- Economy. The U.S. economy has proven surprisingly resilient to rising rates. Real gross domestic product grew at a 2.4% annual rate in the second quarter, a strong showing. Employment continues to grow robustly with some possible slowing on the margin. Labor markets are extremely tight, with 1.6 jobs still available for every unemployed person. Wage growth has moderated but remains at the highest levels since the late 1990s. A broad range of metrics show that inflation peaked in the Fall of 2022 but remains above target. The continued strength of the economy provides the Federal Reserve with justification to maintain a hawkish monetary policy stance, hence the recent hike to 5.25 to 5.50% and leaving the door open to further hikes. The Federal Reserve has been clear that it does not anticipate any rapid reduction in rates, a message that financial markets have resisted taking to heart. It cannot be stressed enough that a soft landing for the economy means higher rates for longer.
- Debt Markets. CRE debt origination activity has remained constrained in the first half of 2023, down 52% year-over-year and 31% compared to pre-pandemic. It’s not just dollar volumes – there are 32% fewer active lenders in the market today compared to a year ago. Originations are down sharply across property types and lending sectors, though office, debt funds and CMBS/CRE CLO are negative outliers. The bigger issue is that the small and regional bank lending engine that has driven the CRE market is rapidly slowing with no clear replacement. All this is occurring at the same time as the market is set to absorb $1.4 trillion in debt maturities in 2023-2025—debt that will mature with significantly higher debt costs than when loans were originated. Additionally, many loans are underwater or nearly so, especially recent loan vintages of most property sector and broad swaths of office debt. We estimate that $626 billion in debt maturing in 2023-2025 is potentially troubled.
- Equity Markets. Investment sales declined 62% year-over-year in the first half of 2023. Granted, the first half of 2022 was historically strong, but sales in the first half of 2023 were still down 30% compared to the 2017 to 2019 average. Momentum is negative as sales declined 12% quarter-over-quarter in the second quarter of 2023. Sales declined year-over-year across property sectors in the second quarter of 2023 and in the first half of the year. Multifamily, office and industrial sales rose slightly quarter-over-quarter but not enough to suggest a trend. Investment allocations continue to evolve. Multifamily has returned to its pre-pandemic share while office and industrial allocations have risen. The office share continued to contract in the first half of 2023. Investment has declined across capital groups, but institutional investors and REITs have declined most dramatically – likely due to higher sensitivity to cost of capital.
- Supply of Capital. Dry powder at closed-end funds currently sits at a record $261 billion. The capital is concentrated in opportunistic and value-add vehicles, while debt strategies have pulled back. We estimate that 75% of this capital is targeting residential and industrial assets. While much of this dry powder was raised prior to the turn in market conditions, new fundraising at close-end funds accelerated in the second quarter of 2023, particularly for opportunistic vehicles. In contrast, contributions to ODCE funds declined to a post-GFC low in the second quarter of 2023 with many funds facing redemption queues. Similarly, new fundraising in the REIT sector has slowed to a halt. Nontraded REITs have been forced to limit redemptions, even as they’ve had success in bringing in new institutional partners and post surprisingly high returns.
- Pricing and Returns. Transaction markets now show clear increases in transaction cap rates, belatedly following the public markets. Even so, both in the private and public markets, cap rates appear distinctly unattractive relative to the cost of debt capital, possibly excepting office REITs. This is not surprising in the private markets where transaction volumes are muted and reflect selection bias and appraisal-based valuations lag market conditions. Extremely narrow cap rate spreads in the REIT markets are harder to justify and seem to require a rapid decline in debt costs, historically abnormal NOI growth or a combination of the two. Notwithstanding the structural deficiencies in NCRIEF valuations during periods of rapid change like today, NCREIF NPI total returns were broadly negative in the second quarter of 2023. Hotel and retail outperformed on the margin. Returns were negative in 59% of metro markets, including 82% of office markets.
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Capital Markets Report
2Q 2023
Newmark Research presents the Second Quarter 2023 Capital Markets Report.