CAPITAL MARKET UPDATE
C apital markets face a set of the financial crisis. The extraordinary growth cycle that began following the rollout of vaccines of COVID-19 has ended. Added to that cyclical challenge are the prospect of interest rates and cap rates rising rapidly and inflation at levels not seen since the 1980s. Challenging as those market conditions sound, the commercial real estate finance industry is in significantly better position to handle the challenges than it was 15 challenges in 2022, the likes of which have not been seen since years ago. As jarring as the changes in conditions may be, none are unexpected. While the pandemic was a surprise, the financial and economic remedies to it - massive stimulus and government spending - produced demand that far outpaced supply and predictably led to both the inflation and the interest rate reaction that followed. In response to these unusual circumstances, lenders maintained liquidity and underwriting discipline, and became more cautious in anticipation of the consequences of the federal government’s intervention. During the second quarter of 2022 the capital markets endured multiple broadsides that may have signaled the beginning of a downturn in dealmaking. In the April-to-June period, interest rates increased, the first signs of slowing industrial activity appeared, gross domestic product (GDP) declined, the chances of recession increased dramatically, and inflation reached 40-year highs. At the same time, the demand for financing remained strong, albeit lower than a year earlier. As borrowers and lenders sort out what the market will look like going forward, the battle to rein in inflation is garnering the most attention. After responding slowly to the persistent inflation in 2021, the Federal Reserve Bank has made quashing inflation its highest priority. Since first hiking its Fed Funds rate by 25 basis points in March, the Fed
has bumped rates higher three times, including 75 basis points increases in June and July. Fed Funds will remain at 2.25-to-2.5 percent until the September Federal Open Markets Committee meeting. Depending on the trajectory of the economy at that point, increases from 25 to 75 basis points are on the table. There are increasing indications of disinflation – a lower rate of inflation – that suggest that the Federal Reserve Bank’s monetary tightening is working. Among those indicators are sharply falling shipping rates (which account for roughly 35 percent of inflation) and industrial commodity prices, easing rents, and spikes in the inventories of graphic processing units and retail goods. This potential shift in trend has not gone unnoticed by the bond markets. Despite the inflationary spike, bond yields have risen modestly. The 10-year Treasury bond has tested the 3.25 percent level several times, spiking to nearly 3.5 percent in mid- June before falling back to 2.8 percent by late-July. Two-year bonds also fell below three percent. Inflation swaps, which are hedges against higher inflation that rise with inflation expectations, peaked at the end of the first quarter but have fallen since the Fed began raising rates. Following the July 4 holiday, three-year forward expectations (as measured by the inflation swaps) were slightly above three percent. The five-year forward expectation was two percent. The normalization of longer-term rates does not mean that capital markets are behaving normally. Pricing for commercial real estate is a function of a base rate – usually tied to a global standard – plus a spread to cover the lender’s risk and profit. Base rates were two percentage points lower in January than in July. That makes it tougher to pencil out a deal and the difficulty is showing up in the marketplace. One early consequence of the higher rate environment has been a slowdown in the mortgage-backed securities (MBS)
market. Non-agency residential MBS activity plunged 39 percent in the second quarter, according to research by Inside Nonconforming Markets. The ripple of the Fed’s tighter policies took roughly 60 days to reach the secondary mortgage market and the reduced appetite for loans made during the period of lower rates pushed volume down to $21.35 billion. The Mortgage Bankers Association (MBA) updated its base 2022 forecast with the expectation that loan volume for multi- family properties will decline significantly for the remainder of the year. Following a record $487 billion in multi-family financing in 2021, the MBA predicts that volume will fall to $436 billion in 2022. MBA vice president for commercial real estate research, Jamie Woodwell, attributed the decline to uncertain economic conditions and significant changes in the lending industry because of the rapidly changing rate environment. Woodwell expects debt and equity markets to adjust to the new conditions by 2023, when the MBA forecasts an increase in multi-family originations to $454 billion. Fundamental conditions of the multi- family market have not weakened, either nationally or locally. Vacancy rates remain below five percent nationally. Average rent for one- and two-bedroom units grew by 14.1 percent year-over-year in June, according to Apartmentlist.com. June’s rent growth was slower than the 17 percent rate of January. Rents have increased 5.4 percent from January through June. The same report showed Pittsburgh’s rent growth at 8.6 percent, one of the lowest rates of growth among cities with population of more than one million. The rent picture for other commercial properties is mixed. Rent increases for industrial properties are expected to be much higher than other property types, although there are indications that the growth in demand for distribution space is cooling. Across the U.S., rents for industrial space are expected to grow more than 11 percent in 2022. (Prologis
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