US Economy Causing Concern For Foreign Investors. Here’s the Good News

As they deal with escalating inflation and rising interest rates in the US, foreign institutional investors are adjusting to market challenges.

According to the latest survey from AFIRE, the association for international real estate investors focused on commercial, foreign institutional investors are adapting to market headwinds as they struggle with increasing inflation and climbing interest rates in the US.

Gunnar Branson, the organization’s CEO, says in an examination of its most recent AFIRE International Investor Survey Summer 2022 Pulse, investors “all are fully aware of the current market issues.” The investors know, for instance, that US inflation has increased by more than 9% since January 2022; the Fed increased interest rates more than it has in nearly thirty years; we passed the six million COVID death mark globally; supply chains are still in disarray; and July 2022 was the 451st consecutive month with temperatures above the twentieth-century average. Countries all across the world have suffered from wildfires; some regions’ water supplies are at dangerously low levels, while others are under water as a result of unprecedented flooding. Of course, Russia also sparked a conflict in Ukraine.

Investors with and without US-based bases foresee difficulties in closing deals in both the US and, to a greater extent, in Europe due to economic uncertainties. Foreign investors are less bullish about both regions than in prior surveys, but they are more positive about the US than Europe. Branson notes that, in contrast to overseas investors (67%), Americans (92%) are more gloomy about the “inevitability” of a US recession.

Branson notes that 86% of respondents said inflation this year has actually been worse than expected, while 60% of respondents are observing an increase in cap rates and a flattening of institutional demand, and that “questions asked about inflation six months ago generate different answers when asked in July.” Additionally, respondents predict that this year there will be fewer funding available for development, refinancing, and acquisitions “across the board,” with debt for development predicted to experience the greatest fall. To make matters worse, more than three-quarters of those surveyed think that the US will experience a recession within the coming 12 months.

Though the rising cost of financing is having an impact on new cross-border ventures, Branson adds that it “may also encourage cross-border activity in new regions and markets.” Roughly 77% of respondents think that, if it occurs, the recession won’t be as bad as it was in the 1970s. This will result in improved ESG processes, special opportunities in strategic and specialty sectors, and a sharper focus on multifamily, single-family, and affordable housing.

Another top goal for survey respondents was energy independence, and over two-thirds said they are currently actively working to increase their energy efficiency. Eighty-two percent of respondents to the study think that the need for investors to address an ESG agenda will increase as a result of the global energy crisis. Additionally, 59% of investors give priority to projects that have previously earned certain sustainability certifications, such as LEED and BREEAM.

In contrast to US-based investors (31%), who place a higher premium on getting rid of outdated or inefficient assets, non-US investors (43%) are more inclined to focus on capital spending for sustainability improvements.

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The emphasis of financial authorities is on examples, accounting modifications, and short-term loan concessions.

Four of the major financial regulatory organizations—Office of the Comptroller of the Currency, Treasury, Federal Deposit Insurance Corporation, and National Credit Union Administration—published a proposed revision to a 2009 policy governing commercial real estate loan accommodations and workouts in the Federal Register at the beginning of last month.

The Federal Reserve has since released its interpretation of the policy with a comment period concluding on November 14, 2022.

The proposed statement would update existing interagency guidance on commercial real estate loan workouts, add a new section on short-term loan accommodations, and “build on existing guidance on the need for financial institutions to work prudently and constructively with creditworthy borrowers during times of financial stress,” according to the proposal. According to the proposal, “The proposed statement would also address recent accounting changes on estimating loan losses and provide updated examples of how to classify and account for loans subject to loan accommodations or loan workout activities

The proposed statement was created in consultation with state bank and credit union regulators by the Board, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the National Credit Union Administration (NCUA), and is identical to the one that was previously made public.

The initial 2009 declaration followed the Great Recession and a significant shakeout in the real estate market, among other factors. The pandemic’s experience and the numerous revisions that came about as a result of business closures that left many owners and investors in a bind are incorporated into the present suggested edition.

Two important initial concepts are still supported by the proposed statement. One, even if the amended loans have flaws, lending institutions who use “prudent CRE loan accommodation” won’t face criticism for doing so. The second is that modified loans won’t be adversely classified if the borrower has the capacity to repay them on fair conditions because the value of the collateral is lower than the loan balance.

Such arrangements are described as tools “to mitigate adverse effects on borrowers and would encourage financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations during periods of financial stress” in a new section on short-term loan accommodations.

Additionally, there are sections on CRE exercise examples and modifications to GAAP accounting standards since 2009.

