Investing in Commercial Real Estate in 2023: A Market in Dislocation

Only recently, we were still in the age of “free money” when in 2020 the US Fed plunged interest rates down to 0% to boost economic activity during the pandemic. Entering 2021, it was as if the floodgates were open for every type of investment, including commercial real estate (“CRE”).  Throughout that year, debt for CRE was so cheap and easy to obtain, and the outlook for a recovering macro environment was so strong, that it resulted in a frenzy of buying activity - assets were bid up at a rate that I had never before experienced over the course of my career, leading to record-breaking price appreciation and transaction activity*

*Real Capital Analytics - Capital Trends. US Big Picture, 2021.

As we entered 2022, the market was behaving as if the rocketship velocity of ascent we had just witnessed would carry on for at least another year. It was a unique period where I was bullish on the burgeoning post-pandemic real estate cycle over the long run but saw risk in the short run. My take entering 2022 was that the CRE market had to normalize. We could not expect 2021 to repeat itself in terms of pricing or rent growth, so it seemed logical to expect a swift reversion to normalized growth rates (i.e. 3-5%) for both. While my hunch was correct on rent growth, I was wrong on price growth.  

Today, the market environment looks almost the opposite to a year ago. What I failed to anticipate in 2022 was how quickly the Fed would raise rates, how much stress that would impose on capital markets, and how much downward pressure those two events would exert on asset pricing. To say that the Fed’s policy in 2022 has doused the broader market with cold water would be an understatement..

With the CRE prices down last year, debt markets still in a state of disarray, and what feels like a near certainty that a recession is in store, it would be easy to have a bearish outlook this year. But instead, I’m moderately bullish. And most of the “why” is summed up in the maxim, “Things are rarely as good or as bad as they seem at the time.”

To elaborate on my position, it is helpful to revisit the past year from both a lending and asset pricing perspective. What transpired in 2022 sets the stage for why I believe we may experience a pivot in the market later this year.

LENDING: THE RIVER RUNS DRY

Debt is used regularly to finance CRE projects, so much so that the overall CRE market comes to rely upon liquid capital markets in order to function optimally. In 2022, the capital markets froze. 

As I see it, three key factors are adversely affecting the current landscape for lending:

• Higher Benchmark Rates: Consistent with the US Fed Funds Rate, the benchmark Secured Overnight Financing Rate, or “SOFR” rate, has shot up from essentially 0% at the beginning of 2022 to roughly 4.4% at the time of writing. This is a massive jump in a relatively short period of time. 
• Higher Lending Spreads: Spreads over benchmark rates are intended to price the level of perceived risk lenders view in the market. Over the course of 2022, our team saw spreads widen with the largest moves typically associated with loans on unstabilized assets or ground-up developments. In some instances, we witnessed spreads expand by 200-400 basis points* relative to where we saw them quoted in 2021.
• Increased Reserve Requirements for Banks: The Fed increased reserve requirements for the banking sector in Q3 2022 as a means to remove lending liquidity from the market. It has since had the desired effect. Throughout Q4 2022 we witnessed the major money center banks (including but not limited to JP Morgan Chase, Citi, Wells Fargo and Bank of America) move to the sidelines, taking a massive share of the CRE lending market out of the game.

Combining the first two factors above, all-in borrowing costs in 2022 spiked anywhere from roughly 4% to as high as 8% in some cases.* This is a tremendous amount of movement for the market to digest in a matter of months and has created strong ripple effects. Relative to cap rates, the cost of debt is more expensive than it has been in decades.

*Based on internal CrowdStreet data as of 2023.

Not only is debt historically expensive, it's also exceedingly difficult to obtain. Dysfunctional capital markets are currently so debilitating to certain deals that some developers and operators are opting to forego using debt altogether. In industry parlance, we refer to this strategy as “unlevered” and it is something we haven’t particularly seen deployed for anything other than core real estate since the Great Financial Crisis (“GFC”). 

The resulting market behavior is significant because when buyers who would normally utilize debt begin to transact without it, it can often signal the bottom of a real estate cycle. To the extent  I see more unlevered transactions occur in 2023 the more conviction I will have that true market clearing price discovery is occurring and that a floor is forming under asset prices. 

PRICING: A REVERSION TO TREND

Dysfunctional capital markets throughout 2022 directly correlated to downward pressure on asset pricing. After reaching stratospheric levels of 24% annualized appreciation in 2021, according to Green Street’s CPPI Index,* CRE prices declined by just over 13% in 2022. I characterize this downward movement in pricing as mainly a reversion towards long-term trends. Prices are still intact relative to expectations from before the pandemic - as I see it,  the price decline in 2022 largely offset the excess appreciation in 2021. I also view the price decline as composed of two stages.

