The consensus is that 2023 will be a challenging year for the commercial real estate debt markets as lenders and borrowers continue to adapt to the impact of higher interest rates, uncertainty around property values and a widely expected recession. Here are five trends to watch in 2023.
1. Recession ahead
Richard Barkham, global chief economist and head of global research at CBRE, believes the expected recession will not be particularly deep. In Barkham’s view, corporate finances are generally in good shape and there is a tight employment market for skilled workers.
“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 percent level,” Barkham said.
While inflation was tempered toward the end of 2022, it was still at a level of more than 7 percent and the US Federal Reserve will continue to increase interest rates until inflation is closer to its 2 percent target. “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,” Barkham concluded.
2. Growth of low-leverage lenders
The coming year could be a good one for private lenders with reserved cash and who have operated without leverage, said Raymond Davis, chief strategy officer at Red Oak Capital Holdings. “The lenders who utilized lines of credit lines have, for the most part, slowed or halted lending operations altogether. In fact, we have seen several well-known lenders close shop, and many others are in a virtual zombie status,” Davis added. “Though we have the ability to leverage, we made a conscious decision not to use that strategy.”
The Irvine, California-based lender has also observed the market is shifting, with some property types falling out of favor and others gaining traction. “That alone is reason to move with caution,” Davis added.
3. Debt as an investment
Commercial real debt has been steadily growing as an investment, with more investors expected to come into the sector in the coming year. “Private debt is a haven of sorts. It provides an opportunity to invest in tangible, income-producing assets at a 25 percent to 35 percent discount to valuation, which gives a margin of safety for pricing compression. As LTVs continue to be compressed, capital sources with dry powder are being overwhelmed with lending opportunities on high-quality assets in strong growth markets,” Davis said. Additionally, private lenders can also be more creative. “There is a lot of capital on the street looking for private debt opportunities. Strong managers who are longtime experts in their niche will stand out from the pack. That is our position, and right now it seems to be helping us achieve our growth objectives.”
4. Distress is coming
Along with the expected recession, market participants are also gearing up for distress – and significant buying opportunities. “We do believe that there will be great buying opportunities in this part of the cycle, whether that involves getting to assets through the debt or by working with market sellers that have time pressure to effectuate a sale,” said Andrew Joblon, managing principal of Turnbridge Equities.
Turnbridge is not the only company that is looking at the potential for making both debt and equity investments, with existing players including Taurus Investment Partners, Kingbird Properties and CARROLL looking at ways to fill gaps in the capital stack.
5. Demand drivers are changing
As lenders look ahead to the coming year, a significant focus will be on lending on the asset classes which are in favor – and avoiding the ones that are seen as being in distress. “Real estate is in a state of adjustment, as the drivers of tenant demand shift markedly and investors adjust their portfolio allocations,” according to a 2023 outlook report from BlackRock published in December. “Occupancy levels across sectors are still high – something that could change as we get deeper into the economic cycle. And valid questions persist about how profoundly the rise in interest rates will disrupt property prices, especially if occupancy rates drop.” By sector, logistics remains steady while office continues to be affected by changes in working patterns. Retail continues to face headwinds while multifamily continues to demonstrate strength.
The biggest question on everyone’s mind is when the market will transact again. The consensus is that this might not occur before the middle of 2023, particularly if the Federal Reserve continues to increase rates aggressively.
But at some point, banks will start to write down loans and borrowers will begin to move ahead as maturities loom.
“We are starting to see glimmers of mispriced risk that are occurring. And anytime the market dislocation is great, it’s a great time to invest,” said Ken Munkacy, senior managing director at Boston-based Kingbird Properties. “We haven’t gotten to a price discovery moment yet and I believe it will unfold slowly.”