US commercial real estate - Four themes to watch in 2023

With third-quarter earnings wrapped and only a few weeks of 2022 remaining, attention has turned to 2023. While there is no shortage of outlooks and forward-looking commentary, it is a good time to take stock of the last +11 months and put the current commercial real estate markets into perspective before the new year begins. We look to highlight a few of the key themes in US commercial real estate (CRE) which caught our attention through 2022 and share some of our views on which themes we think may remain relevant or come to prominence in 2023.

Taking stock of 2022

Macro backdrop

Following the bumper year that was 2021, 2022 had a tall order to fill. For the first months of 2022, there were few signs of slowing in the economy and markets; however, there was growing uncertainty about how long the good times could last.

Market sentiment was still generally positive, though with an increasingly cautious tone. The positivity was supported by most of the data from those early months. Many of the key economic measures had recovered and stabilized; much of the pandemic-related emergency policies which led to massive amounts of liquidity across markets had or were burning off; investor risk appetite was still present as capital was available, and valuations across risk assets seemed reasonable even if a bit rich.

During the early months of 2022, most market participants were focused on the high inflation which seemed to permeate all asset classes. The market’s intense focus and debate centered on this measure because having helped to restore stability and health to the labor market, inflation became the Federal Reserve’s main target. To address inflation, the Fed would be raising rates and thereby putting an end to the ultra-low interest rate environment which had largely lasted since late 2008.

While the market could anticipate the directional change of interest rates and thereby financing costs (up), the speed and ultimate destination of rates were unknown. So, when the Fed began its rate hikes in March 2022, the market sentiment began to shift. As financing costs rose, sentiment shifted, capital began to pull back and many risk-asset valuations came under pressure. This cycle of events continued as it became evident that the Fed wasn’t seeing the response to inflation that it was hoping for and proceeded to hike at a pace not seen in decades.

Combined with the US monetary policy tightening, which alone raised significant uncertainties, many other risks came to the fore for investment committees and capital allocators through 2022. For many, a risk-off tone became dominant, as greater attention was turned toward assessing and managing risks. On the table for discussion were: market volatility, financing cost/availability, valuation, inflation, and recession risk – the usual risk suspects. But also added to the mix were less frequent risks including: inflation, pandemic, climate change, and geopolitics. The presence of both these “normal” and “abnormal” risks all at one time made the second half of 2022 a uniquely challenging time.

US CRE

These macro trends and souring 2023 outlooks permeated all investable asset classes – including US CRE. However, US CRE was not affected immediately. While publicly-traded real estate investment trusts (REITs) did see share price pressure earlier on, when the broad stock market began to reprice, private US CRE (measured by the NCREIF ODCE Index) continued to post positive returns through the third quarter. 

The ODCE Property return dropped to just 0.4%, with appreciation return turning negative in third quarter 2022, ending an 8-quarter streak of consecutive period-on-period growth.

At the start of 2022, there was a case to be made for the relative attractiveness of US CRE compared to other asset classes given its strong track record in inflationary environments. However, around mid-year, it became clear that the higher-rate environment and pullback by many lenders significantly slowed transaction activity and raised questions about appropriate market valuations – especially while heading into a likely recession.

This unanticipated pessimistic shift was captured on a recent Altus webinar, when the CRE industry professionals in attendance indicated that they were caught off guard by 2022.

2023 CRE trends to watch

Despite the consensus call for a recession in 2023, uncertainty will likely remain elevated.

Through much of 2021 and 2022 market and CRE discussions were focused on the levels of specific data points (e.g., pricing, transaction volumes), while these will remain important measure, the focus will adjust to the rates of change and sensitivities of these measures to other macro drivers.

This nuance may seem subtle, but it represents the return of heightened risk awareness and management. Other trends, specific to US CRE, to watch in 2023 include:

Repricing and return reversal

The third quarter NCREIF ODCE returns showed that industrial and apartments continued to outperform office and retail. However, compared to the prior quarter, the opposite was true. On a quarter-over-quarter basis, industrial and apartments saw a steeper drop, driven predominantly by a negative yield effect.

The negative yield effect, which represents a repricing of risk, affected all property sectors, but hit industrial and apartments the hardest. While the negative yield effect across all sectors in a rising rate environment is intuitive, it appears that not all cash flows are being priced similarly, as industrial and apartment cash flows remain stronger than retail and office. This repricing and return reversal trend is worth watching in the coming periods.

Cost of capital to stay front and center

On November 30, Federal Reserve Chair Jerome Powell signaled that the Fed would be slowing the pace of rate hikes. The news was received well by the broad US markets on the day it was announced.

However, a slowdown in the pace of the hike does not mean a rate reversal. If a transaction could not pencil at the start of November, it is unlikely to pencil after the next Fed rate hike, even if that hike was 25 basis points less than the prior hike. Until interest rates and financing costs stabilize, transaction volume will likely remain challenged and down.

The risk-off mentality of many capital sources combined with the overall industry environment will not only slow transaction volumes, but will also shift focus on deal due diligence to be more cash flow focused and return-critical.

Further bifurcation across property sector performance

The pandemic was a shock for us collectively as a society and individually as people. Many may want to put the pandemic in the past and resume life as it was before the pandemic.

However, the pandemic changed how we interact with each other and our space, and those changes altered the demand for CRE. This demand shift has created bifurcations across and within property sectors.

Most obvious has been office, which significantly underperformed over more than a year. While the property sector as a whole is not performing well, there are still many “trophy” assets which show few signs of concern and remain in high demand. Not quite a zero-sum game, these bifurcations will lead to a “winner-take-most” scenario – with the best properties attracting the reduced demand.

What constitutes “core”?

Related to the bifurcation noted above, the concept of “core” assets may be refined. In the span of a decade, ODCE portfolios have made significant composition changes; and most of the mix change happened in the last five years.

Offices that used to account for ~40% of the value of ODCE funds are now less than 25% of portfolio value. Retail value weightings have dropped to 10%. And those two sectors, which used to account for about 55% of all fund values, are now collectively just around about a third. And that reduced share across those two has really been taken up or replaced by the industrial sector exposure, which has gone from 14% to over 30%.

The largest aspect of those structural changes, and we've looked at the data, is down to the performance levels that have been playing out on a sector-by-sector basis as opposed to portfolio investment decisions. 2023 may be the start of the conversation about what does it mean to be “core”?