It’s possible that the regulators are making preparations. The Fed had promoted low-interest rates for years in an effort to boost the economy before the epidemic struck. Due to the higher interest rates the Fed has imposed to combat inflation, many people in the real estate sector, particularly those who are relatively new to the sector and lack considerable prior expertise, have used leverage in ways that are hazardous. Many people in the CRE industry have recently complained to GlobeSt.com about lenders’ tightening underwriting requirements as projects come up for refinancing and they are unable to find anything at rates that are even close to what the original financing rates were. There can be a wave of adjustments and exercises that are required.

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In the upcoming recession, the former US Treasury Secretary sees “significant ferment and opportunity” for the CRE markets.

Former US Treasury Secretary, Lawrence Summers, reassured CRE CEOs that “if the vehicle’s moving faster, we need a firmer brake, but it doesn’t imply we’ll hit the wall before the car stops” on a day when a stubbornly high inflation rate dashed hopes for a smooth landing for the US economy.

Hessam Nadji, CEO of Marcus & Millichap, conducted a wide-ranging online debate on Tuesday. In it, Summers projected that the Fed’s ongoing rate hikes will soon lead to a “recession of choice” that will end the record-breaking employment creation of the previous year.

Summers stated, “The Fed seeks to limit it by constraining demand by hiking rates. We have constant inflation owing to a conflict between supply and demand. My best judgment is that the economy will enter a recession and that employment creation will slow down in the coming year.”

The economy, and the CRE sector in particular, is far better prepared to survive an economic crisis than it was in 2008 when the housing market crashed, according to the former Treasury director.
Summers said, “We won’t see something like 2008 again,” pointing out how much less indebted homeowners have, how the inventory is not overstocked, and how much stronger and more cautious lenders are now than they were before the sub-prime crisis.

Summers suggested that the recession would not start for a few months since fundamentals like consumer spending are still strong and have some capacity to increase.

“It’s important to keep in mind that there is still a significant savings overhang. According to Summers, $2 trillion was the amount of money that individuals were unable to spend because of the epidemic.
Only $300 billion of the total had been spent; more than half was still in checking accounts. That seems to me that customers will persist. Due to discounted salaries, I don’t believe they will run out of money to spend,” he remarked.

Summers advised CRE participants not to assume that “structural” developments, such as the increase in remote work and the boom in e-commerce, that have been triggered by the epidemic, will have a detrimental influence on the demand for CRE.

Even in a year or two when there is no employment growth, there will be significant ferment and opportunity in the CRE markets, according to Summers.

The former US Treasury Secretary adds “Many individuals believe that working from home will be awful. That is untrue.” According to him, the movement of people into new areas creates a need for real estate. He also said that the pandemic’s quick rise in e-commerce increased the need for warehouses exponentially.

Summers believes hybrid work is here to stay in the office sector, but he does not think it will have the same impact on office footprints as some may anticipate.

Many will travel far away from work as the need to live closer to the workplace lessens. He said employers will become a little more tolerant of workers working from home as they make improvements to their oversight of remote workers.

But if employees work three days a week, the employers will want them to come in on those days, so there won’t be as much of an influence on office footprints, according to Summers.

The former Treasury Secretary made a forecast that is a sweet relief to the commercial real estate industry, stating that CRE, with cap rates presently averaging 5.7% across asset classes, represents an attractive investment option when compared to equities and bonds.

In the upcoming months and years, “the position of CRE in portfolios is going to be bigger,” Summers said.

According to Summers, commercial real estate should have a bigger presence in many portfolios. It is very tax advantageous, and it seems even better after taxes.

“A bond currently yields 3.3 percent, and that is all it will continue to yield after 10 years. Property values are far more likely to increase over ten years. It will rise, not fall.” he continued.

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Although there has been a welcome decrease in commodity prices, interest rates are here to stay.

Commercial real estate experts won’t be overjoyed by the Federal Reserve’s September Beige Book, also known as the “Summary of Commentary on Current Economic Conditions by the Federal Reserve District.” However, the good news offers optimism for some reprieve in construction, while the bad news is already known.

First, the obvious bad: don’t expect an early end to interest rate hikes since “price levels remained substantially elevated,” which indicates that inflation is still occurring.
In spite of the fact that nine of the Fed’s 12 districts “reported some degree of moderation in their rate of increase,” indicating that at least the rate at which inflation was increasing had slowed, the report stated that “substantial price increases were reported across all districts, particularly for food, rent, utilities, and hospitality services.” That’s a crucial indicator that prices will finally stabilize. But it appears that is still a ways off.

