2023 is expected to be a difficult one with many uncertainties. The recession’s severity is yet to be determined, the direction of inflation remains unclear, and the timing of the peak in interest rates is uncertain. The resilience of different property sectors is also unclear.
Standing on the shoulders of giants is the best way to have foresight, as it involves leveraging the expertise of leading firms with a staff full of PhDs and daily research and analysis.
One of those institutions I trust is CBRE, and CBRE released the results of their 2023 U.S. investor and lender intention surveys. The survey gathered information from over 180 investment firms, including those managing over $5 billion in commercial real estate assets and life insurance companies.
The results, I think, are the best way to get an insight into the thoughts and decisions of the industry’s biggest players. But they could be complicated to understand, so I wanted to break them down and synthesize them for folks to inform their strategies.
Summary
Here is an extracted overview of what’s in the report if you are short on time.
High-interest rates and a recession will make 2023 a challenging year for commercial real estate. Though inflation eased in late 2022, it still ran at more than 7%.
The Fed will continue raising rates until it sees a marked reduction in inflation nearer to its 2% target. Weakening fundamentals and higher cost of capital will generally lower asset values.
The recession will not be particularly deep.
Corporate finances are in good shape, and employers will shun excessive layoffs to avoid losing employees in a tight market for skilled labor.
While consumer confidence is highly subdued, average household debt is low compared with the onset of previous recessions.
These factors suggest a moderate downturn, with unemployment unlikely to breach the 6% level.
Inflation will be significantly lower by the second half of 2023, setting the stage for falling interest rates and the beginning of a new cycle that will last to the 2030s.
Despite economic headwinds, the pace of change will not ease.
The growth of the digital economy will continue to affect real estate demand.
Hybrid working offers many benefits for businesses and employees, but companies and the office sector must evolve.
Cities, too, will need to adjust to new commuting patterns and reduced office demand.
The resurgent retail sector is just now reaping the benefits of a long period of change, which is attracting keen investor interest.
Data centers and industrial real estate will probably be the most resilient sectors, and the housing shortage will benefit the multifamily sector.
The hotel sector’s recovery from pandemic restrictions will continue, but life sciences activity, which COVID turbocharged, will ease for a while as venture capital becomes scarcer.
Full Breakdown
The first observation in the reports that stood out, though not unexpected, was that purchase and sale activity is predicted to slow down noticeably in 2023, affecting both buyers and sellers.
Nearly 60% of survey participants plan to purchase less compared to 2022, with almost 50% of those surveyed planning to decrease acquisition volume by over 10% in 2023. Only 15% of respondents intend to buy more real estate than the previous year.
On the selling side, investors also reported plans for reduced dispositions, with 44% of those surveyed anticipating selling less compared to 2022. Additionally, over 15% of respondents have no intention of selling any assets in the current market scenario.
Unless their property’s operations are unable to sustain its debt service due to substantial increases in a floating interest rate over the past year or an upcoming loan maturity that cannot be refinanced at current valuations.
On the buying side, investors see ongoing economic challenges, such as inflation and interest rate hikes, as obstacles to both income growth and property value increases. Many companies believe that the worst is yet to come and the market has not yet been affected significantly.
Ultimately all signs are pointing to significantly lower transaction volume overall in 2023.
My take:
Yes, the activity is coming down, but it’s still predicted to be more than any year before 2021.
For those with experience as a buyer, this period presents an advantage as most others will be fearful and retreat. With existing systems and connections, you can pounce on a deal with low competition.
While higher capital costs will deter some buyers, there will be opportunities for large equity players who can deploy capital quickly. However, these investors will likely have a short window: Following the Great Recession, the trough in pricing only lasted around six to nine months before cap rates began to compress. Given expectations for a relatively moderate recession, the window of opportunity may be even shorter this time.
But even, for those just starting, it is an ideal time to equip oneself with knowledge and capital so that when the market offers opportunities, as in similar situations in the past, one is prepared to take advantage.
The next noteworthy aspect of the investor survey was the ranking of alternative asset classes in terms of attractiveness and what it might reveal about the overall investor outlook.
The report showed that debt was the most desirable investment alternative, likely due to high yields in 2022. Other top-tier investment categories included build-to-rent housing, life science properties, self-storage, and affordable housing.
In a recession, these sectors often display remarkable resilience or even see a surge in demand. The appeal of build-to-rent housing often grows as wages decline, leading people to downsize their homes and opt for smaller living spaces or shared living arrangements. The need for self-storage solutions skyrockets as a result.
Meanwhile, a rise in unemployment leads to more individuals and families qualifying for affordable housing, driving up demand.
Multi-family and industrial, which were two of the most sought-after property types during the last cycle, are beginning to experience significant supply issues in many markets, slowing and even reversing the rapid increase in rental rates seen since 2020. Retail, office, and hospitality assets are also facing major hurdles, as the growth of e-commerce and declining consumer confidence threaten retail sales.
Hotels especially feel the burn due to the unpredictable nature of travel demand during a downturn. Travel is typically one of the first expenses to be trimmed during economic downturns by corporate entities and individual consumers.
According to the survey report, over 40% of the surveyed investors anticipate discounts of 10% or higher across all product types in 2023. Approximately 25% of the respondents anticipate a discount of 30% or more on stabilized Class A Office Buildings and shopping malls. In comparison, over 50% of the respondents expect a discount of 30% or greater on value-add Class A Office Buildings.
All of this is to say that specializing in a niche product type right now might be one of the best strategies if you are in a position to do so.
Finally, a major factor revealed in these reports that is likely to decrease transaction activity and drive down pricing this year is the more cautious approach that lenders plan to adopt in 2023.
86% of the surveyed lenders stated their intention to adopt a more conservative approach in underwriting this year, with 24% of the respondents planning to adjust their cap rate assumptions, 20% planning to change their exit strategy assumptions, and 17 to 18% planning to revise their debt yield requirements.
48 percent of all lenders surveyed expect origination activity to be more than 10 percent lower than in 2022,
Although all of these data points are valuable, what caught my attention was that most of the surveyed lenders also predicted that inflation and the 10-year U.S Treasury rate will reach their highest points in the first half of 2023. When asked about their plans for issuing fixed or floating rate loans in the new year, 57% of the respondents stated their intention to offer more floating rate debt than fixed rate loans.
57% of those surveyed also indicated that their preferred loan term would be for five years or less. With lenders intending to provide more floating rate short-term loans, this suggests that the borrowers these lenders are working with also expect inflation and interest rates to decrease over the next 12 to 18 months, and are considering floating rate options to take advantage of potential rate reductions in the future, or they are looking at fixed rate products today that they can exit in the near future if rates decrease significantly in the next 1 to 2 years.
Again, this all leads to a decrease in transaction activity in 2023 because if investors think that interest rates will reach their highest point in Q2 and then decrease toward the end of the year, sellers are likely to wait to sell until after that decrease happens, and buyers are likely to wait to make offers until they can finance their purchases at a more favorable cost of capital.
I reckon that by positioning yourself to take advantage of a potential increase in origination volume that may result from mid-year rate cuts, you will be well-positioned to be in the thick of the action when that activity eventually occurs.
If you are in the wait-and-see camp, my recommendation would be to ammo up now with knowledge and systems so you can get ahead in line, when the market opens up.
That’s all - hope this piece helps you make more de-risked and high-growth decisions.
