Music students who aren't pianists must achieve a level of proficiency sufficient to play simple piano accompaniments with their future students. Thus, beginning class piano is a rite of passage for music majors who aren't pianists.
One skill music students must demonstrate is transposition – reading music in one key and playing it in a different key on the piano. Although I’m primarily a violinist, I also took 12 years of piano lessons, so I can easily transpose simple piano music. But for a student who can barely play the piano, transposition is a daunting task.
When my child, a first-year music major came home, I saw first-hand how challenging transposition can be for someone who has played the piano for only two months. I spent what felt like hours on end listening to Kumbaya played dozens of times on the piano – first in D major and then transposed one-half step higher to E-flat major. It probably was a lot less time than that, but it still made me think about the mental process involved in transposition.
That transposition is more complicated than "one-half step higher" sounds. A piano has seven white keys and five black keys in an octave. For the most common key signatures, the black keys play the sharps and flats. D major has two sharps in its key signature, but E-flat major has three flats.
To play every note in D major a pianist will play five white and two black keys (F-sharp and C-sharp). In E-flat major, a pianist will play four white and three black keys (B-flat, E-flat, and A-flat. So, D major and E-flat major overlap on only three piano keys, all white keys – G, C, and D.
Transposition requires active participation, and the musician must be proactive. They must remember which piano keys are used in the new key. Since piano fingerings can depend on the layout of black and white keys in a passage, a transposition might require a fingering change, which can require planning to ensure the hands are where they need to be to play the written notes.
Musicians learn solfeggio (like the Do-Re-Mi song in Sound of Music) so they can view notes based on their "roles" or interrelationships in each key. Although solfeggio is sung, this mental exercise helps musicians transpose music as an interrelated group of pitches in a horizontal sequence that creates a melody without transposing each note individually.
In real estate investing, it’s easy to think market and economic conditions are like key signatures. The property owners may believe they are helpless in the face of market-wide or nationwide economic conditions. However, owners still control management and acquisition/disposition strategies for their properties. This article discusses how owners can proactively address market and economic developments.
History of Real Estate Investments - 1970-2020
Real estate investments became popular in the 1970s, a period of high interest rates and inflation. Some people believed that real estate is an inflation-proof investment. As interest in real estate increased, real estate syndications became popular.
Changes to federal tax law depreciation also made real estate a more attractive investment. The "accelerated cost recovery system" enabled investors to shelter more of their real estate income from real estate taxes at the beginning of their investment. These tax changes incentivized real estate investment. Since investors could take more depreciation deductions earlier, shorter investment hold periods became more attractive. Real estate no longer had to be a long-term investment.
Leverage also makes real estate investments attractive. With mortgage financing, for decades, investors could invest only 20% of the capital required to buy real estate while receiving 100% of the growth (after mortgage loan payments) on the asset value. With the real estate market driven by the belief that values could only increase over time, many investors added mezzanine debt on top of mortgage loans, resulting in total leverage of 90% or more. A similar structure using a second mortgage enabled more people to purchase homes.
However, there was a cost to this high leverage. Mortgage fraud, particularly for single-family homes, became rampant, recession, and the resulting lower home values triggered foreclosures. Both investors and mortgage lenders learned that the sky isn't the limit for real estate prices and that values could decline. After losses from the 2008 recession, mortgage lenders tightened their underwriting, replacing 80% limits on mortgage leverage with 60% or 70% limits.
The market adjusted to the new underwriting standards. As the recession ended, real estate again started increasing in value and again attracted investors.
Real Estate During the Pandemic
In 2020-2021, the COVID-19 pandemic abruptly accelerated the real estate cycle, causing a downturn in many asset classes. As office buildings sat empty, tenants either didn’t renew their leases or sought to renegotiate them for lower rent. Hospitality assets struggled with the decline in travel and tourism.
Closures turned thriving retail centers into ghost towns. Multifamily assets in major metropolitan areas saw increasing vacancy rates as telecommuting tenants fled for less crowded (and less expensive) parts of the country. As a result, many commercial real estate assets declined in value as their vacancy rates increased and revenues decreased.
The Real Estate Industry in 2023
By 2022, inflation set in. The Federal Reserve (Fed) increased in interest rates, which translates to higher interest rates on mortgage loans for real estate buyers. Higher interest rates drive Cap rates for commercial real estate investments higher. Real estate prices are determined mainly by applying the market Cap rate to a property's revenues. Therefore, increases in Cap rates without commensurate increases in revenues caused property values to go down in many markets and sectors.
Multifamily properties continued to thrive in most markets. After all, people need a place to live, and during the pandemic, government programs helped many people pay their rent. Supply chain challenges impeded the entry of new rental units into the market in response. So, rent rates continued to increase into 2023.
