US commercial real estate market update - February 2023

Two months into 2023, and still waiting for the bass to drop...

Many questions were raised across markets last year, and this year seems set to provide many answers – just not quite yet. Currently, the markets are in a transition period. The period is characterized by mixed interpretations of data that reflect a hot economy slowing but not stopping.

Views across capital markets are divergent, with debt markets anticipating a hard landing while equity markets a soft landing. Hard or soft, a “landing” is expected. The deviating outlooks of these segments of capital have led to cross-asset correlations converging higher. This is one reason to believe that the current period is a transition period because these correlations rarely come together for long.

Diverging views across capital markets

While the “landing” debate rages on between debt and equity investors, higher cost of capital, market volatility, and inflation well above the Fed's target keep capital sources cautious. For CRE, this is seen by the dramatically slower CMBS issuance pipeline and continued pullback across bank lenders.

Bank lending for CRE

With less capital accessible and costing nearly twice as much as a year ago, fewer transactions make economic sense at current prices. This slows transaction volume and price discovery, as the entry price that a would-be buyer requires to hit required return hurdles to cover financing costs cannot be achieved with the price that would-be sellers demand.

I believe that something has got to and will give in 2023. The current uncertainty is largely attributed to rising interest rates aimed at taming runaway inflation. These rising rates increase the cost of capital, which has led to the divergent outlooks discussed above and disrupted market behavior. The cost of capital will continue to be the key determinant of broader capital and CRE market functioning. However, I think a more accurate driver of the market uncertainty is the expected real net cost of capital – which considers not only the base rate of capital (i.e., risk-free rate) but also inflation and default risk. Base rates are still rising, inflation is high, albeit trending down, and default risk is growing (defaults are procyclical) – the real net cost of capital is very high and climbing. When this cost of capital stops rising (steadies or falls), we'll start seeing markets begin to function more normally.

Until then, here are a number of the key developments that caught my attention recently:

Economy

The World Bank cut its 2023 growth outlook in half since June 2022 and warned of a global recession. It expects 1.7% global growth in 2023. Senior officials of the institution noted tightening financial conditions, heavy indebtedness contributing to weaker investment and risk of corporate defaults. The forecasted growth rate is one of the lowest in recent decades but will improve by 2024.

In the US, the Federal Reserve Bank of New York's recession model implies a 47% chance of a recession over the next 12 months, the highest probability since 1982. The US economy grew at an annual rate of 2.9% in 4Q22, down from 3.2% in 3Q22; for reference, at this time last year, economic growth was 1%, compared with 5.7% in 2021.

The US debt ceiling crisis continues in Washington as a bipartisan tensions delay solution. Per Treasury Secretary Janet Yellen, the US has until June 2023 before it defaults on its debt. In the past, Congress has raised the debt ceiling or revised the definition of the debt limit 78 times since 1960. While negotiations drag on, Congress has stressed that the US will not default.

As expected, the Fed slowed its tightening pace to 0.25%, after a 0.5% hike in December and a series of four 0.75% hikes ended in November. The fed funds target range now stands at 4.50% to 4.75%.

Capital markets

While the Fed made (and continues to make) clear it intends to hike more before pausing, markets so far in 2023 priced in less than one additional 25 bps rate move. Investors anticipated that they would be declining by the second half of the year; however, those anticipations were revised after the very strong job numbers.

The US Treasury 2-year note yield rose about 35 bps to 4.50% in early February as investors began to price in the generally hawkish Fed stance. The jump in short-term yields pushed the 10s/2s yield curve spread to -86 bps in early February, the most inverted level in 42 years.

Full-year and 4Q22 earnings are underway for US public companies. With 7 of 10 S&P 500 Index constituents having reported for 4Q22, blended earnings per share (which combines reported data with estimates for those that have yet to report) shows that earnings declined 5%. At the same time, sales rose about 4.7% compared with the same quarter a year ago, according to data from FactSet Research. About 70% of reporters have beaten consensus EPS expectations, below the one-year average of 75% and the five-year average of 77%.

Commercial real estate

Based on analyst targets, FactSet reports that the real estate sector is expected to see the smallest price increases for the year. The sector has the smallest upside differences between the bottom-up target price and the closing price.

CRE capital availability and cost continue to dampen transaction activity and investment. Banks representing about 35-40% of all CRE lending reported in 1Q23 that they continue to tighten underwriting standards for all CRE (development, multifamily, and commercial). About 80% of banks reported tightening for CRE, with a greater portion tightening for development (~85%) and fewer tightening for multifamily (~78%).