“The Fed still has an inflation concern and is determined to front-load rate hikes as aggressively as possible,” says Jeffrey Roach, chief economist at LPL Financial.”If next week’s inflation report surprises positively, the chances of a 75-basis point boost later this month may grow.”
The Fed also pointed out that certain aspects of real estate still face difficulties. It was noted in the study that, “despite some reports of strong leasing activity, residential real estate conditions weakened noticeably as home sales fell in all twelve districts and residential construction remained constrained by input shortages. Commercial real estate activity softened, particularly demand for office space. “Loan demand was mixed; while financial institutions reported generally strong demand for credit cards and commercial and industrial loans, residential loan demand was weak amid elevated mortgage interest rates.”
The districts that specifically mentioned real estate included Boston, where the outlook deteriorated; Richmond, where activity was flat to slightly down, Atlanta, where there was a mix of commercial and residential real estate activity, Chicago, where construction and real estate declined slightly, and San Francisco, where residential activity slowed.

There were also some encouraging developments in the crucial field of materials. The report stated that lower fuel prices and a decline in overall demand helped to relieve cost constraints, particularly those related to freight transportation rates. However, manufacturing and construction input costs remained high. However, most contacts outside of the Federal Reserve system believed price pressures would last at least through the end of the year. “Several districts reported some tapering in prices for steel, lumber, and copper.”

Inflation and interest rate fears are dismissed by survey respondents, but the market may be due for a “recalibration.”

While CRE transactions may level off this year, investor sentiment is still positive, according to a recent Marcus & Millichap investor poll.

The headline index number of 159 in the mid-year poll is “somewhat similar to the path we witnessed in 2016,” according to John Chang of Marcus & Millichap, in which confidence somewhat dipped as rising interest rates bit into the market. But they’re not down as much as one might anticipate, he adds.
The index fell 12 points in 2016 and there was a flattening of CRE transactions. In what Chang refers to as a “very minor softening,” the index has dropped 11 points this year, and it might produce comparable outcomes.

According to him, “yes, the market is seeing a recalibration as investors redo numbers based on the increasing cost of capital, but the survey respondents aren’t telegraphing a substantial market change.”
The poll indicates that interest rates and inflation are the two main issues for investors. Almost 9% said they would buy more commercial real estate as interest rates rise, while more than two-thirds said they would not change their investment plans as rates rise.On the sell side, 77% claimed that the rate hikes had not changed their plans, and 11% claimed that they intended to sell more as a result.

The survey found that participants disregarded inflation even more. However, over 12% of respondents indicated they would buy more CRE. Twenty-four percent of respondents said they would buy less CRE. A higher percentage of investors overall indicated they would purchase more of the more inflation-resistant property types, such as flats, hotels, and self-storage, with 14.4% indicating they would do so.

In addition to rising interest rates, cap rates are anticipated to climb as well; according to 14% of investors questioned, cap rates will increase by 50 basis points or more during the next year. About 35% predict an increase of less than that, while 27% predict no change. According to Chang, yields and stability look appealing because there is still a lot of cash flowing into CRE.

Think about the fact that the year that just ended, in the second quarter of 2022, was by far the busiest for commercial real estate investment transactions ever, Chang advises. The upcoming year “will probably rank as the second most active year, even if activity slows down a little.

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1. FUTURES MARKET FORECASTS 75 BP HIKE

Fed Futures markets are now firmly predicting another 75-bps hike at the FOMC’s September meeting based on estimates from the Chicago Mercantile Exchange.
Following the committee’s July meeting, future markets were initially forecasting a more moderate increase of 50 bps come the September meeting, as seen in May and June before the Fed turned up the heat. As of September 8th, 86.0% of the Fed Futures market forecasts a 75-bps hike at the Fed’s next meeting on September 20th-21st.
Since late July, markets have digested several key data points, including above-expectations job growth, a rebound in consumer sentiment, and a modest but unconvincing decline in year-over-year inflation. During recent talks at the annual Jackson Hole Summit, Fed officials also maintained a relatively hawkish tone, signaling a sustained willingness to raise rates to tackle inflation.

2. BEIGE BOOK ANALYSIS

The September 7th version of the Federal Reserve’s Beige Book shows that economic activity remains relatively unchanged across the nation compared to recent weeks, with most businesses reporting steady or growing activity.
Most federal reserve districts reported steady consumer spending levels, but purchases are moving away from discretionary items and toward food and other essentials, and inflation pressures mount. Auto sales continued to be hampered by low inventory and high prices, while hospitality and leisure remained relatively strong throughout the summer.
Commercial real estate experienced softened activity, particularly for office space. Loan demand was reportedly mixed with solid demand for credit cards and commercial and industrial loans, while residential (buying) demand continued to weaken in the face of rising mortgage rates.

