Be careful what you wish for. The U.S. economy is adding jobs and is expected to keep adding jobs for the next two years. The unemployment rate is close to its lowest point in decades. But prices are rising much more slowly than a year ago.
Over the last year and a half, the Fed raised benchmark interest rates over and over again to choke off price inflation. As inflation comes under control, officials at the Federal Reserve are less likely to raise rates again.
But the rate of inflation is still higher than the target set by the Fed. They are unlikely to significantly cut interest rates if they believe that inflation could speed up again—especially without an economic recession to motivate them to move.
That means more stress for real estate investors, said panelists discussing the ULI Real Estate Economic Forecast, Fall 2023, which surveyed 46 economists and analysts at 39 leading real estate organizations in October.
“For commercial real estate, this is not only a recession,” says Ken Rosen, chairman of the Rosen Consulting Group. “In parts, it’s a depression, especially real estate finance and the office sector.”
Few properties trade
With higher interest rates, investors are expected to buy just $312 billion in 2023, according to the ULI Fall Forecast—a fraction of the volume of sales in 2021. It’s also more than $100 billion less than expected in the spring forecast, just six months ago.
The shortage of transactions is likely to prolong disagreements between potential buyers and sellers.
“If there is less transaction volume, it’s going to make values less certain. That keeps the bid-ask spread between buyers and sellers much wider,” says Anita Kramer, senior vice president of the ULI Center for Real Estate Economics and Capital Markets, and moderator of the panel.
The prices investors are willing to pay for these properties are falling as interest rates rise, forcing many to pay more to finance acquisitions. The National Council of Real Estate Investment Fiduciaries (NCREIF) capitalization rate is expected to rise to 4.6 percent for 2023 and rise higher to 4.8 percent in 2024. That’s up from 4.0 percent in 2021.
Many property owners resist selling at these higher cap rates. But some economists expect cap rates to rise even higher, since the interest rates have risen much more than just 80 basis points. “The correlation between the cap rate and the 10-year bond in the short run isn’t high but over a longer period of time it’s 85 percent,” says Rosen. “Count on [cap rates] at 5.5 percent—not under 5 percent.”
Economists like Rosen also point to the lower prices and higher yields on the stock prices of real estate investment trusts (REITs). REIT stocks now sell at prices that work out to cap rates 100 basis points higher than the cap rates available to buy private real estate, says Rosen.
According the Fall forecast, property prices are forecast to drop just 7 percent for 2023 on the MSCI Real Assets index. But the prices of equity REIT stocks already dropped 24.4 percent in 2022, as interest rates started their rise, and dropped another 4.5 percent in 2023.
“That definitely speaks to another leg down in valuations coming over the next 6 to 12 months,” says Sara Rutledge, head of global real estate market research for StepStone.
“It’s a slow-moving process,” says Rosen. “People are going to see as much as a trillion dollars of losses, concentrated in office but even apartments and other areas that were over-leveraged.”
The U.S. economy enjoys a “soft landing”
The U.S. economy seems to have dodged a recession. The gross domestic product is now expected to grow 2.3 percent in 2023 and it is likely to grow again a sluggish 0.94 percent in 2024, according to the latest ULI Forecast.
That’s much better than expected. Just last year, leading economists predicted a short, deep recession in 2023, as officials at the U.S. Federal Reserve raised interest rates to fight inflation, followed by a quick recovery in 2024.
The unemployment rate in the U.S. is likely to be 3.8 percent by the end of 2023, up from 3.5 percent at the end of 2022, according to the forecast.
Price inflation is also slowing down more than experts thought it would just a few months ago—though prices are still rising faster than the target rate of 2 percent set by Federal officials.
The consumer price index is likely to have risen 3.5 percent in 2023. That’s a big improvement from 7.0 percent in 2021. Inflation is expected to slow further to 2.5 percent in 2025, according to the ULI forecast.
Federal officials are much less likely to raise interest rates again, as the rate of inflation shrinks closer to their target of 2 percent. But they are unlikely to cut rates with inflation still high and no recession to motivate them, says William Pattison, head of research and strategy for MetLife Investment Management.
Federal Reserve has already raised interest rates higher than experts expected. The benchmark yield on 10-year Treasury bonds is now expected to end 2023 at 4.6 percent, according to the forecast. That’s a full percentage point higher than the expectation in the spring survey.
“The consensus is that that the 10-year hovers around 4 percent for the next three years,” says ULI’s Kramer. “There was a broader expectation earlier this year that rates would stop rising.”
The high cost of war, and other risks
The future could also include surprises. “The odds of something going wrong are much higher than the odds of something going right,” says Rosen.
In particular, inflation may stay in place even longer than the consensus view. Two wars in oil-producing regions, affecting Russia and the Middle East, could affect energy prices. Trade disruptions and new tariffs could affect prices of imported goods and materials. Climate events could affect food costs.
“Inflation could be sticky on the way down,” says Rutledge. “Central banks will be forced to react to that.”
That would mean even higher interest rates for an even longer time than the current consensus view—putting even more pressure real estate investors who depend on financing.
“The biggest thing that I’m worried about is interest rates going up on the 10-year bond more than anyone expects,” says Rosen.
