Capital Markets | Q3 2022 U.S. Market Snapshot
The commercial real estate market is amid a massive slowdown, and what market participants have been feeling for months is now reflected in transactional data. Sales are down compared to last year and Q2 of this year, and there is little to suggest rapid market liquidity is coming. In addition, interest rates rose rapidly in Q3, as the Federal Reserve is in a hawkish state to tame entrenched inflation. However, with October’s core CPI reading coming in below consensus, expectations for continued Fed action on the overnight borrowing rate are shifting. In turn, this may loosen liquidity in the quarters ahead.
Today’s market conditions are abnormal. Typically, a liquidity challenge is due to eroding fundamentals or a banking crisis, but neither is at play today. Instead, fundamentals are generally sound, if not improving, in most asset classes. However, real estate investors are facing higher borrowing costs, creating a wide bid-ask spread on deals in the market. In addition, many buyers are “pencils down” right now, waiting for interest rate stability. Stubborn inflation, geopolitical concerns, a strong U.S. dollar, and fear of a recession have the market spooked, despite tremendous amounts of uninvested capital.
Context matters, as well. Benchmarking to 2021 is challenging. It was a year of pent-up investment from a pandemic-induced slowdown in 2020, low-interest rates, and a risk-on mindset. Together, this led to record investment sales, which continued through Q2 of this year. However, that surge in sales has come to a halt, and future year-over-year comparisons will look harsh. Assessing upcoming activity to longer-term investment sales averages would be more prudent. Despite the recent slowdown, Q3 volume was still ahead of the 2014–19 average.
Capital is sitting on the sidelines but is available for the right deals. Private buyers have moved to the forefront of deals with 1031 exchange capital, as have cash buyers. With cap rate spreads to BBB bonds and 10-year Treasuries at record lows, cap rates need to rise. Transactional data has yet to show a meaningful change, but dealmakers have felt a movement of 50-100 basis points, on average, across markets and asset classes.
Office
Office is out of favor. Sales volume declined each quarter of the year, and Q3 sales volume is well below the 2014-19 average. Buyers today are very selective, while owners of the most in-demand product, trophy Class A properties, are holding.
Office fundamentals are challenged. Rents are still holding for the most part, but concessions are up, sublease availability is growing, and absorption has been slow. In addition, the country’s return-to-office plans have stalled, with little additional movement post-Labor Day and many investors sitting on the sidelines or pivoting capital to other asset types. NCREIF data shows that pension funds have reduced their share of office holdings by 11% since 2019. Volume declines are most pronounced in CBD markets. Suburban volume, on the other hand, has been relatively stable in 2022. In aggregate, sales prices are falling. Transactional prices dropped in Q3, the most significant decline of all asset classes. Median prices are back under $300 per square foot. Office-to-residential conversions are starting to gain more attention. How this plays out is still to be determined, but these conversions would help ease supply-side pressure on cities nationwide. However, not all buildings are sound conversion plays; floorplate sizes matter and the cost is a factor.
