Market Matters: Exploring Real Estate Investment Conditions & Trends
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MAY 18 EDITION
Another month of inflation data (for April 2023) confirms that the labor-intensive segments of the economy continue to fuel hotter-than-desired wage growth and inflationary pressure. Both headline and core CPI were up 0.4% m/m, placing headline CPI at 4.9% y/y all as Core CPI is still trending at 5.5% y/y. Narrowing the view to the trailing 3-month annualized rate, Core CPI is still tracking a 5.1% pace. Stripping out the Shelter component of Core CPI, which is on the cusp of an inflection, Services Ex-Shelter is still registering at 5.2%.
Labor market costs are still the crux of the story and will remain a key challenge for the Fed. While we’ve seen moderating job openings and hiring plans alongside stronger labor force participation, it’s not been enough to move the needle on labor costs. So, progress…on some fronts, but pressure remains on others. Labor market dynamics are generally considered less sensitive or less reactive to interest rate movements (i.e.; “stickier”), thereby implying that the Fed’s job is particularly difficult. Our house view remains that it’s going to be very difficult for the Fed to maneuver out of this without the economy resetting to allow for some slack to manifest in the labor markets. The sooner that such a reset happens, likely the better, as it can help to loosen credit availability and put interest rates on a more predictable path.
In the meantime, much of the immediate/near-term outlook remains focused on the considerably tightened credit conditions across the lending markets more broadly, as well as throughout CRE lending space. The Fed’s April 2023 Senior Loan Office Opinion Survey (“SLOOS”) released last week found that lending standards among banks are expected to tighten further throughout 2023; this point remains consistent with what our Equity, Debt and Structured Finance (“EDSF”) team continue to report. CRE lending conditions haven’t completely frozen, yet they remain highly selective. According to both the SLOOS survey, as well as to our on-the-ground insights, tightened credit standards come in the form of widened spreads, more stringent loan selection by property type and asset quality, lower LTV requirements, higher DSCR requirements, higher debt yields, and in some cases personal guarantees (for certain challenged office assets, for example).
Banks and life companies remain particularly cautious and are largely focused on evaluating their existing loan books rather than new originations, unless it’s for an existing top-tier sponsor or borrower. Most capital, whether debt or equity, is focused on preferred asset classes with the highest quality profiles until this period of uncertainty, price adjustment and discovery continue. As bank lending retreats and as standards tighten, private debt funds have an opportunity to step in at relatively attractive risk-adjusted returns (less competition and quality assets secured by lower LTVs and strong sponsors).
Gauging Industrial Sentiment: Pulse from C&W’s Interchange Conference
Cushman & Wakefield’s Logistics and Industrial Americas platform hosted a lively Interchange Conference in Scottsdale. Sentiment throughout the conference was upbeat, and the mood has improved in the wake of what was a tumultuous first quarter. Despite that clarity on the macroeconomic outlook hinges largely on the path of inflation and on monetary policy, focus remains on Industrial’s robust fundamentals, and on the resilience of rent growth and NOI.
- Perspective is everything: Extending this concept throughout the capital markets, interest rates are normalizing (coming off a period of a unique lower-bound), and a reversion back to 2%-4% treasury rates is consistent with many other points in history. The difference now, of course, is that the period of such significant cap rate compression is cooling, and we’re coming off a period of exceptional return prospects. A moderation does not imply that forward-looking 3-, 5-, and 7-year returns will be negative. In fact, Industrial’s forecasted cumulative total returns are projected to outperform against the context of both a downshifting economy as well as downshifting cross-asset class returns.
- Investors realigning to their core competencies: as the market accelerated over the last few years, bringing with it newfound capital, some investors stretched: either accepting overly rich going-in pricing, negative leverage, or pushing out on the risk spectrum from a strategy perspective, etc. Now that the market has receded, investors are refocusing on the strategies they were deploying pre-run up.
- Focus is shifting back to the basics. Against this period of interest rate normalization and given the fact that cap rate compression is no longer a fail-safe strategy, we are now in an income-oriented era. Properties with shorter WALT are generating strong interest, all as property resilience is being redefined against the context of tenant quality, even down to tenants’ industry-quality characteristics.
