It’s getting to be a cliché, but 2023 could be a pivotal year for commercial real estate — basically because of what happened last year.
The market entered 2022 with high hopes. There were readily available vaccines against the worst of the novel coronaviruses, and restrictions on public gatherings were dropping one by one. The housing market was chugging along, with apartment rents in particular on a steep rise. A mass return to office — and to normalcy — seemed imminent.
Then, in March, the Federal Reserve Board raised its benchmark interest rate sharply and announced further such increases were coming. Why? Rising inflation. Inflation, in fact, would hit a 40-year high in June, and remain high through the end of the year.
The situation — higher borrowing costs, historic inflation and general economic uncertainty — has commercial real estate pros reaching way back to explain what might happen in 2023.
“If you think about the 1970s, which is the last time we really saw this economic situation, most of the people in the real estate business, they either weren’t alive or they or they weren’t investing,” said Ronald Dickerman, founder and president of Madison International Realty, one of New York City’s largest retail landlords.
Dickerman says he thinks Federal Reserve Chairman Jerome Powell is taking a lesson from his predecessor Paul Volcker, who led the central bank in the late 1970s and 1980s. Dickerman remembers that period — and that it took Volcker and company time to ease inflation through rate hikes. That means the market should settle in for the duration in 2023.
“This new rate environment is going to persist for a long period of time,” Dickerman said.
Even positives might work against the market, or not be as uniformly felt.
“As compared to previous downturns, mainly the Great Financial Crisis, borrowers are going into a potential recession this time in better shape from a loan-to-value basis given that the use of excess leverage has been restrained over the past 10-plus years,” said Raphael Fishbach, a principal at lender Mesa West Capital. “However, the challenge is that this time around we are in a rising-rate environment. This has a negative impact on carrying costs and ultimately values.”
Fishbach, then, says he thinks higher rates could pose a very challenging situation for those owners without access to liquidity. Those with access should be OK in 2023, though.
“When we think about comparisons between where we are today and the Great Financial Crisis, one of the key differences here is that the financial associations today, while under real pressure, are able to bring capital to well-structured projects,” said Sam Chandan, director of New York University’s Chen Institute for Global Real Estate Finance.
Then there’s the contrarian view for the new year, one that has rates trending downward and therefore resolving a lot of the uncertainty.
“There’s definitely a feeling in the market that long-term rates are going to come down and stabilize a bit,” said Morris Betesh, a senior managing director at Meridian Capital. “I definitely think that rates are trending down.”
Betesh noted that a big challenge in the market, however, is that bid-ask spreads have increased.
“The bid-ask spread between buyers and sellers is wide right now and that is constraining investment activity,” said Chandan.
Brokers like Betesh say they are hoping more market participants will come back in 2023 and add a jolt of liquidity to the market, which will help compress spreads. But when will that happen, and what will it take to coax nervous financiers and investors from the sidelines?
“I personally believe that the current situation in real estate is not sustainable,” Dickerman said. “This is going to continue through the spring. The Federal Reserve is still going to raise interest rates. So borrowing costs are going to rise, but cap rates have been slow to adjust. There will be continued pressure on prices.” Dickerman says it will be summer before the market could start to see some semblance of equilibrium.
As for investment opportunities in the new year in the meantime, they run the gamut.
“We’re very invested in tech-enabled, growth-oriented sectors that were involved in the multifamily, single-family home for rent, seniors housing, logistics, cold storage, life science and data centers,” Dickerman said. “So, where we’ve been de-emphasizing office and retail, we’re very active in those other sectors.”
Market observers do expect the office sector to continue its labored struggle as work from home continues. Older office stock will just not fare as well as the newer, more amenitized construction.
“A number of buildings are really going to struggle in the coming year and years. To be honest, some may only be worth land value,” said Ric Clark, co-founder and managing partner of WatermanClark. The company is currently redeveloping Lever House, a 307-foot-tall office building at 390 Park Avenue.
Clark echoes others in believing 2023 could bring a wave of office conversions. “Although there’s work to be done in order to make conversions feasible and economical,” Clark said. (Case in point, as 2022 drew to a close, GFP Real Estate Partners, Metro Loft Management and Rockwood Capital closed a $536 million acquisition and redevelopment loan for the office-to-residential conversion of the 1.1- million-square-foot 25 Water Street.)
On the financing side, look at the collateralized loan obligation market, according to Meridian Capital’s Betesh. “You’re going to start to see the CLO market come back to life next year. That was a big driver of liquidity for the last three years, and it really dried up in the second half of 2022. I think issuances will pick up in 2023.”
Finally, the economic uncertainty ahead in 2023 will impact cities at large, market participants say.
“One of the most significant things that will come into greater prominence in 2023 is the health of our cities,” Chandan said. Factors including the evolution of space use patterns to the high inflation environment are affecting everything from tax revenues to the fiscal stability and operating performance of the public transportation infrastructure in a city like New York, never mind crime and residents’ sense of security
“In 2023, some cities around the country are going to have to make some very difficult choices,” Chandan said. “This is not limited to New York and San Francisco, Chicago and Boston.”