The industrial sector, which increased in popularity with the increase in e-commerce during the pandemic, continued to be in demand. Retail and hospitality assets began to recover in 2022, although office offices struggled.
Early 2023 brought small bank failures as interest rates and mortgage defaults increased. According to the National Association of Realtors’ September 2023 Commercial Real Estate Market Insights, "massive interest rate hikes have hammered the commercial real estate market," noting that eleven collective rate hikes and regional bank failures caused small- and mid-sized lenders to be more cautious in real estate lending. 2023 also brought a slowdown in commercial leasing and rent growth while vacancy rates remained the same.
Also, as new construction commenced in response to a supply shortage was completed, the multifamily sector experienced increased vacancy rates. Still, rent increases prompted rent control legislation in several jurisdictions.
The office sector continued to struggle. With fewer people going into offices, tenants required less space, so office properties experienced record-high vacancy rates. Retail stores continued to struggle as pandemic-era e-commerce settled in for the long haul, and industrial property growth slowed from record highs due to pandemic-area demands for warehouse space for online retailers.
According to CBRE’s 2024 US Real Estate Outlook, investment volume in commercial real estate fell by 45% in 2023. CBRE forecasts that pricing will bottom out during the first half of 2024, driven by a 5-15% decline in values due to additional market interest rate increases.
A December 22, 2023 HUD and Census Bureau report estimated a slight year-over-year increase in new single-family home sales from November 2022 to November 2023. However, after a post-pandemic surge, the seasonally adjusted annual rate of sales has been in the 2019-20 range for the past year.
CBRE forecasts that the office sector leasing in 2024 will continue to be below pre-pandemic levels. Due to a lack of new construction and resulting limited inventory, retail leasing will continue to recover in 2024. Due to an increase in e-commerce and anticipated increase in US industrial production, CBRE predicts the industrial sector will grow toward the latter part of 2024 after absorption of new post-pandemic new construction. Also, data center properties are forecasted to increase in price in 2024 as new construction increases to meet demand.
According to the CBRE report, the multifamily sector will experience a significant increase in inventory due to the completion of additional post-pandemic new construction. However, due to the high cost of home purchases, tenant demand will continue to remain strong in 2024. So, rents will continue to increase, albeit at a slower pace.
On December 13, 2023, the Federal Reserve (Fed) announced it was not increasing interest rates given its two percent inflation rate goal. According to the Bureau of Labor Statistics, year-over-year consumer prices decreased by 0.2% in November 2023 but increased by 3.1% from November 2022 to November 2023. Therefore, many analysts predict stable interest rates in early 2024, with possible reductions as inflation continues to slow.
Preparing for 2024
Real estate is a long-term investment. It is cyclical, and most real estate investments have the same end goal – to increase the property value, plus, for some assets, to create cash flow along the way.
Real estate investors can benefit from the concept behind musician’s solfeggio training. The intervals remain the same in every major key, even though the notes in that key may differ. Likewise, real estate fundamentals don’t change, even though they may look different in different economies.
Some owners will need to sell during the first part of 2024 even if that means sales at prices below their original forecasts or their acquisition price. For instance, owners whose mortgages are maturing may be unable to refinance given higher interest rates and lower property values. Some owners have been struggling due to increases in floating interest rates or rate caps and may need to sell to avoid foreclosure.
Early 2024 also will be a good time to sell properties acquired before the pandemic with long-term, assumable mortgages with below-market fixed interest rates. Although cap rates will remain high, the opportunity to benefit from assigning the arbitrage on their long-term mortgages may offset any reduction in underlying asset value due to high cap rates. However, this opportunity is likely to wane if, as many predict, interest rates go down later in 2024.
Increasing occupancy, rent growth, and asset preservation should remain central focuses for all owners. Increased occupancy and rent growth will result in increased revenue, which can help maintain asset value in the face of higher market cap rates.
Investors should avoid the temptation to cut maintenance or capital improvements to support short-term income. Instead, investors should focus on asset preservation and long-term growth and make capital improvements to support that growth.
Owners who don’t have to sell should hold their investments at least until the last two quarters of 2024 or when interest rates decline. Lower interest rates should translate to lower cap rates and higher sale prices on real estate investments. When this happens, owners that have focused on real estate fundamentals over short-term income will be best situated to sell.
Conclusion
Transposing music works best when the musician thinks in the new key rather than reading notes in the old key and transposing them one by one. Likewise, property owners will find it challenging to adapt if they hold onto old strategies and attack market and economic changes one-by-one. Instead, like musicians transposing music, property owners will obtain the best results when they change their base paradigm to match current market and economic conditions and develop new management and investment strategies in that milieu.