3. CMBS DELINQUENCIES

CMBS delinquencies registered a slight decline in August, falling eight bps to 2.93%, according to Trepp— it is the first time delinquencies have fallen below 3% since the COVID-19 pandemic began.
Delinquencies have steadily declined over the past two years as most Commercial Real Estate segments recovered, but recent improvements in the Hotel and Retail sectors have fueled the latest reductions.
August represents the 24th decline in CMBS delinquencies in the past 26 months. Industrial continues to boast the lowest delinquency rate of 0.51% through August. Multifamily follows close behind with a rate of 0.95%. The rate for Office stands at 1.5%, Lodging (Hotel) at 5.18%, and Retail at 6.45%.

4. SINGLE FAMILY RENTAL CMBS ISSUANCE

A new report by Trepp looks at the rise in Single-Family Rental CMBS issuance in recent years, as the sector has risen from just 7.22% of all CMBS issuance in 2018 to 13.92% so far in 2022.
According to the analysis, $73.53 billion of Single-Family Rental CMBS has been issued since 2013, dominated mainly by players such as Progressive Residential, CoreVest American Finance, Invitation Homes, and Tricon, which accounted for more than half of all SFR issuance. SFR issuance in 2021 was more than double its 2019 level.
While it appears that SFR will remain a notable portion of the CMBS market for years to come, the sector has seen a similar slowdown in recent months as seen in the broader CMBS market. Trepp notes that a total of five new deals so far in Q3 totaled $2.11 billion, on pace to fall below the $7 billion total hit in Q2.

5. INDEPENDENT LANDLORD RENTAL PERFORMANCE

The on-time collection rate for independently operated residential properties fell by 55 bps between July and August, landing at 79.7%, according to the latest Independent Landlord Rental Performance Report by Chandan Economics.
Gateway markets have maintained higher on-time payment rates than units located elsewhere for eight consecutive months through August 2022. Measured month-over-month, gateway market on-time collection rates rose by 16 bps but are down 211 bps year-over-year. The July on-time rate for Gateway markets stands at 81.4%, while non-gateway markets registered an on-time rate of 79.5%.
Sun Belt rentals have underperformed the rest of the US for five consecutive months, standing at 78.4% in August compared to 80.3% for non-sun belt rentals. The Sun Belt’s growing success has seen some affordability issues arise, as markets re-price more quickly than some existing residents can handle.
2-4 Family rentals maintained the highest on-time payment rate of all sub-property types in August, rising 52 bps month-over-month.

6. CONSUMER SENTIMENT

Despite growing recession concerns over the summer, consumer sentiment appears to have stabilized. The University of Michigan’s final August Consumer Sentiment estimate was revised up from 55.1 to 58.2. Moreover, consumer expectations saw a significant revision from a previously estimated 47.3 to a final reading of 58.0.
The Consumer Sentiment Index has risen from its all-time low level of 50.0 in June, climbing in consecutive months. The upswing has been widespread across most demographics, though lower-income consumers’ sentiment has risen higher in recent readings, even exceeding that of higher-income consumers, bucking the historical trend.
Inflation expectations have also receded, falling from 5.3% in July to 4.8% in August.

7. JOBS REPORT

The US economy added 315,000 jobs in July while the unemployment rate rose slightly to 3.7%, according to the Bureau of Labor Statistics.
This month’s jobs report fell slightly below expectations and signaled a slight loosening in the labor market. Still, job-adds continue to be strong, notably in professional and business services, health care, and retail trade.
The uptick in the unemployment rate primarily reflects the reentry of some workers into the labor force, as the US labor force participation rose to 62.4%. Average hourly wages also climbed, increasing 5.2% year-over-year.
Professional business services employment climbed the most during the month (+68,000), followed by healthcare (48,000) and retail trade (44,000). Meanwhile, leisure and hospitality job gains receded from their recently typical high levels, remaining relatively unchanged from July.

8. MALL VISITS FALL ACROSS U.S.

Globe Street reporting of an analysis by Placer.ai finds that visits to American malls have started to decline as inflation eats into consumers’ wallets, falling in August after two consecutive years of increases.
Year-over-year foot traffic to indoor malls, open-air lifestyle centers, and outline centers declined during the month. Indoor malls saw the steepest fall from the month before, falling by 1.1% month-over-month.
Despite the declines, their shallow nature presents a dose of optimism for brick-and-mortar businesses in the face of recent economic headwinds. According to the Placer.ai report, all three segments of the mall sector ended August more strongly than they began, with indoor malls and open-air centers posting their most significant week-over-week gain since June 27th. Moreover, Retail REIT Simon Property Group recently reported strong occupancy and leasing volume, showing a 26% year-over-year increase in sales per square foot through the second quarter of 2022.