- Alongside the return to basics, the proverbial flight continues: whether that be flight to quality from an asset quality standpoint, a market or submarket standpoint, tenant credit-quality, or even a sponsor or partnership standpoint. The market has been repricing debt, but risk spreads for Industrial haven’t blown out in the aftermath of the volatility witnessed in Q1. Caution persists, but the general view of risk (for Industrial) has not fundamentally shifted from where it was at the start of the year. Real-time pricing appears to have shifted up about 100 bps across the board (more for secondary and Tier 3 markets).
- Debt-related conversations and capital stack considerations continue to take the lead, which is positioning highly liquid, nimble and flexible cash-buyers at a relative advantage. Debt remains highly selective, all as capital stacks are growing increasingly complex.
- The pool of active buyers continues to diversify. While some heavy-weight institutional, open-end and public buyers are still largely in pause / wait-see mode, this is allowing other institutional investment managers with closed-end or separate account funds, private investors HNW investors and some SWF to emerge as more active sources. Our on-the-ground, real-time intel continues to witness broadened and stronger interest on a deal-by-deal basis, with an increasingly robust pool of interested buyers who are showing more engaged, active interest in marketed deals.
- Amassing land remains an attractive strategy, particularly given the relatively more appealing cost-bases that some sectors are offering.
Many of the themes that I’ve highlighted throughout previous editions of Market Matters were prevalent throughout last week’s C&W Sunbelt Capital Markets Forum held in Miami , including investors’ desire not just for trophy assets, but “magnet offices” geared towards attracting tenants and workers back to the office in the new-era hybrid environment. Experts also reflected on the overarching challenges in repurposing and repositioning assets, as discussed throughout our Obsolescence Equals Opportunity paper released a few months ago.
Despite the region’s robust growth and generally higher return-to-office metrics, the Sunbelt has not been immune from the disruption in the capital markets, but the tone was noticeably more upbeat than would be for other regions, especially looking ahead. Many panelists (which included those from Related Companies, Hines, Nuveen, Highwood Properties, and Banyan Street Capital) are expecting to be net buyers next year, and some of their equity partners are also pushing them to be buyers this year, albeit smart buyers. Those that were not planning to be big buyers were looking to reinvest in existing assets, investments of which are being scrutinized just as if they were new acquisitions.
Flexibility was another key theme. It takes a few forms:
- Flexibility on execution and building creative capital solutions to put deals together.
- Flexibility on new construction/redevelopment: adding in more mixed-use components that are complimentary to office space to create a more dynamic project, which also lend itself to more favorable capital markets.
- Flexibility for customers: whether that’s laddering leases, or creating more shared amenity space, which allows tenants to take less square footage, but remain efficient.
Office-Using Employment Highlight
Eventually the relationship between job growth and office-demand will resolidify. The relative optimism shared for the sector’s longer-term prospects was underscored by the fact that projected office-using job growth remains concentrated in the Sunbelt (albeit moderated from the breakneck pace witnessed over the last several years). Utilizing this lens of outperforming office-using growth, it’s possible to see a world in which one grows their way out of current environment with relatively stronger office demand.
Leading Indicators in Tracking Potential Trouble in Office Loan Performance:
Weakening Office fundamentals, deteriorating property cash flows, alongside rising service debt costs, tightening credit conditions, declining property values and mounting loan maturities will pressure Office loan performance in the quarters and years to come, particularly properties facing mounting competitive and functional obsolescence.
Cross-sector CMBS Watchlist status fluctuations provide a useful, real-time proxy for loan performance across other CRE loan/lender portfolios (even if CMBS loans possess slightly different risk profiles overall). The share of CMBS properties on Watchlist rose most notably for Office, up to 23% as of May. This share reflects a total of 1,005 loans and $40 billion in allocated office loan balance.
Keep in mind that Watchlist is only one metric in tracking oncoming weakness. Leading into Q2, loans that failed to pay off at maturity that were classified as “non-performing-matured” arose as the primary culprit towards rising delinquency (implying that the loan may not have even been on Watchlist status as it could very well have been performing prior to maturity). For the $40.47 billion million in office CMBS loans maturing by the end of 2024, lenders have grown increasingly conservative in offering financing to commodity office product, thereby increasing the risk of maturity default for this cohort.
