set up well for a sector specialist like us because we track our hospitality and residential sectors on a daily basis, and we have deep experience navigating distressed capital structures and loan situations.
So how are we navigating this environment? In a nutshell, we’re extremely focused on:
- Basis vs. physical replacement cost / historical trades / our real-time valuation frameworks incorporating higher rates. And we’re favoring properties that can achieve a high stabilized yield on cost without having to believe a lot (in anticipation of higher exit cap rates)
- Properties positioned to enjoy above-average demand growth due to (a) market forces and (b) the opportunity to fix something using our internal expertise
- Recently built properties that can often be unencumbered of brand and management, as these high-quality properties will be the most attractive to buyers 3-5 years from now
- Thoughtful portfolio construction where we overweight towards yield-oriented investments and properties with a clear growth-bias in income
And what should LPs be focused on in this environment?
- Investors should dust off their IRR attribution analyses for investment managers and focus on managers who have a demonstrated track-record of generating returns based on buying at an attractive acquisition basis and driving income growth through hands-on value creation. These skills are imperative in a world where debt costs eat up a lot of current income and investors can’t count on cap rate compression to drive returns
- Investors should assess their exposure across real estate investment styles. We have yet to see how that mega-fund sector allocation model functions in a higher / rising interest rate environment, so ensuring you have exposure to sector specialists with specific expertise will help ensure you’re not overweight market beta that might be negatively impacted by rising interest and cap rates
A Quick Note on the New Administration’s Economic Agenda
Other than interest rates (and excepting third-deviation type events like global pandemics) it’s hard to think of another factor that may impact investors more than the new U.S. administration’s economic agenda. While the early actions rhyme with the broad outline that we laid out a year ago, significant questions still remain. Even the administration continues to recalibrate the scope and sequencing of various initiatives on a daily or weekly basis. Of the new information that has come out in recent months, one item that caught our eye was Stephen Miran’s November 2024 white paper titled A User’s Guide to Restructuring the Global Trading System, which received more attention after the financial press began mentioning the provocative phrase “Mar-a-Lago Accord.” Stephen Miran was recently appointed as President Trump’s Chair of the Council of Economic Advisors for the U.S.
The white paper is a worthwhile read as it provides a framework and set of economic ideas for how the administration might be able to accomplish its economic agenda – namely, higher revenue from tariffs, low/no inflation due to natural currency offsets, a weaker U.S. dollar through currency accords, re-shoring manufacturing in critical sectors considered important to national security, terming-out foreign treasury holdings (swapping short-term instruments for long-term instruments) to bring down longer term interest rates, making room for the Fed to lower short-term rates, and better aligning defense spending with U.S. global geopolitical objectives. It also answers the critical question “how does the administration think tariffs won’t lead to inflation?” Side note: it also seems that Mexico tariff negotiators read the paper, as one of their key concession ideas – matching the U.S.’s tariffs on China – came from the paper.
We mention the Miran white paper not because we have strong views or positions on it – after all, we’re not PhDs in economics. Rather, and more importantly, we think it helps decode some of the administration’s actions and motivations and make them seem less like erratic and unscripted behavior and more in keeping with a strategic blueprint. It also provides insights into what the economic thought partners sitting inside the oval office are actually talking about – that they believe this blueprint or major elements of it could address their concerns and grievances makes us more firmly believe that the administration is going to push forward with these actions, at least directionally. Said differently, it indicates to us that President Trump is NOT bluffing when he talks about tariffs and tax cuts and balancing the budget – he believes there is a path, and this is it.
Clearly, some of the initiatives might get throttled and phased differently to balance the impact on the economy and stock market, but there seems to be a high probability of more action from the administration, not less. And we’d advise investors not to under-weigh the risks associated with the administration’s actions or brush them off as a negotiating tactic.
Finally, the paper gives us some threads to pull on to consider the potential knock-on effects of this playbook being implemented and how it might impact property markets and investing more broadly. The key considerations we see for property investors in the coming months are: inflation / rates (as discussed above), shifting domestic and foreign consumption patterns (driven by exchange rates and nationalism / geopolitics), higher risk premia (and spreads), and even stronger headwinds against new construction / supply growth with tariffs and immigration policy exacerbating the higher construction cost environment.
It’s hard to know where things will stand in 2026 and beyond. There’s a lot ahead of us, including potential actions around the Fed / Jay Powell, retaliatory trade wars, arguments around tax cuts and the budget, more prongs of the Miran blueprint to be rolled out, the 2026 mid-term elections, and the 2028 presidential election. And let’s not forget about other market-moving forces like AI, actual wars, or what might happen with the Chinese economy.
Thinking about the middle distance again, we do think there’s a possibility that the market uncertainty and volatility are more highly concentrated over the next two years leading up to the U.S. mid-term elections, and then we have a more divided government and relative calm following the mid-terms. Additionally, thinking about lessons from the post-COVID extreme short-termism we described earlier in the letter, investors should be cautious to make 5+ year bets assuming that near-term dynamics are the new “new normal forever.” For instance, the Trump administration may initiate re-shoring of manufacturing, but if a Democrat takes office in 2029, will the pendulum swing back towards a free trade regime? As always, we’re busy in the lab analyzing interesting investment themes we believe will emerge from these dynamics. And we’ll continue to lean on our sector specialization and conservative approach to investing to identify opportunities with downside protection and the opportunity for asymmetric upside.