9. MANUFACTURING PMI

S&P Global’s US Manufacturing Index declined to its slowest growth rate since July 2020 during August, registering a reading of 51.5. An index reading above 50 indicates growing activity in the sector, while a reading below 50 indicates declining activity.
New orders reportedly fell for the third consecutive month amid weak client demand caused by high inflation and rising economic uncertainty. Output also contracted for the second consecutive month.
On the flip side, supply chain disruptions are reportedly the least severe that they have been since October 2020, while input price inflation was its slowest since January 2021.

10. POST-GFC HIGH FOR AD&C LOANS

In the second quarter of 2022, acquisition, development, and construction (AD&C) loan volume reached its highest level since the Great Financial Crisis, according to an analysis by the National Association of Home Builders (NAHB).
However, pushing up volume levels is a rise in loan balances stemming from homes remaining in inventory for longer as homebuying slows, filtering into a slowdown in home-building activity.
Balances are expected to decrease in the coming months as rising borrowing costs slow the rate of new borrowing. According to NAHB’s latest survey on AD&C financing conducted in August, the average effective rate on AD&C loans rose across all loan types between Q1 and Q2. The rate on Land acquisition loans rose from 6.32% to 8.19 quarter-over-quarter. Land development loans saw rates climb from 7.85% to 9.55%. Speculative single-family loans saw rates rise from 7.38% to 8.48, while pre-sold single-family loan rates rose from 7.90% to 8.63%

SUMMARY OF SOURCES

(1) https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
(2) https://www.federalreserve.gov/monetarypolicy/beigebook202209.htm
(3) https://www.trepp.com/instantly-access-delinquency-report-august-2022?hsCtaTracking=6851c4cd-6d3a-4f5c-895d-3e93db2cd92b%7Cd6075c9b-7c7e-49f6-aec4-d810563171a9
(4) https://www.trepp.com/trepptalk/single-family-rental-issuance-flourishes-will-lending-continuewhat-does-it-mean-for-affordability
(5) https://www.chandan.com/_files/ugd/df56fe_4e79d75ae2db4bb9a890fbe35f9eb9bc.pdf
(6) http://www.sca.isr.umich.edu/
(7) https://www.bls.gov/news.release/empsit.nr0.htm
(8) https://www.globest.com/2022/09/08/mall-visits-slump-as-inflation-heats-up/
(9) https://tradingeconomics.com/united-states/manufacturing-pmi
(10) https://eyeonhousing.org/2022/09/adc-loan-balances-rise-as-sales-slow/?_ga=2.64372591.1796051761.1662673965-1254428321.1662496463

In the first half of the year, fewer than 80,000 new households were built, which cooled the market as economic headwinds accelerated.

After a protracted period during which the asset class was experiencing high demand, the third quarter saw a slight decline in demand for multifamily housing as household formation returned to normal and inflation started to affect consumer budgets.

According to a recent Marcus & Millichap analysis, the average effective monthly rent in the United States increased by almost 16 percent in 2021, with certain Sun Belt markets seeing increases of more than 25 percent in just the previous year. But as economic headwinds accelerated, 80,000 fewer households were generated in the first half of the year, depressing the market.

Nevertheless, the research observes that “even with a slower second half, vacancy at midyear leaves ample leeway before rates in most metros approach pre-pandemic levels.” Overall, according to Marcus & Millichap experts, the sector’s future is still promising.

“Despite the 60 basis-point rise in national apartment vacancy during the first half, approximately 20 percent fewer rentals available at midyear across the U.S. compared to year-end 2019,” they claim. “These circumstances and the steep barriers to homeownership support sustained momentum in the apartment sector.”

Over the past two years, the median price of a single-family house has increased by more than 30%, and mortgage rates have reached levels that many customers haven’t experienced in their adult lifetimes. Has a single-family median price. Additionally, according to the firm, “this is widening the affordability gap, or the difference between an average monthly payment on a median priced home and an average rent obligation.” The affordability gap is now more than $1,000 per month, which is roughly three times the size of pre-pandemic norms.

According to the research, “the cost-saving benefits, coupled with lifestyle elements, locational advantages, and flexibility, will sustain apartment demand.”