On a cross-sector basis, Hotel loan performance continues to improve on the back of the sector’s ongoing recovery from the pandemic. MF loan performance remains the strongest, owing to the sector’s strong occupancy and income-oriented resilience; this is not to say that the MF universe will be immune from default risk, but historically, the sector has been more resilient given its needs-based demand profile.
MAY 5 EDITION
Monetary Policy & Outlook: Is This The End?
Yesterday, the FOMC raised benchmark interest rates another 25 bps in its 10th consecutive hike, bringing the target to a range of 5%-5.25%, the highest since August 2007.
The move was widely expected, and the FOMC statement also lightly acknowledged the possibility of pausing rate hikes, in line with the latest Summary of Economic Projections released in March. The FOMC statement also removed the phrase “some additional policy firming may be appropriate,” and Powell specifically said they would be taking a data-dependent approach to determine if additional rate hikes would be necessary. The Fed also made efforts to specifically note that the “U.S. Banking system is sound and resilient,” underscoring a point Powell made in his press conference. The Fed appears poised to examine the cumulative effect of its tighter monetary policy; however, a less-dovish script should not lead the way for unbridled optimism. Powell stressed that price stability remains their key objective, particularly against the context of a tight labor market.
Heading into the FOMC meeting, the forward curve priced in four rate cuts this year, beginning in July. Following yesterday’s hike, markets similarly pricing-in substantial rate cuts through the end of this year. We’re wary of trusting the forward curve – it’s typically a poor prognosticator at best – but it’s useful to determine whether the risks to the treasury rate are tilted up or down.
Notwithstanding the myriad of dizzying media headlines, the Fed still has work to do. Upcoming inflation and employment data are more than likely to register at a pace consistent with another 25 bps hike (regardless of how optimistic futures-implied fed funds rate trajectories may be).
Therefore, flying notably against such widely-held market sentiment, we believe cuts are unlikely to happen this year, even as headline inflation improves due to base effects. The shadow of Volcker is long at the Fed, and with key measures of inflation still notably hot (particularly core inflation), the Fed is wary of pivoting prematurely and of a double-dip, wherein inflation reaccelerates much like it did in the 70s and 80s. When asked about cutting rates, Powell reiterated "FOMC view is that inflation is going to come down not so quickly…And in that world, if that forecast is broadly right, it would not be appropriate to cut rates. We won't cut rates." This would imply that treasuries will drift up through the year as these cuts fail to materialize.
Despite that uncertainty remains, we’re collectively further through this rate hike cycle than it may feel. Assuming the Fed holds course long enough to curb inflation and avoids a double-dip scenario, we’re on the path towards further rate stability, which bodes well for financial markets, for CRE debt markets, for price discovery, and ultimately for CRE liquidity more broadly.
The Delicate Balance of Reporting on Capital Markets in a Dynamic Market: Leveraging Real-Time Intel while Maintaining a Data-Driven Approach
We now have two consecutive quarters of performance demonstrating that the private, institutional side of CRE valuation is adjusting and normalizing. Many have (and will) write me and say, “Abby, why are you even writing about NCREIF right now, it’s so backward looking, it’s meaningless!” To which I would say, first, I understand your frustration. And second, yes, I agree value adjustments on the private institutional side inherently lag behind real-time and public valuations due to their backward-looking appraisal-based approach, but they serve as an important benchmark for institutional portfolio performance and they do inform decision-making at the portfolio level.
Intel is everything, anecdotal intel, financial market intel, as well as preeminent industry sources such as NCREIF. I would also argue that each piece of intel (anecdotal, public/financial market, and private) each hold their own special purpose. The sooner we see an alignment of adjustments across the full spectrum of intel-sources, the more efficient the market will become from an alignment standpoint (rather than floating in an impasse/limbo).
Income Returns continue to offset negative capital appreciation, though not enough to lift Total Return into positive territory. We saw greater dispersion in negative Capital Appreciation returns this quarter, with a particularly pronounced negative adjustment for Office (-5.2% quarterly and -12.7% annualized). Consistent with our house-view, cap rates continue to adjust upwards. From a cross-sector perspective, the q/q adjustment to transaction-based Office and Industrial cap rates particularly stands out; yet, their adjustments stem from different reasons – widening risk premia for Office as opposed to Industrial’s lower-cap rate spreads to other rates.
