By Roland Murphy for AZBEX
No matter how much spin some analysts might want to put on the state of the U.S. commercial real estate sector, the casual observer, and most observers at ground level, have to squint and cock their heads to the side a little if they want to see the current cup as half full.
Hyperbole is rarely justified. The sky is almost never actually falling, but it’s also just about never completely filled with sunshine and rainbows either. Still, recent news continues to reward the pessimist’s perspective more than those who have continually been saying a soft landing and better times are just around the corner.
A smile, a wave and a clearly sung out, “All clear,” are just as harmful as crying wolf. The greatest risk comes in the form of entrenched disappointment after all those near-term positive indicators fail to coalesce and turn into long-term disappointment.
Since inflation and interest rates are at the core of CRE’s currently lagging state, let’s start there. Going into 2024, pundits were predicting multiple rate cuts over the course of the year, as the long-sought “soft landing” in post-pandemic inflation was expected.
As a reminder, when inflation skyrocketed due to federal spending to stave off a greater economic slowdown caused by COVID-19 and the response to combat it, the Federal Reserve raised interest rates 11 times, bringing the rate from 0.08% up to 5.33%.
That interest rate movement proved a double whammy for CRE, making new capital for development hard to secure and putting trillions of dollars in existing asset investment at risk as prior loans came due for rate adjustment and refinancing.
The current hope is there may be two interest rate reductions this year. No serious odds maker will give better than even money on that bet, though. Many experts are also cautioning that unless inflationary indicators start faring much better, there could even be new increases. According to a recent Reuters report, the best near-term hope is for no change in monetary policy.
Banks Tighten Lending Standards
At the same time distress was increasing, banks were, and remain, under pressure to maintain their balance sheets at or above tightened federal standards. CRE took a disproportionate hit, since money had been flowing freely into the sector before and during the pandemic and initial post-pandemic boom. Reminiscent of the pre-Great Recession housing boom, the degree of activity warranted enthusiasm, and nobody wanted to be the one to say a slowdown would have to come along at some point.
The Fed’s Senior Loan Officer Opinion Survey for April continued the CRE market gloom. Banks reported tightening all lending policies across all CRE loan categories. This includes loan-to-value ratios, interest-only payment periods, and spreading loan rates over the cost of funds.
Some banks also reported demand weakening for construction and development loans, and several reported lower demand for loans secured by multifamily and nonfarm nonresidential properties because of higher interest rates, slowdowns in both property development and asset acquisitions, and projected softening in rental demand.
This also ripples out to loans for general business operations and for households, tightening standards and lowering originations, meaning fewer businesses are taking out loans for expansion or new investment, and fewer potential homebuyers or homeowners are taking out mortgages and home equity lines of credit.
This is half of the Fed’s goal: cooling the overall economy to slow inflation. However, while that half of the equation is showing up, the desired result is not, at least not to any meaningful degree.
April inflation was down year-over-year from 3.5% to 3.4%, which was trumpeted as a sign of progress. Consumer prices rose 0.3% between March and April, less than some were expecting. That followed, however, three months where prices remained unexpectedly high, and a key inflation gauge excludes food and energy prices. Even though that measure has reached its lowest point in three years, it has little to no real world bearing on consumers or on businesses or CRE as the effects flow upward.
To complicate matters even more, while consumer price increases moderated, producer prices were also up slightly. Specific to construction, the increase of 0.5% has been more than slight, particularly rolled in with the rest of the year to date, which has seen inputs up 3.5% so far.
Employment
The state of employment as positive or negative depends entirely on what one chooses to look at. Politicians and policy analysts tout that the job market has remained strong, but that is simultaneously a blessing, a curse and not entirely accurate.
Several times in recent months, the labor market has posted record or near-record gains. Upon closer inspection, however, nearly all the jobs added were part-time. Several cynical observers commented those positions were fueled by consumers who needed to take a second job to cover a 26% growth in housing rents and significant increases in food and gas prices.
Labor Fueling the Fire
With all the talk in recent years about the skilled labor shortage adding costs, expanding timelines and generally keeping construction more fettered than it could or, ideally, should be, many CRE observers fail to consider labor and productivity in the broader economy and their impacts on the sector.
Data released earlier this month show only slight increases in productivity—2.9% year-over-year for Q1 and 0.3% month-over-month—but unit labor costs were up 4.7% year-over-year, meaning the increase in productivity doesn’t balance out the increase in labor costs.
This translates to inflationary pressures remaining high, which could continue to erode those hopes for any action on rates. Tepid language from Federal Reserve Bank of New York President John Williams and Federal Reserve Chair Jerome Powell after the latest inflation data gave little room for enthusiasm. Williams said, “The overall trend looks reasonably good.”
Reuters reported: “Williams said unemployment would likely rise to 4% this year from the current 3.9%. Meanwhile, he said inflation by the Fed’s preferred measure—the personal consumption expenditures price index—will likely be in the low 2% range by year end, putting it at around 2.5% for the year. He expects it to hit around 2% next year and remain there sustainably after that.
“To change monetary policy, Williams said the Fed needs to have confidence inflation will hold at 2%, not for it to hit 2% before acting to cut rates. ‘It shouldn’t be that we’re at that 2% level because then I think we will have waited too long,’ he said.”
More of the Same vs. Best and Worst Case
The old joke goes that the optimist sees the glass as half full, the pessimist sees it as half full and the pragmatist sees it as twice the size it needs to be for the current circumstance. There’s a bit of room for all three in the current boat, even if no one will be particularly comfortable.
A recent Moody’s CRE report showed a hopeful, but minor, turnaround in CRE transactions. Unfortunately, there were so many aberrations and one-offs in the transactions under review it would be foolish in the extreme to pin up any hopes of things to come.
In the best case, the inflation rate will dip enough for the Fed to get a little bit adventurous and float a trial balloon interest rate reduction that will ease pressure on CRE owners and developers, and lead to a calm and stable pace of normalization.
That won’t happen.
In the worst case, inflation will spike again and the Fed will raise rates sharply to arrest the process before it takes root, triggering fractures across multiple already brittle markets—most notably CRE, which had $85.8B in distressed assets at the end of 2023, according to Urban Land Institute.
That probably won’t happen either.
With it being graduation season, there’s an age-old conundrum that makes a good comparison for the current situation. Graduates are entering the job market looking for experience but can’t get hired for a position unless they bring experience with them.
Similarly, CRE and development can’t shake off their current restraint until interest rates recede. Interest rates can’t go down until inflation goes down. Inflation can’t go down until cost factors for assets, services, labor and materials go down and relieve pressure on CRE.
It’s a juggling act, and the best we can hope for at the moment is for all the balls to stay in the air. The downside of that, however, is as the vicious circle normalizes, more and more players in every part of the game will become more and more afraid to be the one that breaks the pattern.
Ultimately, that continues the cycle and makes it even more vicious, but anyone who says they can chart a clear and safe way forward at this exact point is wrong, at best, or lying, at worst.