There are no crystal balls. I cannot tell you where rates will be at the end of 2024. Nobody can. And if they could, they’d be trading bonds, not writing a Substack newsletter.

But real estate is about making educated predictions of the future. This trend will continue, that neighborhood will get hot, this rezoning will pass. And people make good predictions of the future not by being better at the art of prognostication but by watching the right things. The best people in real estate know where to pay attention.

If I do nothing else for our Thesis Driven readers, I hope I point out things that are worth watching: asset classes that haven’t yet drawn institutional interest, technologies still early on the growth curve, and consumer trends that could shape the future of the built world. (We’re must be doing something right, as we’re now the 14th largest business newsletter on Substack after a little over a year.)

As we open 2024, I’d like to share six big themes I’ll be watching closely in the new year:

1. Will the AV and AI acceleration continue?

Two trends—autonomous vehicles and artificial intelligence—are poised to have a major impact on real estate over the coming decade.

AI is obviously having a moment, and it’s tough to think of an aspect of real estate it won’t impact in some way. Sourcing, underwriting, marketing, leasing, management, accounting are all in the path, and platforms like AppFolio are aggressively rolling out AI tools. But perhaps the biggest change will be in how people interact with software such as PMS systems. Rather than manipulating an array of buttons and fields across various screens, users will be able to interact with software by speaking or writing plain English—simplifying complex tools and giving more users access to data and systems with previously steep learning curves.

But it’s worth wondering whether AI’s current pace of innovation—and hype—can continue. After all, AI tools have been around for years, and the current wave of interest was prompted by the launch of ChatGPT, a better user interface on top of an existing model—GPT-3. While GPT-4 clearly leveled up the quality of responses—and led to significantly more investment in the sector—it’s possible that 2024 will be more about an increasing number of AI applications and use cases rather than another fundamental step forward in the underlying model. This is all well and good for

While AI is getting the bulk of the attention right now, there’s reason to believe that AVs are coming sooner than we all think, with Waymo in particular making major inroads into cities such as Phoenix, San Francisco, and Los Angeles. While Cruise’s recent stumbles show the challenges that still remain, full Level 5 autonomy isn’t required to make a huge impact on the real estate industry. Even Level 4 autonomy—available now through Waymo and Cruise in certain cities—can transform the daily commute and change the calculus of viable housing and office locations within a metro area.

Waymo’s current coverage area in the Phoenix MSA

Next year, I’m watching whether Waymo continues rapidly expanding its geographic footprint, including more areas in its geofenced coverage area. Specifically, I’m paying attention to two things:

• Will Waymo expand to include the entire Phoenix metro area, making it the first MSA with full driverless coverage?

• How will Waymo perform in a city with less-than-ideal weather conditions? Thus far, their four cities—SF, LA, Phoenix, and Austin—all have mild winters. Handling the elements is a key risk factor for continued AV growth.

2. A wave of new deliveries will hit multifamily as rents sag

In a number of markets—particularly Sunbelt cities—a glut of new multifamily supply delivering over the past six months has led to sagging rents as existing assets compete against new buildings offering aggressive leasing concessions.

This situation is unlikely to improve any time soon, and there’s a good chance it will actually get worse through much of 2024. Multifamily completions continue to trend up, and many construction projects launched in 2022—which saw high levels of both permits and starts—are likely to deliver in the coming year.

Multifamily completions continue to trend up

The question is when the glut of deliveries will slow, giving multifamily owners some relief in the form of less competition and (ostensibly) higher rents. While many industry experts are predicting that multifamily rents will begin rising again in 2025, I’m less sure for a few reasons:

1. While permits and starts are off their 2022 highs, they’ve merely reverted to pre-pandemic norms—slower, but hardly a freeze.

2. The supply glut means that assets take longer to lease; for larger buildings, this could be well over 12 months. So a building delivering in Q2 2024 could still be offering lease-up concessions in Q3 2025, weighing on the rental market.

3. The multifamily sector no longer benefits from the demographic tailwinds of 1995-2015 in which each cohort of young people was larger than the last.

Multifamily housing starts are off 2022’s highs but have yet to drop below pre-pandemic levels

So I’ll be watching permit and start data closely over the first half of next year. While the vibes in the industry are certainly poor, I want to see the drop in starts in the data before predicting a rent recovery—which at this point looks like 2026 at the soonest.

3. Alternative uses of class B/C office space will emerge

This summer, we wrote about alternative uses for underutilized office space—particularly the Class B and C product that is struggling mightily in a historically weak office market.

But now we’re actually seeing some of these assets trade, and it’s not pretty. Office buildings from San Francisco to Manhattan to the Chicago suburbs are selling for a fraction of their previous value—and nobody seems to believe it’s going to get better any time soon. The office market, after all, was showing weakness even before the pandemic hit, with some submarkets kept afloat by WeWork alone.

