US commercial real estate market update - July 2023

Defying gravity

In spite of the Federal Reserve’s aggressive monetary tightening, the resilience of the US economy has defied many economists’ initial expectations and calls for a 2023 recession. While the Federal Reserve has made it clear that further tightening is likely over the coming months, the markets and investors have recently restored faith in the possibility of a soft-landing narrative.

After many months of second-guessing Fed talk and guidance, investors and capital markets appear to be more aligned with the Federal Reserve’s guidance than at any other point during the central bank’s aggressive tightening cycle. Having taken a pause on additional hikes in its June meeting, the Fed is expected to continue hiking (25 bps in July), as it manages inflation down further and aims to avoid a break in the markets or economy.

Figure 1 - The absence of obvious systemic threats has many investors hoping for a better-than-expected 2H 2023

“Soft landing” back on the table?

So, is a soft landing back on table? Inflation is high, but falling; the labor market remains tight, but shows signs of loosening; the biggest banks passed their stress-test and no additional banks have gone bust since the March woes. Things seem to be trending in the right way for a soft-landing. The absence of obvious systemic threats has many investors hoping for a better-than-expected 2H 2023 – despite the expectation of higher-for-longer (inflation, interest rates).

Equity markets entered bull territory in 2Q 2023, as excitement around artificial intelligence (AI) fueled a few of the largest tech companies, which pulled up broad indices. While few doubt the impressive tech, and many more can see the potential, there have been few cases of successful widespread application. Nevertheless, the market reaction serves as a reminder that investors are pricing future expected cash flows. While much of the fanfare helped boost share prices and indices, the private markets were largely left muted or untouched.

Even with renewed optimism with the prospects of a soft landing, investors are paying extra close attention to company performance and guidance through 2Q earnings season, as the full effect of the rapid rise in interest rates has yet to be fully felt. And while the economy as a whole may be able to dodge a recession there are still many sectors that are still vulnerable to a “higher for longer” environment either because of their leverage, ability to manage expenses and protect profit margins, or both. It is the author’s opinion that if no outright recession, the scenario of rolling, industry-concentrated downturns, characterized by falling profits, deteriorating credit quality and declining valuations, is still in the cards.

The continued progress on the inflation front should be somewhat comforting, validating that higher interest rates are working to some degree. However, inflation is still above target and many markets have been significantly disrupted – begging the question: will the Fed throw the baby (economic and market stability) out with the bathwater (inflation)? Seems like we should have a better understanding of the answer to that question in the coming quarters.

CRE taking it on the chin

One of the sectors significantly impacted thus far and likely to continue to be affected is commercial real estate (CRE). CRE has suffered a double-whammy from: 1) rising cost of capital and 2) the indirect, but lingering, impact from March’s regional banking woes. Both of these factors have challenged confidence seen by the dearth of transaction activity this year and desire for greater price discovery. As of writing (late-July), the 1H 2023 aggregate metrics show a near-halving of investment activity across property types.

Figure 2 - Quarterly number of CRE transactions (YoY % change)

Figure 3 - Quarterly dollar volume of CRE transacted (YoY % change)

Here are the key developments that caught my attention over the past weeks:

Economy

During his semiannual congressional testimony on monetary policy, US Federal Reserve Chair Jerome Powell informed lawmakers that though the pace of Fed rate hikes has slowed, there are plans for further rate increases later this year. Powell mentioned that a significant majority of the Federal Open Market Committee members anticipate two more rate hikes. The decisions on rate adjustments will be made incrementally during meetings. However, Powell acknowledged that achieving the 2% inflation goal will require considerable effort. He also stated that policymakers anticipate a rise in the unemployment rate but still envision a feasible path to achieve an economic soft landing.

US homebuilder confidence rose in June (55 from 50 in May). Existing home sales fell by 20.4% in May, while new home sales increased by 12.2%. The Case Shiller national home price index declined by 0.2% year over year in April, the first drop since 2012. Low inventories of existing homes benefited builders of new homes, with housing starts up 21.7% from the previous year.

US June nonfarm payrolls rose by 209,000, below the expected 230,000. The unemployment rate ticked down to 3.6%. Average hourly earnings remained at 4.4% year over year. Despite all this positively strong data, it may not affect the decision to hike rates again in the Fed's July meeting.

Capital markets

Bond yields surged due to hawkish FOMC minutes, tight labor markets, and concerns that inflation is declining too gradually, potentially leading to a persistent issue. The yield on the US 10-year note surpassed the 4% level, reaching a new high for 2023 and surpassing the pre-banking crisis levels seen in March.

The US Treasury 2-year / 10-year yield curve was inverted and approached the lows set in March (nearly -110 bps). To see a yield curve inversion this deep, one has to look back nearly 40 years. Inverted yield curves have historically preceded recessions.

In the Federal Reserve's annual stress test, all 23 US banks successfully withstood a severe recession scenario and maintained their lending to consumers and corporations. However, there was a wide range in terms of projected total loan loss rates among the participating banks. Of the loan products stress tested, credit cards were the worst performing product. And while many banks have gotten accustomed to the annual stress test, Fed’s Vice Chair for supervision, Michael Barr, spooked many banks and the markets when he noted that there may be a shift away from the internal model-based approach to the standardized risk-weight, which is significantly more regulatory capital intensive.

As second quarter earnings got underway, FactSet reported that it expects the index will likely report a year-over-year decline in earnings for 2Q, the third consecutive quarterly decline.

Commercial real estate

High interest rates, concerns of deteriorating credit quality, and lingering scrutiny from investors and regulators all challenged CRE transactions through the first half of the year. The number of transactions was down significantly year-on-year; 22.4k properties were transacted in the 1H 2023, down 41% compared to the same period in the prior year. In dollar volume term, 1H 2023’s $85.9B was down more than 53% compared to the same period in 2022.

The Federal Reserve, FDIC, OCC, and National Credit Union Administration jointly issued a final policy statement on commercial real estate loan accommodations and workouts on June 29. These updates, initially proposed in 2022, remain mostly unchanged in the final version.

Disclaimer: The following commentary is solely the opinion and analysis of the author and does not reflect the views or opinions of Altus Group or any of its related entities or affiliates (collectively “Altus”). The information provided in this article is for informational purposes only. It should not be considered as financial or investment advice. Altus does not endorse or guarantee the accuracy, completeness, or reliability of any information mentioned in this commentary. The author and Altus shall not be held responsible for any decisions made based on the information provided in this blog.