Economic Overview – Cautiously Optimistic
The first half of 2023 was a whipsaw of economic and real estate data that turned from gloomy to bright and back again. As the fog lifts, the case for a soft landing has become clearer. The most notable change over the past few months has been meaningful progress on inflation, which seems to be moderating, down considerably from its 8.9% peak last year to around 3% where it currently stands.
Consumers and businesses are beginning to show signs of optimism in the face of decreasing inflation and resilient labor markets. The Conference Board’s consumer confidence index has exhibited steady, if bumpy, improvement over the year. Additionally, both the second and third quarter GDP reports showed healthy growth in business investment, an indication that businesses feel better about the near-term future.
Despite these encouraging markers, not all data over the past several months has been positive. Fitch downgraded the U.S. federal government’s AAA credit rating to AA+ in August, citing concerns over fiscal governance and rising deficits. The resumption of student loan payments in October could begin to create an economic headwind which could weigh on consumer spending and thus, real estate demand in early 2024.
Data showing increasing credit card usage and receding checking account balances also point to possible weakening household solvency. Lastly, interest rates across the economy remain near the highest level on record after a series of rate hikes this year, and financing costs will likely be a drag to growth in the near term.
Similar to the economic outlook, real estate capital market conditions remain challenged, but we believe the market is beginning to show some bright spots.
Capital Market Conditions
Early signals in the real estate capital markets suggest that transaction activity is poised to recover. The wide bid-ask spreads that have driven transaction volumes back to COVID-19-era lows are partially a result of monetary policy uncertainty. Recent month-to-month data show that monetary policy uncertainty might be peaking. According to a forecast by MetLife Investment Management (MIM), the Fed has completed its rate hike cycle. MIM expects the 10-year Treasury to end 2023 in the 4% range, and to remain near or slightly below that level through the end of 2024. Stability in the rate environment has the potential to drive transaction volume back up. This view is generally in line with market consensus.
The often-illiquid office sector is also beginning to see capital markets improvement as buyers and sellers tighten the bid-ask spread and the numbers of trades modestly grows.1 This is evidenced by the amount of time office assets for sale are sitting on the market, which peaked in late 2021, and has been slowly but steadily improving.2 Lastly, MIM believes that real estate equity is offering fair-to-attractive relative value in the spot market. This, coupled with recovering public markets that have helped heal the denominator effect on commercial real estate, should continue to draw in investors to the sector in our view.
Filling Up the Capital Stack
Spreads for higher-yielding debt and preferred equity have widened this year, mainly as a result of declining property values, stress in the banking sector, and sustained weak fundamentals in the office sector. However, in our view these pressures have created opportunities for investors.
Decreasing property values have made it increasingly difficult for borrowers to source new loans or refinance at maturity from traditional lending sources, leading borrowers to seek other sources of capital. The extent to which this is occurring leaves opportunity for higher-yielding debt and preferred equity investing.
Stress in the banking sector, we believe has also created opportunity. The combination of real estate market turmoil and interest rate-related banking stress has caused regulators and bank executives to increase capital reserves, sidelining banks. Lastly, many lenders remain reluctant to increase exposure to stressed real estate segments like the office sector, retail, and more complex property types like hotels. As a result, these property types are likely facing a liquidity gap, pushing up yields even for senior first-lien mortgages.
Fundamentals in general remain healthy outside of the office sector, which could see vacancies rise further next year.
- Apartments: The apartment sector is being impacted by a large influx of new supply, though healthy consumers and a still-tight for-sale housing market has kept rent growth positive for the year thus far in 2023. Larger-format rentals, including single-family rentals, manufactured housing, and apartments with a greater concentration of 2-and 3-bedroom units are of particular interest as trends like hybrid work stick around.
- Retail: Despite high-profile retail bankruptcies in 2023, store openings are handily outpacing store closings. This may be due to a combination of healthy consumer spending and an increase in demand for discounters and off-price stores that are e-commerce resilient. A combination of accelerating demolitions and a declining supply pipeline coupled with positive demand conditions have helped to balance fundamentals in the sector, driving retail vacancy to the lowest level on record.
- Industrial: After a two-year streak of robust fundamentals, the sector shows signs of moderating. Industrial is being affected by a simultaneous moderation in demand back to normal levels and a large supply pipeline. Fallout from inflation, higher interest rates and the regional banking crisis are also pushing up construction costs and causing supply growth to moderate. Still, despite moderating fundamentals, vacancy remains well below its historical average, which should continue to drive healthy income growth for industrial in the near term in our view.
- Offices: The office sector posted another period of negative net-leased space despite positive office-using employment growth last quarter; although, as has been the case for the past two years, lower-quality assets accounted for the bulk of weakening demand. A number of Fortune 500 firms have enacted forceful return-to-work policies, and MIM believes investors should consider the possibility that weak office leasing is now more a function of an uncertain economic outlook rather than downsizing due to remote working.
Alternatives: According to a report by MIM and as seen in Figure 1, favorable opportunities may exist in infill industrial, limited-service hotels and residential alternatives (seniors housing, manufactured housing and moderate-income housing.)
Figure 1 | Property Type Overweight / Underweight Guidance
Despite the risks, the real estate market presents opportunities for well-capitalized investors in our view. In the office sector, negativity around the overall outlook may be peaking, which could mean spot-market prices are near a trough. In the residential sector, larger-format rentals continue to outperform. Retail and industrial are experiencing healthy fundamentals at the same time – which has not happened in over a decade. Real estate capital markets remain challenged, but we believe unlevered equity assets are offering favorable relative value. Debt markets remain dislocated as a result of a pullback from banks, which is creating strong opportunities for senior mortgage, mezzanine, and preferred equity investors, in our view.
1 NCREIF, RCA. 3Q 2023.
2 CoStar. December 2023.
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