“Sea Change”
On any given day we can peruse a plethora of financial publications proclaiming the demise of U.S. commercial real estate. The concerns are arguably well-founded, as the sector is influenced by various factors, including higher interest rates, inflation, and geopolitical concerns.
The regional bank failures in March 2023 and the recent whiff of another round of banking woes (New York Community Bancorp), while not caused by real estate, have highlighted the hazards that longer-term assets pose to liquidity.
While banks have retrenched their lending amid investor and regulatory scrutiny, the most recent Federal Reserve Senior Loan Officer Survey (SLOOS) showed that while US banks tightened lending requirements again in the fourth quarter of 2023, fewer did so this time, indicating that the trend may be moderating.
Nonetheless, the US economy remains relatively robust. Strong consumer spending and employment growth, along with strong federal stimulus, have been positive indicators. Inflation has decreased significantly since its peak in the middle of 2022, prompting the Federal Reserve’s tilt in December to a more accommodative monetary policy.
Higher borrowing costs have posed substantial challenges in real estate underwriting. Buyers and sellers continue to have vastly different pricing expectations. Furthermore, the flood of maturing real estate loans presents a considerable refinancing risk.
Yet, there remains a near-record amount of dry powder, noted Tim Wang, head of research, and Julie Laumont, research officer, at Clarion Partners in their 2024 US real estate market outlook report. “Clarion Partners believes that 2024 may see greater stability in asset pricing. If investor sentiment improves in 2024, more real estate deals should be transacted,” the authors wrote.
The New York-based real estate firm is “cautiously optimistic” about this year, believing the present situation will generate “attractive buying opportunities over the next 12 to 18 months.”
With the Federal Reserve expected to lower interest rates this year (the central bank has telegraphed three cuts, while the market is pricing in six), market cap rates are likely to have peaked, but appraisal-based cap rates, which respond with a lag, may be close, according to DWS Group.
This would be a “sea change” for the real estate sector, added DWS Group, which will likely remove a significant barrier to valuations, and create a tailwind for future performance, assuming cap rates follow interest rates lower.
Higher interest rates and lower asset prices may limit some borrowers’ capacity to service and refinance their existing debt. However, many loans have enough cushion to withstand these demands. “Over the past five years, core real estate cash flows have increased 21% and prices 15% (after recent declines),” wrote DWS, citing data from NCREIF and Bureau of Economic Analysis (GDP).
Furthermore, a looming credit crisis discussed for much of 2023 has not materialized yet: spreads on core real estate loans have barely moved, remaining consistent with historical norms and far below COVID peaks.
The forecast for real estate is improving. A steady decline in inflation, and more importantly inflation expectations three and 5 years out, has prepared the way for looser U.S. monetary policy, which will continue to help valuations. Recession is certainly the fly in the ointment. But any economic downturn is expected to be mild, and “real estate’s positive momentum will only slow, not stop,” wrote DWS Group.