…whether that be relative to risk-free rates or to risk-adjacent asset class yields (corporate bonds). Zero or negative cap rate spreads to these returns mean that CRE returns are not in a sustainable position (from a cross-asset class portfolio management standpoint). This means that yields will have no choice to adjust to assure CRE remains attractive. Such an adjustment can of course come from upward shifts in cap rates (as we expect), but we also expect relatively robust income growth to help offset cap rate movements, thereby insulating the impact on values. Additionally, this doesn’t mean that spreads need to be as wide as they once were when rates were super low, but it does mean that some spread must exist for efficiency to hold. In our forecasts, we assume relatively tight spreads, but we do forecast value declines as the market adjusts to rising interest rates.
The public market has already been pricing in this sort of adjustment for some time now, which helps bring up an important point: in many respects, we are further along in this period of adjustment and adaptation than it may feel (at least for the stronger-preforming sectors). In addition, public markets inherently contain some degree of elevated volatility given their liquidity, so it’s important not to ascribe too much specificity to the magnitude of the change. Nevertheless, it is instructive to look at the directional movement overall, particularly because it has maintained a general trend consistent with the outlook we’ve been calling for.
APRIL 19 EDITION
Inflation & Cutting Through the Noise ~
The positive improvement in headline inflation captured most of the focus throughout the media week, ultimately distracting from the more critical story related to core inflation. Indeed, headline inflation edged up just 0.1% m/m to 5.0% y/y; however, core inflation rose 0.4% m/m bringing the y/y figure to 5.6%. Ultimately, the resilience of the labor market continues to propel wage growth, which in turn is pressuring Core Services Inflation (excluding Shelter); this is both a cyclical and structural challenge for the Fed to confront; it is cyclical in the sense that tightened monetary policy can bring slack and softness to the labor market, but it is structural in the sense that there’s still a shortage of educated, skilled labor.
Expectations for Monetary Policy & Outlook ~
Meanwhile, the market implied terminal rate has reverted to where it was before the 500k standout jobs report for January and the Banking Episodes and collapses of Silvergate, SVB and Signature Bank. While I don’t look to market-implied rates as a good indicator for the true terminal rate (and much prefer to utilize the Fed’s Summary of Economic Projections and its own dot-plot), this re-grounding in market expectations is a “good thing” because the market is more aligned with the Fed’s guidance, thereby implying that it is pricing-in such assumptions more consistently again and not growing enthusiastic over the prospects for a premature pivot or pause. Taking the Fed at the Fed’s word helps in one sense – in reducing volatility and reducing the noise. The markets have been much more aggressive in pricing-in rate cuts in the back half of this year, which despite my natural utopian tendencies, feels unrealistic given where inflation is at and why it is where it is. And, keep in mind, we don’t necessarily need a pivot or a cut in order for the capital markets space to gain more incremental clarity.We expect another 25 bps hike from the Fed on May 3 resulting in a terminal target range of approx. 5% - 5.2%. From there, the Fed is likely to pause to monitor the progress of tightened monetary policy on inflation and the labor markets. As slack unfolds (i.e. recession unfolds), we should see some freeing up in the CRE capital markets space by Fall. This is not to say that interest rates will have reverted back to normal by then, nor is it to say that the portions of the economy and the macro environment will not be strained, but rather to say that we are likely to have more visibility into terminal Fed Funds, and the scale of impact that monetary policy will have on the economy, which will bring more stability to debt markets and likely more liquidity to the equity markets.
Financial Market Response, post SVB and post CPI:
In the wake of SVB, we’ve seen a further flight to quality in the financial markets; treasury yields compressed or declined quickly, while spreads throughout riskier segments of the investment landscape expanded, implying expanding risk premium (this extends to corporate bonds, as well as to CRE, shown in the chart below). CMBS is still rather locked up, and you’ll notice that CMBS spreads have widened to thresholds not seen since last fall when the effect of tightened monetary policy (rising rates) was growing particularly acute on the CRE debt markets space.