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RSM reported that sales volume and cap rates were slightly easing.

According to a study this week from RSM, real estate funds seem to be maintaining their path and accounting for a small overall cooling of the market.

The volume of sales transactions and associated cap rates realized in those transactions have both decreased, it was claimed, and fundraising is adopting the same mentality.

Since interest rate increases and inflationary pressures suggest that a possible impending recession may be imminent, investors are currently on the defensive and reevaluating values and strategy. RSM stated that capital is being directed toward core and core-plus assets, value-add investments, and less risky initiatives.

Real estate investment may have slowed down from its record-breaking rate in 2021, but prices are still significantly higher than they were before the pandemic, and there is still enough of money for investors to keep spending.

Finance Is Generally Affordable

According to RSM, property cash flow, particularly from multifamily and industrial properties, is still strong, and financing is still quite affordable.

According to the statement, “We anticipate transaction volume to pick up in the fourth quarter of 2022 or early 2023 as fund managers reevaluate their strategy and the return expectations of their investors, looking to deploy cash that has been sitting on the sidelines.”

Cap rate compression on a global scale

Even the “darlings” of the pandemic, multifamily and industrial, saw cap rates compressed.

Compared to an average reduction of 0.15% over the preceding three years, multifamily cap rates have decreased by 0.79% since the second quarter of 2020, according to CoStar.

RSM claimed that because of growing values, it has become harder for acquisitions to meet investment objectives.

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In addition, if compared to the past, would “high” inflation actually be that high?

According to a Bloomberg story, if you believe that rising inflation is only a transitory issue and that everything will return to normal before the pandemic, you disagree with some of the largest bond investors in the world. They believe that the Federal Reserve’s target of 2% inflation is essentially an impossible dream, which is why they have piled up on inflation-protected bonds, increased their exposure to commodities, and maintained a sizable cash reserve.

Cheap energy and labor kept inflation low over a protracted period of growing globalization. (A sober addition would likely be the long-term cheap monetary supply that central banks kept thinking would boost GDP.)
But it’s time to take a deep breath. Look up the U.S. yearly inflation rate for the past few years. The Fed’s goal inflation rate of 2% was greatly exceeded for numerous stretches. The commercial real estate market did not collapse.Looking at the recent past is something that might confuse people. According to Kevin Swill, CEO of Thirty Capital Financial, “to have a market, with low interest rates for more than 12 years, does not follow logic or the cycle that existed for decades.”

However, returning to normal does not guarantee that it will be painless, especially in light of the investment methods that were used in conjunction with those low rates. “Levered investors might struggle to cover debt service and secure loans if cap rates spreads to interest rates narrow,” said DWS Group’s U.S. Real Estate Strategic Outlook for July. “Real estate leasing could also retrench amid job losses and dwindling profits. Indeed, recessions have been the proximate cause of every broad-based decline in real estate prices since the early 1960s.”

Additionally, as the Fed attempts to restrain growth, increasing inflation will result in continuous higher interest rates. That will have an impact on the price of finance as a whole.

Peter Tuffo, president of the south region for Suffolk Construction, claims that the real-estate industry runs on credit and the fundamentals of real estate are out of balance. Real estate investment is tied to confidence, and some projects are simply not penciling out. Real estate responds negatively to higher risk.”
Rogelio Carrasquillo, managing shareholder and cofounder at Carrasquillo Law Group, tells GlobeSt.com that “this situation has a significant effect on bridge and short-term loans that become more expensive for developers. As a result, programs such as EB-5 and other alternative sources of financing that would not be considered otherwise, become viable alternatives for the financing and development of commercial real estate projects.”

Even said, not all is lost because, according to Zachary Streit, founder and managing partner at WAY Capital, “inflation could also mean higher rent growth and NOI that could offset some of the impact of higher interest rates.” Additionally, “We are seeing a trend of more deals getting done with fixed rate financings and some sort of partial recourse or creative financing structures like PACE to offset today’s higher rates offered by floating rate lenders.”

1. INFLATION

The Consumer Price Index (CPI) rose by 8.5% year-over-year through July, but remained flat from the month before, according to the Bureau of Labor Statistics. It was the first time that inflation hadn’t increased on a month-over-month basis since May 2020.
A 7.7% decline in gasoline prices in July helped alleviate pressure on the broader index, while an increase in food and shelter offset some of that movement. Food costs rose by 1.1%, the seventh consecutive monthly increase of 90 bps or more.
Other declines were seen in airline fares, used cars and trucks, communication, and apparel.
Core CPI, which removes food and energy prices from the calculation, rose 30 basis points, the smallest increase in four months. Core CPI is up 5.9% year-over-year.

