The lyrics to the Talking Heads’ “Same As It Ever Was” certainly don’t fit how 2022 is playing out in the commercial real estate market. Two quarters of negative economic growth have dampened market sentiment and raised fears that the US economy is headed for recession. In the middle of the year, market analysts took a close look at their rosy forecasts from the start of the new year and redrawn the boundaries.
There was once…
At the start of 2022, forecasters were optimistic that commercial real estate investment and lending levels would be nearly as good as 2021. This was significant given that 2021 set new records for deal and lending volumes as borrowing and equity amassed during the pandemic in search of a home in US commercial real estate.
What a difference a few quarters have made. Virtually all predictions beginning the new year were outdated by mid-summer. The abrupt change in market conditions is palpable and takes almost everyone by surprise. Markets are now reaching an inflection point in sharp contrast to last year’s strong recovery.
The two I’s: inflation and interest rates
At the heart of the recent deterioration in market sentiment is persistently high inflation, which appears to be ignoring all attempts by the Federal Reserve to raise interest rates and lower prices. Higher inflation is affecting the entire economy, driving up the cost of building materials, energy and consumer goods. Notable economic indicators showing stress mid-year included GDP, which fell for the second straight quarter, and the consumer price index, which rose 9.1% year-on-year in June – the highest increase in about four decades.
In July, the CPI fell to 8.5%, an encouraging sign that inflation was beginning to stabilise. However, LightBox’s latest August report dashed those hopes as the CPI showed little improvement and held at a still high level of 8.3%.
Market reacts to higher cost of capital as lenders hit the brakes. As the cost of capital rises with every rate hike and fears of a recession mount, many large US financial institutions are cutting lending for the remainder of 2022 and into 2023. This change of tenor is a significant shift given that 2021 was a record year for commercial real estate finance. Many lenders have already moved to a more defensive underwriting stance to mitigate risk.
The Mortgage Bankers Association, which previously predicted that loan levels would surpass $1 trillion for the first time in 2022, revised its forecast downward in mid-July. By the end of the year, the MBA now expects a volume of significantly 18% below the level of 2021 – and a third below the optimistic forecast made in February. Now investment activity is cooling as higher borrowing costs drive some buyers out of the market.
In the investment world, transactions fell 29% mid-year, reflecting a thinning pool of buyers as higher interest rates hamper access to debt. Market volatility is causing investors, lenders, and owners to reconsider strategies, reconsider assumptions, and prepare for potential disruptions.
Looking towards the end of the year and 2023
The rapid and varied market movements make for an uncertain forecast and certainly a more cautious investment environment. The battle between inflation and interest rates will continue in the short term. As LightBox’s investor, lender, appraisal and environmental due diligence clients, they are moving towards the 4thth Quarter – typically the busiest quarter of the year – unprecedented volatility drives them to recalibrate and forecast in light of recent market developments.
Ongoing weakness in transaction volume is likely to continue as interest rates and valuations rebalance. As property prices begin to level off, there is increasing pressure on buyers to think about how to improve a property to earn their return on investment. How long inflation lasts, how high interest rates rise, and whether the economy slides into recession (and how deep) will determine the next chapter in the commercial real estate market. The greatest opportunities are in asset classes such as office and retail, which are moving away from traditional uses and adapting to the demands of today’s market. Until the barometers stabilize, it is important to revise assumptions, monitor developments and recalibrate if necessary.
Dianne Crocker is a Principal Analyst for LightBox, providing strategic analysis, risk management best practices, market research reports, training seminars and custom research for commercial real estate stakeholders. She is a highly respected expert on trends in the commercial real estate market. This piece is exclusive to Broadband Breakfast.
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