A cloud of uncertainty continues to hover over the economy as the Federal Reserve (Fed) remained steadfast in its efforts to curb inflation through an aggressive set of rate hikes. Through November 2022, the Fed instituted four consecutive rate hikes of 75 basis points each and looks set to continue raising rates, albeit at a potentially slower pace through early 2023. For rate hikes to slow or stop, the Fed will need to see consistently lower inflation prints or a decrease in the strength of the labor market. Looking forward, many predict a possible recession in 2023, leading to concerns about the trajectory of economic health.
The Fed’s actions had pronounced effects on the public U.S. equity and bond markets, which were both down sharply in 2022. While real estate values held up relatively well in 1H 2022, the sector is now feeling the effects as well. The NCREIF ODCE index registered the first quarter of negative appreciation since 3Q 2020, with property values declining 0.4% quarter-over-quarter. Most of the value change is driven by adjustments in capital market assumptions, namely rising cap and discount rates. Debt market conditions have also become increasingly challenging in recent months, further weighing on values. A combination of rising interest rates and widening spreads have increased borrowing costs sharply, making it difficult to source accretive debt.
As investors looked for clues on where pricing was headed and lenders became increasingly selective, transaction activity slowed in the third quarter. According to data from Real Capital Analytics, sales activity for the quarter was down 21% compared to 3Q 2021. Looking forward, for this trend to reverse, investors and borrowers would need to see a more stable economic environment coupled with a more liquid debt market.
One of the major trends in the commercial real estate debt market remains sectoral dispersion. Office remains the least favored sector with relatively heavy supply compared to the amount of demand for office space. While the retail sector has faced challenges between COVID-19 and online shopping, conditions have improved. Finally, the two most favored sectors remain multifamily and industrial properties, both backed by strong fundamentals. This trend has played out in valuations as well: office and retail tended to trade much wider toward the end of 2022 than they did in 2015; likewise, multifamily and industrial tended to trade tighter in late 2022 than historically. We expect to see this continue in 2023.
Post-pandemic spreads better reflect risk
Sources: Bloomberg, FactSet, Giliberto-Levy, J.P. Morgan Asset Management; data as of 11/30/22. Average spreads shown over full year 2019 and trailing 1 year ending 11/30/22. U.S. Investment Grade: Bloomberg US Corporate Investment Grade Index. Source for private mortgage spreads: J.P. Morgan Asset Management survey; calculated as the difference between the average yield as indicated by the survey and the yield of a U.S. Treasury with a similar duration. Retail, Office, Industrial and Multifamily data are based on the weighted average survey data for 5-year stabilized loans ranging from 50%-65% LTV (60% weight) and 10-year stabilized loans ranging from 65%-75% LTV (40% weight). Interpolation used to appropriately match duration profile to that of the ICE BofA Corporate Index, which is currently 7.3 years. Y-axis shows spread in basis points (bps). This information is general in nature without taking into account any specific investor’s circumstances. It is provided to illustrate macro and asset class trends, is not indicative of current or future results and is not an offer, research or investment advice. Not all investments are suitable for all investors. Forecasts or estimates may or may not come to pass.
Office assets will continue to be challenged in the near term, particularly those that are anything but best in market. Lenders appear particularly hesitant to lend on office properties in the current environment, which will weigh on pricing. Over the mid to long term, the sector should have a tailwind in the form of more limited supply. While deliveries will be high across the country in 2023, the pipeline appears to be thinning and future completions more modest, helping to bring supply and demand more in balance. Beyond that, the oft-discussed return to office will be the continued focal point for those monitoring the sector. And, while an economic downturn is a headwind for the sector, it may play a role in shifting the power back to the employer that generally wants employees back in the office at least 2-3 days a week.
The retail sector coming out of COVID-19 has been doing well given the limited supply over the past few years. The consumer has been in a position of strength but, more recently, inflation has been a big challenge for spending, especially heading into the 2022 holiday season. Despite healthy sales and growing foot traffic, the long-term expansion of online shopping is still a threat, especially for certain segments of the sector. Overall, the potential for an economic slowdown is a concern, but a mild recession shouldn’t pose as a major threat to well-positioned properties in strong markets.
We continue to expect that suburban multifamily and single-family rental products will outperform within the sector as the millennial generation continues to age into their peak family-formation years. These types of multifamily products offer new families the space and amenities they’d like in favorable locations at a more affordable price point and with more flexibility than buying a home. Geographically speaking, we still favor the Sun Belt markets. These markets have benefited from an inflow of population driven by relative affordability and rising employment opportunities thanks to a low regulatory and business friendly environment. Although there may be ebbs and flows in the near term, we expect these markets will remain long-term outperformers.
We see two key factors driving performance within the industrial property sector. First, we expect assets in infill locations to outperform over the near and long term. Not only are these assets more attractive to tenants given their close proximity to consumers, but also they are more sheltered from new supply given the lack of available land and barriers to industrial entitlement in denser infill locations. Second, we expect to see markets with key logistical infrastructure and importance outperform. More specifically, we expect the Southern California, New York and Northern New Jersey markets to benefit from the continued strength of the ports and scarcity of developable land.