US commercial real estate market update - April 2023

Recent banking system turmoil surfaces commercial real estate concerns

Macroeconomic and market signals remain mixed, driving increased volatility and uncertainty across capital markets and contributing to slower commercial real estate (CRE) activity. CRE reflects the broader economy and capital markets that it contributes to and operates in – even if individual assets do not seem to fluctuate with each new economic or market data point. It is because of this interconnectivity that current macro and capital market happenings are critical to contextualizing CRE’s situation and performance.

At the macro level, the Fed rate hikes appear to be slowing, as a growing number of dovish opinions among Fed officials surface in the wake of recent banking turmoil and mounting recessionary concerns. Inflation data continues to trend downward from its peak a year ago, its current pace suggests that it is still many months away from being even close to the Fed’s target range. Similarly, unemployment claims data suggests that the Fed’s monetary tightening is starting to create some softness in the labor market, but it is too soon to confirm to what extent.

Figure 1 - Inflation measures: CPI, PCE, PPI

A softening of the US housing market coupled with diminished savings and high-cost credit is beginning to curtail consumer spending to some degree. Days of inventory on hand across producers is beginning to climb, most notably for retailers.

Figure 2 - Days of inventory on hand

What triggered the spotlight on CRE market risks?

After the failure of two mid-sized banks in early March and the market panic that spread in its aftermath, many regional and community banks faced heavy deposit outflows, as customers moved funds to larger banks and money market funds. What started as a liquidity and funding risk event, evolved into capital adequacy concerns across many of these lending institutions, bringing interest rate-sensitive loan portfolios under extra scrutiny. CRE quickly came to the forefront of the discussion, as it has been a large and growing portion of the loan book for many small and mid-sized banks.

CRE loans were not the cause of the recent bank failures and ongoing troubles, though many market participants see the large amount of outstanding CRE debt as a potential problem. The current CRE debt concern is multifaceted, but two of the major concerns are:

1. Mark-to-market risk - what capital issues would materialize across lender portfolios if these CRE loans or the underlying collateral were marked to market?

2. Refinancing risk - with nearly $1 trillion in CRE debt coming due over the next two years (including, but not limited to bank balance sheets), how much will be able to refinance when it matures?

These questions are straightforward, but their answers are not. Answering these questions is complicated by both market dynamics and CRE-specific characteristics. The current market environment is characterized by elements not seen in decades (e.g., rising rates, high inflation, large-scale pullback in financing) occurring all at once. And even if these various factors are not entirely novel, the median age of finance (~45) and CRE professionals (~48), suggests that this is the first time many of the current decision-makers navigating this type of situation. Additionally, CRE assets (and loans backed by CRE) are illiquid, idiosyncratic, and often have deterministic outcomes based on the select path by participants (e.g., lender/borrower or tenant/landlord behavior).

So, while these questions remain unanswered, an industry consensus appears to be forming: something’s got to give.

If the current capital market conditions persist, and the time of super-cheap and abundant financing does not return soon, then this “something” will mean different things depending on the CRE investor’s intention (buy, hold, sell).

Figure 3 - Illustrative example using “typical” 2021 multifamily deal

The current market environment has changed the economics of CRE investments; no longer are the economics from 2021 available (reference A). As a result, either CRE investors (and their LPs) need to either lower their expectations for returns (reference B), or CRE investors need to…

• Acquire properties at a discount to current valuations (reference C)

• Increase NOI margins over the property lifecycle (reference D), or

• Capture significant value at reversion/exit (reference E).

While top managers will continue to explore these (and other) options, each of these cases is challenging on its own and none of these are likely widely applicable across all CRE properties, in the current market. Hence, we are left waiting to see how the current environment develops.

Here are some of the recent developments that I am watching…

Economy

• The Federal Reserve met market expectations when it increased base interest rates by 25 basis points to a range of 4.75-5.00% in its latest rate decision; though the central bank’s tone became more dovish amidst recent banking system concerns. Many market participants interpreted the tone-shift to suggest that the Fed may pause additional rate hikes sooner than anticipated. In the Fed’s minutes from the March FOMC meeting, the Fed noted that the fallout from the recent banking crisis will be the catalyst for a recession this year. The minutes revealed that several Fed officials argued for a pause to rate hikes at the March meeting, which took place two weeks after the start of the banking crisis.

• Headline consumer prices in the US fell to 5% in March from 6% in February, though core inflation rose to 5.6% from 5.5%. One of the Fed’s preferred measures of inflation, core services excluding shelter, remained elevated at 5.7% from a year ago – signaling that despite inflation is still well above the Fed’s target range. Complicating the inflation picture, recent data from the University of Michigan’s inflation expectation survey shows that one-year inflation expectations jumped to 4.6% in April from 3.6% in March.

• Recent weekly jobless claims in the US jumped to 228,000, well above forecasts, signaling a potential softening in the labor market, though the data was partially obscured by revisions to the Bureau of Labor Statistics methodology for seasonally adjusted figures.

Markets

• The yield curve remained inverted and spreads widened through the month of March, driven largely by the banking crisis concerns. Financial stability concerns coupled with rising interest rates added to bond market volatility. The ICE BofAML MOVE index, which measures bond market volatility, nearly hit 200 in early March, exceeding the early pandemic highs set in March 2020. Investment grade spreads widened from 120 bps over US Treasuries to 163 bps over, while high-yield widened from 389 bps over US Treasuries to 511 bps.

• Equity market volatility, as measured by the CBOE Volatility Index (VIX) rose rapidly at the start of March, before falling back down as the banking crisis subsided and the first quarter earnings season kicked off. FactSet recently reported that analysts expect a 6.6% year-over-year decline among members of the S&P 500 Index, which if true would follow a 5.8% decline in fourth quarter 2022 earnings. A weaker macroeconomic backdrop, recession concerns, and higher expenses due to inflation – weigh down on earnings.

Commercial real estate

• Overall CRE transaction volume in the first quarter was $53.4 billion, down nearly 69% year-on-year. The sharpest year-on-year decline was seen in multifamily volume, which was down nearly 70%. Median transacted prices ($/SF), not controlling for asset quality and location, also turned negative for most property types, with the exception of industrial properties. High financing costs and constrained credit availability for CRE will continue to weigh on transaction activity and price discovery.

• The early March banking crisis brought widespread attention to bank liquidity risk and loan book concentrations – notably commercial real estate debt. With nearly $1 trillion of CRE debt due over the next two years, many market participants and pundits voiced concern over borrowers’ ability to refinance, given higher interest rates, lower asset values, and limited lending capacity from existing lenders (especially the smaller regional and community banks).