While low-end office owners will take a bath, these sales are a good thing—they indicate that the market is "unsticking" and forcing owners (and lenders) to accept new realities. Eventually, this will allow office rents to reset to a place that enables alternative uses to pop up. Community uses like education and recreation, membership clubs, new managed office platforms, and even residential conversions are all on the table when commercial rents reflect market rates rather than the 2019 "sticker price".

In 2024, I’ll be watching for these distressed office trades—and what becomes of the product on the other end. In particular, I’ll be on the lookout for new investment platforms and operators with creative uses for underutilized Class B/C office space—particularly uses that bring people and vibrancy back to hollowed-out central businesses districts.

4. Will Shelter CPI fall hard?

Over the past month, the macro consensus has come around to the view that the Fed will cut interest rates in 2024—possibly two or three times. While inflation has come down, it is still higher than many at the Fed would prefer.

But upon further investigation, the narrative of continued inflation appears shaky; a majority of year-over-year inflation today is shelter inflation, which is weighted to make up almost a third of CPI. Subtract housing and year-over-year CPI is close to zero.

Rapidly increasing housing costs would be a surprise to the many developers who face sagging rents and increased vacancy due to a wave of deliveries and slow demand in many markets. The major measures of national apartment rents—Zillow, Corelogic, and ApartmentList—all show rent growth well below the two measures incorporated into CPI: Owner Equivalent Rent (OER) and primary residence rent.

via Calculated Risk

It’s not that shelter inflation is wrong, but rather that it badly lags actual conditions on the ground due to the way it is calculated, which gives heavy weight to aged, in-place leases and owners’ own estimates of the market rent of their home. With rents stagnant or declining across the board, shelter inflation will inevitably come down hard in 2024, bringing CPI down along with it. And remember that multifamily supply glut hitting in 2024 and unlikely to clear until 2026? This will push rents and shelter inflation down further, possibly even driving CPI into deflationary territory by the second half of 2024. The San Francisco Fed happens to agree, and recently published this projection of shelter inflation:

In other words, the San Francisco Fed is predicting deflation even if other CPI categories such as food, energy, and services don’t continue their downward shifts. If this materializes as predicted, rates may come down faster—and harder—than anyone expects.

5. A growing wave of reforms could unlock more housing… and opportunities for developers who can go small

After years on the political fringes, the YIMBY movement is finally seeing some success. While California drew the bulk of attention for passing a raft of reforms over the past few years, they’re not alone; Montana legalized ADUs and fourplexes on all lots, Arlington County (VA) abolished single-family zoning, and even deep-red Texas enacted a 14-day shot clock on permit reviews.

While a number of pro-housing reforms include poison pills—such as Salt Lake City’s requirement that all new housing legalized by their reforms include affordable units with no changes to FAR or setback rules—there are undoubtedly new development opportunities in the market for developers willing to get creative.

For the most part, the new deals unlocked by the recent wave of reforms are smaller-scale: fourplexes, ADUs, and other "missing middle" housing. While these typologies will have the most appeal to small developers self-financing or raising money from individual investors, small multifamily is gaining interest from institutional investors and may present an aggregation opportunity: put enough small multifamily together into a coherent portfolio and sell it to a larger player looking to deploy bigger checks at a compressed cap rate.

An ADU by Villa Homes

In a sense, the current environment is a great time to be a small, scrappy developer: regulatory reforms are unlocking more opportunities while sellers face increasing urgency and buyer competition is depressed.

This coming year, we’ll be watching for more state- and local-level legislation that could propel missing-middle housing production and unlock opportunities for small developers. In particular, we’re watching states that have yet to pass significant reforms—New York, I’m looking at you—but face increasingly dire housing shortages.

6. As traditional financing sources slow, alternatives step in

One of 2023’s biggest real estate shifts was the retreat of traditional bank lenders from the construction lending market—only to be replaced by private debt funds and other alternative lenders enticed by higher rates and little competition.

Even if rates retreat in 2024, it seems unlikely that traditional banks will rush back into construction lending. Existing loan balances—some of them in trouble—will take time to get worked out. And a lot has changed since the heady days of 2021 and 2022. Specifically, high-profile bank failures in early 2023 led to more regulatory scrutiny of bank lenders, a situation that is unlikely to unwind in the near term. All this points to continued hesitation from traditional lenders through 2024.

But as debt funds have stepped up, sponsors and lenders have had to get creative to help debt funds—which have more expensive capital than banks—hit their return targets, which are often in the mid-teens IRRs. Increasingly, lenders are offering preferred equity in addition to debt, moving up the capital stack to achieve higher returns. (See last week’s letter for more color on how those deals can look.)

I expect to continue to see non-bank lenders get creative to make deals work while hitting equity-like return targets. I wouldn’t be surprised to see some of these debt funds craft products specifically targeted at high-growth OpCos looking to build real estate portfolios as well, possibly taking slugs of OpCo equity in exchange for providing programmatic debt.

—

What are you watching in 2024? Share and discuss in the comments!

—Brad Hargreaves