*Commercial Property Price Index®, Green Street, 2023.

First, when borrowing costs increase dramatically in a short period of time, asset prices tend to fall - a phenomenon that has been on display since Q2 of 2022 and which continues today. 

From my vantage point, roughly the first 7-10% of downward price movement in 2022 was mainly attributable to the Fed’s interest rate hiking spree. During the first half of 2022, each time the Fed raised rates, the debt markets would respond by increasing borrowing costs leading buyers to retrade sellers and to ratchet prices lower. The key takeaway from this period was that deals were still transacting but at successively lower prices. In fact, when we exited the first half of 2022, overall transaction volume for single-asset sales was up 36% year-over-year.*

*Capital Trends. US Big Picture. Real Capital Analytics, November 2022.

Second, when we entered Q3 of 2022, the effects of the Fed’s reserve requirement increase came into play. As major money center banks increasingly exited the originations market, higher priced debt coupled with a substantial decline in available financing options convinced numerous buyers to go “pencils down,” thus vacating a chunk of demand from the market. When demand vacates a market, prices tend to fall and, true to form, this is what we saw occur during Q4 of last year. Accordingly, we also witnessed a precipitous drop in transaction volume. On a percentage basis, I believe the decline in demand during the second half of 2022 accounted for the majority of the next 3-6% decline in asset prices (of the total 13%). Given the current sentiment in the market, the full extent of price declines may have yet to fully materialize. 

DARK CLOUDS STILL LOOM BUT WITH A SILVER LINING

During the webinar our Office of the CIO presented in November of 2022, I described our market dynamic as mostly “manufactured”. What I meant by that statement is that the market we find ourselves in 2023 is more a function of the current Fed policy and less a function of deteriorating CRE market fundamentals, far from it. I have never before seen such a disconnect between underlying market fundamentals and asset pricing. Scenarios where market sentiment is bearish while fundamentals are moderately bullish, yet current pricing reflects the bearish sentiment, have historically translated to a buy signal. 

With that said, as a fan of Howard Marks (CEO of Oaktree Capital Management), I subscribe to his belief that market prognostication is a fool’s errand. I don’t pretend to know when the market will recover or how swiftly it will grow once we reach the other side of the trough. For the CRE market to actually recover, I believe we need liquidity to return to the capital markets. It is implausible to forecast with confidence when that may occur. What I do see is that asset prices today present better value on a relative basis than they did at the beginning of 2022. Therefore, I’m inclined to believe that 2023 presents a better entry point, on average, than what 2022 offered. 

While uncertainty remains, depressed levels of institutional investor activity inure to the benefit of private investors. A relative scarcity of equity capital in the broader market is compelling operators and developers to offer private investors the types of deal structure incentives we haven’t seen since the depths of the pandemic. Such incentives can include increased preferred returns, increased splits to limited partners above preferred returns, reduced fees to sponsors and, in certain instances, profits participation with the sponsor. The dry powder is out there at record levels, it’s just currently on the sidelines. Once institutions re-enter the market in force, I anticipate that we will experience increased competition for deal flow leading to a normalization of deal terms and an end to the dynamic of exceptional investor-friendly structures. Overall, these transition times often provide a window of opportunity for private capital to invest as the large pools of institutional capital sit and wait for continued data to support a market recovery.

It is fair to expect that the distress induced by the Fed on the capital markets will bleed over to some degree into actual deterioration of CRE fundamentals in 2023. This would likely play out in the form of things such as an increase in the unemployment rate and/or a stalling out of wage growth leading to downward pressure on occupancy levels and rent growth. In a year with the expectation of a recession on the horizon, it’s a risk that is difficult to discern to what level it is already priced into the market. However, if the Fed eases its interest rate stance and allows its heightened reserve requirements to expire in Q3 (as currently scheduled), I would expect liquidity to begin to flow back into the capital markets. And in that case, I would then anticipate the pendulum swinging towards renewed upward pressure on pricing. 

Ultimately, the leading indicator I’m looking for in 2023 is for buyer demand to re-enter the CRE market. The good news is that we don’t necessarily need interest rates to subside to see that occur. Rather, we simply need investor perception of the future state of the market to improve. While acknowledging that I don’t know how this will all unfold, the current market paradigm appears to me as more short term than long term in nature. As quoted by the CEO of an investment firm in ULI’s 2023 Emerging Trends report, “The short-term risks are real, and I’m not making light of any of them. But if you have the long view, I don’t think it’s time to panic.” I couldn’t agree more.

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