Notwithstanding the daily whipsaw and volatility of the Treasury (at about 3.5% today) and bond markets, this monthly inflation read also isn’t enough to shift CRE debt and equity market sentiment or liquidity meaningfully; the proverbial uncertainty meter is high and the “wait and see” tactic dominates.
Words on the Street; When does the Gridlock Lift?
Clarity: The Fed’s May meeting and another few CPI readings will be critical to providing further insight and for allowing for conditions to change. Until then, forward looking views should remain measured (manage expectations) and focused on strategizing for the longer-term.
Impasse: The CRE markets are at an intellectual gridlock; many sellers believe that a correction is already priced in, while buyers contend that prices have further room to fall. Notwithstanding our house-view (which indeed calls for a reset in values as cap rates adjust upward to coincide with comparative yield spreads to risk adjacent asset classes), a forecast cannot ‘illicit or motivate the market to shift.’
Bid-Ask Spreads: In needs-based sell conditions, we’re seeing more seller capitulation than buyer capitulation, particularly on the lower-quality spectrum, which offers a bit of a leading indicator to suggest that the bottom end of the market is going to move first. Bid-ask spreads range from 10% - 40% depending on where the asset stands on the quality spectrum, with lower-quality, fundamentally-challenged properties garnering notably wide prevailing bid-ask spreads.
Capital Stack Comments: Ultimately, in this period of heightened uncertainty, for-sale inventory is increasingly motivated by a necessity-based situation (whether that be a need for fund liquidity, floating debt or a maturity-based deadline, or some form of tenancy or debt-coverage stress); these situations may involve impairment for owners, but often offer attractive opportunities for “rescue capital.”
Capital infusions in this chapter have an opportunity to enter the capital stack at relatively more attractive risk-adjusted conditions and terms than in prior cycles. As loans mature, Mezz debt or additional equity will continue to play a critical role in capital flows, particularly for under water properties. Mezz Debt remains popular given the relative protection alongside attractive yield. And on the equity side, particularly in underwater circumstances, the rescue capital being infused today is receiving relatively more secure positions (purely as a factor of negotiation): in upside-down/underwater cases, the decision comes down to whether to sell at a loss or take a flyer with a new equity provider to ride it out for a few years; this of course depends on the asset and on whether fundamentals support such a decision. It’s a complex conversation and consideration process that requires alignment across a diverse capital stack, and one that our debt and capital markets folks continue to have daily.
Seller Concessions: You’re more likely to trade if you offer seller financing, or you offer a 49% interest with a preferred return (a cushion).
Greenshoots for Stability and Quality: Other sellers not in a necessity-based situation will aim to hold through a downturn and through the most acute reset period. This is naturally going to make high-quality product more scare from an acquisition standpoint. Development, in this sense, is also well positioned as upon completion (assuming they can manage their floating debt in the meantime).
It’s also important to distinguish between liquidity and availability of capital, versus supply – the supply of debt and equity capital is there (bank debt capital aside), it just remains on the sidelines – this bodes well for best-in-class assets, which will receive heightened competition from both lenders and equity sources.
APRIL 5 EDITION
Perspectives Leading into Q2
As we enter the second quarter of the year, the necessary process of recalibration and rebalancing across all facets of CRE capital markets took a frustrating pause, largely due to heightened financial market volatility and uncertainty. We also took a few steps backward both on the inflation front all as the collapse of Silvergate, SVB and Signature Bank sounded critical alarm bells of the consequences of sharply rising interest rates on the underlying value of and exposure to various bank assets. Yield curves remain historically inverted, all as financial market liquidity conditions have noticeably tightened.
These bumps in the road are to be expected, though, as the Fed is navigating a difficult course, and there is no easy or fast way out; all of this takes time to flow through the economy and the markets. Just as the Fed can’t hasten its monetary policy influence on inflation, CRE capital markets participants cannot hasten the process of price discovery between buyers and sellers because caution, conservatism, selectiveness and flight-to-quality abounds.
While the momentum and hopeful clarify that was felt at the onset of the year may have downshifted, our overall message and U.S. Macro outlook remains the same. The CRE industry is facing a confluence of two dynamics right now, an oncoming potential macroeconomic slowdown as well as the required adjustment to a normalizing, rising interest rate environment. The former is expected to soften fundamentals across the board, though it will not derail CRE performance prospects altogether. With the exception of Office, which as we’ve outlined in our Obsolescence Equals Opportunity paper is facing a trifurcated landscape, the other CRE sectors are well-positioned to bounce back relatively quickly.
