Market Intel: Repricing Real Estate: How Interest Rates are Affecting CRE

SKIP AHEAD TO:

• Deal-making Roadblocks
• Winners, Losers, and Sharks
• A New Cost Landscape
• With Recent Bank Failures, Where Do We Go From Here?
• About CompStak

What is the most exciting (or stressful) live event on TV? It may well be the monthly Federal Reserve Open Markets Committee press conference. A discussion of economic fundamentals and future interest rate guidance has recently become one of the most impactful hours of television. 

Each month, key economic factors oscillate as economists and Wall Street analysts reevaluate the chances of victory for the Fed in its battle against inflation and predict how and when interest rate rises will abate.

Deal-making Roadblocks

The Fed’s battle against inflation has reshaped the investment world. Rising interest rates change the cost of loan financing and the way companies conduct business. Current interest rates make it more expensive to take on debt, thus slowing the pace of deal-making and financing, and in turn, cooling the economy. This cooldown is crystal clear in the commercial real estate deal landscape.

Year over year, commercial real estate transitions have declined and average sales prices have plummeted. The slowdown in activity has been affecting both beleaguered sectors like the post-COVID office market and formerly hot assets like industrial. As the Fed continues to tame inflation, its policy is working as intended – the economy has slowed down as cautious investors are taking a wait-and-see approach in the current interest rate environment.

Winners, Losers, and Sharks

All changes naturally bring new opportunities. As the state of the economy is more uncertain, there is suddenly room for negotiation for a savvy buyer for the first time in recent years. Because deal flow has slowed to a trickle, buyers have every right to ask for healthy concessions to get deals done such as longer closing periods and lower offers. Even though the cost of money has almost doubled in the past year, buyers may still come out worse even with decent price reductions.

In these conditions, buyers who have access to large piles of cash and cheap credit mechanisms, have the best of both worlds – room for negotiation to make deals happen while still locking in favorable financing. Like in previous economic downturns, investors with enough liquidity were able to secure favorable terms expecting to make a profit in the long term. 

The current market reflects a delicate dance between motivated sellers, tentative buyers, and sharks hunting for deals. Investments like this are a long-term strategy, and this market can offer exactly that.

A New Cost Landscape

One important feature of economics is that different costs adjust at different rates. By raising interest rates, the Fed has rapidly increased the cost of capital and provided a strong disincentive for new investments. This stress on debt finance extended to the larger economy, suppressing wages and disincentivizing debt, which slows down inflation.

However, this happens at different speeds. While a rise in the federal funds rate almost instantaneously percolates into the underwriting terms of new loans, other parts of the economy are slower to react. Building supply companies don’t immediately drop prices and construction unions don’t decrease wages as an instant response to the Fed’s interest climbs.

The Fed intends to keep raising rates as long as it takes to control inflation. In the near term, the cost of debt has increased, but the cost of wages and materials hasn’t declined or moderated substantially. For new construction, it means that either the consumer will have to compensate for the cost of material and debt increase by paying a higher price or the developer is going to make lower profit margins. CompStak recently evaluated the rise in work values provided in office transactions in major markets as compared to the increase in the Producer Price Index (PPI) since 2019. In February as well as March, the PPI for non-residential construction goods increased more than anticipated. But the slight increase month over month for goods was coupled with a slight decrease for services. While the indices remain below their June and May 2022 highs, goods are up 41.2% from the beginning of 2019 followed by a 32.0% increase for services. These increases are concerning because PPI is considered a leading indicator of consumer prices as producers pass these increases on to consumers. This is additional evidence that inflation remains stubborn and the FOMC is still facing considerable challenges, especially as rising interest rates (their main tool to combat inflation) have created unintended consequences in the banking sector.

With Recent Bank Failures, Where Do We Go From Here?

Before the most recent bank failures including Signature Bank and Silicon Bank, the Federal Reserve seemed poised to raise rates by another 50 basis points at March’s meeting, but recent and substantial stress in the banking system upended those plans. A plan for a 50 basis point rise was considered justified based on previous data points available including CPI figures and jobs data. But since the last rate hike, additional employment and inflation data has been released and appears to show further weakening in the economy and inflation than was apparent before March’s meeting. 

Each month, the release of the monthly job numbers and the Bureau of Labor Statistics’ monthly Consumer Price Index (CPI) have been hotly anticipated data points especially since the Federal Reserve began raising rates in March 2022.  In March 2023, the Consumer Price Index (CPI) for All Urban Consumers increased 0.1% month over month and was up 5.0% over the last 12 months, its slowest year over year increase since May 2021. March’s moderation in inflation was helped by a decline in energy prices and flattening food prices. In addition, the most recent jobs report from the Bureau of Labor Statistics revealed the U.S. economy added 236,000 jobs in March. This was  slower than expected growth and the smallest monthly growth since December 2020 when nonfarm employment dropped by 268,000 jobs. Similarly, the latest release of JOLTs (Job Openings and Labor Turnover Survey) for February demonstrated that the number of job openings declined to 9.9 million, falling below 10 million for the first time since May 2021, with the sharpest declines year over year in Professional and Business Services and Education and Health Services.  While these statistics reflected a deceleration from previous months’ gains, the gradual weakening in job growth and inflation may not be enough to satisfy the Federal Reserve.

All of these numbers indicate the real-time progress of the Fed’s success in cooling the economy. Inflation may continue to prove resilient and keep on rising. On the other hand, high-interest rates may push the world into recession especially if greater stress is revealed in the banking system After this recent turbulence, the Federal Reserve has downgraded their economic projections for the rest of 2023 all but directly conceding that a recession is now appearing more likely.  This has left the Federal Reserve with tough choices to make. With an April break in FOMC meetings, all eyes will be on the performance  of the economy over the next month until the next FOMC decision on May 2, 2023.

The CRE market and economic activity as a whole are under significant stress as lending and capital markets slow and uncertainty about the direction of the economy reigns. At CompStak, we are the trusted data provider for commercial real estate data and analytics, which is one of the leading indicators of the economy’s trajectory. An increased deal cadence may indicate a sanguine trend. Steep drops in effective rents due to substantial concession packages may reveal a rising pressure on balance sheets. When we see a signal, you will be the first one to know.

About CompStak

CompStak creates transparency in commercial real estate markets by gathering information that is hard to find, difficult to compile, or otherwise unavailable. Since 2012, CompStak has delivered this unmatched insight to a network of tens of thousands of members and clients, including Tishman Speyer, Wells Fargo, and every major brokerage nationwide. CompStak Exchange is an exclusive platform for CRE brokers, appraisers, and researchers to get analyst-reviewed commercial lease comps, sales comps, and property details at no charge. Through CompStak Enterprise and CompStak Analytics, lenders, landlords, and investors can access granular CRE transaction information and market analytics.

Interested in learning more how interest rates are affecting CRE? Contact us today!