2. INFLATION REDUCTION ACT IMPACT ON CRE

On August 7th, the US Senate passed the “Inflation Reduction Act” bill, which now goes to the House of Representatives, and is widely expected to pass before being sent to the President’s desk.
While the bill primarily focuses on climate and health care policy changes, it also effectively closes the door on this congress’ attempt to boost Affordable Housing programs or amend how some real estate gains are taxed.
A proposal by the White House to change the tax treatment of carried interests, often used by real estate developers to reduce capital gains tax liability, was removed in the 11th hour to gain the support of Senator Kristen Sinema (D-AZ), whose vote was needed for the party-line bill to pass. The National Association of Realtors and other industry trade groups opposed the proposed change.
While maintaining the status quo for carried interest should stave off any direct negative impact on Commercial Real Estate investments, the final bill did not include an expansion of the Affordable Housing programs or incentives generally championed by the industry as a way to boost housing supply.

3. STAGFLATION RISK TO CRE

In a recent analysis of factors that could affect CRE valuations, Fitch Ratings finds that the combination of inflation and weak economic growth could soften tenant demand and cause upward pressure on cap rates, potentially resulting in a decline in net operating income.
The analysis, which looked at the historical relationship between interest rates and NOI, found that during a period of rising long-term interest rates, property-level cash flows tend to keep pace or grow
faster than cap rates. Still, a period of stagflation, which implies that we are in both a rising cost and falling growth environment, may result in prolonged elevated cap rates, likely softening CRE values.
The analysis notes, however, that the historical link between cap rates and the yield on the 10-year Treasury has weakened since the 1980s, making the circumstance of rising cap rates in our current tightening environment less certain. Still, evidence of upward pressure on some sector cap rates has surfaced since the Fed began hiking interest rates in the spring.

4. SURGING RETAIL INVENTORIES

A recent market analysis by Prologis projects that an additional 800 million square feet of warehouse space may be needed to handle excess inventories taken on by retailers in recent months.
According to a Wall Street Journal summary of the report, many large retailers, including Walmart, Bed Bath & Beyond, and Best Buy, have reported dealing with unexpected inventory increases as consumers move away from goods spending due to inflation. Meanwhile, supply chain bottlenecks continue to force retailers to stretch out buying cycles, incentivizing them to stock shelves earlier in the season than they would have previously, further increasing industrial space demand.
Demand so far is growing the most among discount retailers and liquidators. Still, some observers caution against being too bullish. Many retailers are also cutting prices and canceling orders to cope with the excess, a signal that higher demand for space may be unaffordable for some.

5. JOBS REPORT

The US economy added 528,000 jobs in July while the unemployment rate ticked down to 3.5%, according to the Bureau of Labor Statistics.
This month’s jobs report far exceeded most economists’ expectations, with widespread gains led by leisure and hospitality, professional and business services, and healthcare. Both employment levels and the unemployment rate have returned to February 2020 levels, recovering all jobs lost during the COVID-19 pandemic.
Nonfarm employment has increased by 22 million jobs since reaching a pandemic low in April 2020, with private sector employment 629,000 jobs above its February 2020 level.
Despite leading job gain metrics for much of the pandemic recovery, leisure and hospitality employment remains 1.2 million below its February 2020 level. Meanwhile, professional and business services employment is 989,000 jobs above its February 2020 level, and retail trade is 208,000 above its February 2020 level. Construction employment is 82,000 jobs above its February 2020 level and manufacturing is 41,000 jobs above its February 2020 level.

6. LAW FIRM LEASING ACTIVITY

According to Savills’ latest quarterly report on law firm activity, leasing activity among law firms ticked up by more than 43% in Q2 2020, a turnaround from COVID-era lows reached in Q2 2021.
Data shows that 1.6 million square feet of office space were leased to law firms in Q2, returning leasing volume to the quarterly average seen over the past four years.
Seven of the ten largest leases completed so far in 2022 were in the most recent quarter and exceeded 100,000 square feet. 63% of activity year-to-date, measured by square footage, has been relocations.
The report suggests that there is evidence that flexible in-office work schedules represent a longterm shift, with firms moving away from dedicated office space but towards denser, shared use and collaboration spaces.