Last quarter reinforced the importance of taking the Fed at the Fed’s word, and of the importance in focusing more closely on the bigger picture, rather than on allowing the whipsaw of market sentiment to take one’s own sentiment along for a tumultuous ride. The focus on structural demand drivers, defensive strategies, and on credit-, income-, and asset- quality remains a key theme throughout the CRE investment landscape.
While there are certainly a few pockets of isolated weakness throughout CRE (particularly as it relates to commodity and lower-quality office product), institutional, foreign and private buyers remain focused on the abundance of thematic investment plays- whether that be acquisition or development-oriented strategies throughout the multifamily, industrial, retail, hotel, high-quality office, and alternative/niche sectors – all of which offer attractive risk-adjusted returns even in a higher-rate environment.
Banking Sector Update
This week provided the financial markets with a much-needed period of relative calm to digest the conditions of the U.S banking sector as well as the Fed’s most recent 25 bps hike. Fed Chair Powell made a concerted effort to contextualize the banking crisis as one of liquidity (linked specifically to interest rate duration risk), not one of credit risk linked to CRE, which hopefully continues to provide the markets with the confidence necessary to avert further panic-driven deposit outflow.
In addition to our first-take view “Bank Failures and Panics: Five Key Thoughts for CRE” that we published a few business days following the collapse of SVB, I also released two thematic Market Matters on the topic (the March 23rd Edition, which features a special view on key takeaways and some points monetary policy, and the March 15th Edition, which features a view on CRE financing by Lender Type).
Our Head of EMEA Forecasting, Sukhdeep Dhillon, also released an article focused specifically on the European banking system, highlighting the unique circumstances leading up to Credit Suisse’s collapse that were unrelated to the interest rate risk and deposit flight issues that caused issues for the handful of failed regional banks in the U.S.
Hitting the Proverbial Wall: Maturities
Before launching into this topic, I’ve noticed that the media and CRE industry at-large has been approaching the topic of ‘distress’ without first acknowledging that distress can materialize in many forms and requires that we contextualize the concepts into a few key categories first: maturities, overall value (equity) diminution related to rising cap rates, and asset-specific obsolescence risk.
In the wake of the banking sector events, CRE lending conditions tightened across the board, leading the media to place heightened focus on the impending wall of maturities. This, however, is an area of both challenge and opportunity for the sector that we’ve been tracking closely for some time.
Lending conditions were already tight, whether you looked at it on March 1 of this year or post-SVB. Maturing loans face the confluence of higher interest rates (higher debt costs for a refinanced loan compared to incumbent loan maturing) as well as potentially weakening property-level NOI conditions (depending on the sector), thereby making it that much harder to service their debt obligations.
Previously, we’ve featured oncoming maturities broken-out by initial loan origination term, which helps to highlight the relatively higher maturity default risk facing loans secured by properties that haven’t had as much time to accrue value appreciation.
These next charts, meanwhile, feature cross-sector loan maturities by year, which can be overlayed with our U.S. Macro forecasts, to provide a view of oncoming maturity risk by sector.
Unless owners, investors or the funds such properties are backed by can put up more capital to reduce the loan balance enough to make the numbers work, then the owners can get themselves into a precarious position, either being forced to sell or being forced to look for outside debt or equity capital.
Many lenders are looking for ways to work with their existing borrowers, which might mean offering interest deferral or extension in exchange for putting more money against assets that have some degree of promise of rebound. Neither the debt or nor equity side is going to want to put good money after bad, so we’re finding that many banks are taking this opportunity to dig into their portfolio to get a sense of where potential loan trouble will arise so that the lines of communication can be open early. As a result, our Capital Markets, Valuation & Advisory and Equity, Debt & Structured Finance Teams are busy advising clients right now. The key for the industry at large will be in maintaining a realistic perspective – and ultimately coming to recognition of what a given property’s reset value really is.
Cross-Sector Loan Maturities Vary by Magnitude
Office + Multifamily Loan Maturities Comprise ~50%