Reasons for Optimism After 2023’s Lump of Coal

As we wrap up Market Monitor for 2023, it seems appropriate to reflect on the year—one of the most tumultuous for the commercial real estate industry since 2008. The industry notorious for its cyclicality enjoyed an unprecedented 12-year bull run before the immutable laws of the universe kicked in. What goes up must come down, and market headwinds that emerged in 2022 with the Federal Reserve’s relentless interest rate increases were exacerbated by challenges from underlying operating fundamentals to global-macro events.

It was a fun exercise to re-read the article I wrote to start the year. Early optimism was driven by a temporary retreat in our industry’s bellwether 10-year U.S. Treasury index, which had declined nearly 100 basis points to 3.3% from its October 2022 high of 4.25%. Shortly after, the 10-year renewed its ascent (peaking at 5.00% this past October). Historic bank failures in March dried up lender capital, resulting in plummeting transaction volumes. Consumer balance sheets became more stressed, and our previously forecasted rent declines manifested as predicted. As the year went on, events cascaded, further stressing real estate capital markets. Here’s my take on the three most impactful industry events of 2023 and the three most hopeful outcomes for 2024.

Most Impactful Events

Impact 1: Bank failures. The failures of Silicon Valley and First Republic banks, the second- and third-largest, respectively, in U.S. history, caused ripples still being felt today. The immediate aftermath was a substantial reduction in new construction loan origination from regional lenders, the lifeblood for many developers, triggering a decline in new construction starts.

Impact 2: Fed focuses on inflation. The Consumer Price Index peaked in June 2022 at 9.1%, and ever since, the Federal Reserve has communicated that it will increase the Fed Funds rate as needed to achieve its stated target of 2% inflation. The fastest increases in history and the sustained elevation have perhaps most acutely affected real estate operators and developers who utilized floating-rate financing effectively tied to the Fed Funds rate. Most investor or developer pro formas created in 2020, 2021 and early 2022 did not anticipate these events, which then required significant infusions of capital to shore up the higher cost of interest. Achieving economic stability is surgical; but with November CPI at 3.1%, the Fed’s use of a blunt instrument appears to be working.

Impact 3: Political and geopolitical instability. On the positive front, we avoided a government shutdown in November—temporarily, until the issue re-emerges in early 2024. The Ukrainian conflict is now nearly two years old, impacting, among many other issues, materials and energy pricing. The events of Oct. 7 in Israel were the most shocking and tragic to emerge in a generation, and regional instability will create additional, unquantifiable hardships and risks. The simultaneous presence of two large-scale geopolitical conflicts adds to economic uncertainty.

Hopeful Outcomes for 2024

Hope 1: Continued declines in the 10-Year Treasury. No single metric has a greater impact on the commercial real estate industry than this one. The primary input in determining cap rates and borrowing rates is the benchmark risk-free rate. When the 10-year briefly hit 5.00% in October, there was real concern that, if sustained, valuations could see systemic structural impairment. While this risk remains, the near-20% reduction to the current 4% range has provided the best gift of the holiday season. If the 10-year settles here or, ideally, trends to mid-3%, valuations will stabilize and we may see the return of positive leverage. A true holiday miracle!

Hope 2: Banking stability. New regulations from the Office of the Comptroller and the FDIC following the 2023 bank failures will come into effect in 2024. It appears likely that the Basel III capital requirements imposed on larger banks following the GFC—including higher requirements to hold cash and reduce risky loans—will be imposed on smaller banks. These regulations should create further stability but also further constrict lending from this vital segment of the construction financing ecosystem. A viable banking system is more critical to long-term industry success than near-term liquidity needs for development financing, so I view this reform positively. However, the wave of office loan maturities in 2024 will exacerbate liquidity issues for small and regional bank lenders. Fingers crossed here.

Hope 3: Reshoring domestic supply chains. Supply-chain disruptions from COVID-19 exposed weaknesses within our domestic economy. Since then, the U.S. has begun reshoring manufacturing production and rebuilding its supply chains through enhanced Western Hemisphere trade partnerships. While this is a decades-long effort, the hope is that some of these actions will have results in 2024 and reduce lead times for critical-path construction items such as electrical switch gear and HVAC components. Improved supply chains will likely result in some stabilization in construction-pricing inflation, and perhaps some price declines.

For all the challenges 2023 brought, we turn the page to 2024 with a spirit of optimism that the commercial real estate industry will continue to adapt, evolve and thrive once again. We are a resilient bunch and have weathered far worse storms than those of 2023. Underlying demographics, economic and structural fundamentals here in the U.S. still underpin the long-term strength of the industry.