7. CAP RATES

Cap rates on office properties ticked up slightly in Q2 2022, rising ten basis points to 6.3%, according to data from MSCI Real Capital Analytics. Office cap rates remain close to historical lows met in the previous three quarters. A 10 bps rise in CBD and Suburban cap rates in Q2 led to the overall increase. Meanwhile, cap rate compression in Suburban offices has driven much of the reduction in the broader sector over the past year.
Industrial assets saw cap rates rise on average by 20 bps to 5.7% in Q2, led by a rise in Warehouse cap rates, while Flex spaces compressed by 60 bps.
Retail cap rates were unchanged quarter-over-quarter, remaining at 6.3%. Over the past decade, retail cap rates have steadily compressed, though at an increasingly slower pace in recent years.
Apartment cap rates continue to post all-time lows, dropping 20 bps to 4.5% in Q2 and down by a halfpercentage point year-over-year.

8. INVESTMENT VOLUMES

Quarterly transaction volumes averaged across all commercial real estate property types rose in Q2 2022 to $190 billion, up by $5 billion from the previous quarter, and up 17% year-over-year. Transaction volume year-to-date is roughly 38% above the total volume registered in 2021.
On a year-over-year basis, Apartment and Retail transactions represent the bulk of the increase in activity. Retail led all sectors with a 46% year-over-year increase in transaction volume; however, current growth in retail activity is dwarfed compared to the triple-digit increases seen throughout the early parts of the pandemic recovery. Still, on a quarter-over-quarter basis, Retail transactions ticked up marginally. Meanwhile, Apartment transactions rose by $18 billion in Q2 2022 and are up 42% year-over-year.
Industrial volume rose 8% year-over-year through Q2 2022 but declined by roughly $4 billion quarterover-quarter. The annual increase in volume was pushed by a rise in warehouse demand, while flex
space transactions remained unchanged.
Office transaction volume fell by $8 Billion from the previous quarter and is down by -9% year-over-year.

9. LOAN MATURITIES

A recent report by Moody’s Analytics investigates how rising interest rates create refinancing challenges for CMBS loans approaching maturity. The analysis finds that there has been an increase in loans past their maturity dates but have not yet paid off, as lending headwinds impact performance.
Comparing 2012 vintage CMBS loans, many of which are maturing this year, to 2011 vintage loans that matured last year, Moody’s analysis finds that, on average, the 2012 batch has performed better. However, they note that a higher amount of outstanding 2012 vintage loans are due in the latter half of 2022. As rising interest rates cause additional pressure on refinancing activity in the coming months, non-performance among 2012 vintage loans could increase.
Additionally, the report finds that higher LTVs and the resulting decrease in reappraisal activity appear less prevalent among Hospitality and Multifamily loans than in others. The findings are consistent with space and capital market trends, apartment rent growth, household formation, and income fundamentals.

10. ADAPTIVE REUSE ON THE RISE

A recent article by Multi-Housing News details how Adaptive Reuse projects are on the rise across the US, mainly targeting under-occupied office properties and the industry’s challenges.
In addition to the opportunities presented by falling urban office demand and rising urban apartment demand, financing options, including Low-Income Housing Tax Credits (LIHTC), Historic Tax Credits, and other federal programs, are helping incentivize adaptive rescue efforts.
Challenges include building, mechanical, and electrical system conditions and weatherproofing. Additionally, inspecting environmentally hazardous materials and removing costs can present
unpredictable obstacles.
Interestingly, some architects believe that older, pre-1950s office buildings may be better suited for conversions than those built in the latter decades of the 20th century due to more nuanced attention to detail on interior design features. Building shape matters, too, with some suggesting that narrower buildings have easier access to outside light and air often desired by apartment tenants.

SUMMARY OF SOURCES

(1) https://www.bea.gov/news/2022/gross-domestic-product-second-quarter-2022-advanceestimate
(2) https://s3.documentcloud.org/documents/22122291/summary_of_the_energy_security_and_climate_change_investments_in_the_inflation_reduction_act_of_2022.pdf
(3) https://www.fitchratings.com/research/corporate-finance/us-commercial-real-estate-valuesthreatened-by-rising-rates-stagflation-risk-sluggish-noi-will-likely-harm-values-10-08-2022
(4) https://www.wsj.com/articles/retailers-seeking-more-warehouse-space-to-stow-excessinventory-11659460929
(5) https://www.bls.gov/news.release/empsit.nr0.htm
(6) https://www.savills.us/research_articles/256536/331757-0/savills-u.s.-law-firm-activityreport-q2-2022
(9) https://cre.moodysanalytics.com/insights/cre-trends/loans-reaching-maturity-without-payingoff-more-trouble-ahead/?cid=YJZ7YNGSROZ5414
(10) https://www.multihousingnews.com/why-multifamily-adaptive-reuse-is-on-the-rise/