What to Expect in CRE Investment Sales in 2023

David Cohn
Jan 21, 2023
CRE Investment

CBRE estimates that US commercial real estate investment volume will experience a 15% YoY decrease in 2023 but still exceed the pre-pandemic peak recorded in 2019.

This investing activity may hit its lowest point during Q1 before gradually getting better throughout the rest of 2023 when there's a clearer perspective on where the terminal federal funds rate and overall economics are heading.

Long-term yields and spreads should lower capital costs, enabling more reliable underwriting.

As a result, many experts believe that activity in the capital markets will increase quarter-over-quarter from Q2 onwards.

The results of GlobeSt.com's recent survey of commercial real estate professionals are similar to the findings of CBRE.

As a result, many investors anticipate a decrease in deals. However, there will still be activity in the form of debt maturing and distressed situations. Here are some insights from that report.

Capital is available

Abundant capital is still accessible, but investors exercise caution and deliberation when making acquisitions before stabilizing the market.

In this volatile economic environment, cautious investors pay close attention to every Fed note for signs of how the economy adjusts as growth declines, inflation slows down, and labor markets loosen up.

The fundamentals remain strong, with plenty of tenant demand and consumer spending behavior seen. There may be some longer-term softness across retail sectors, but there shouldn't be any extensive pullbacks.

Recapitalization requests are increasing.

After the recent rate hike, many investors are feeling more confident in their near-term projections and believe that transaction volumes will increase drastically in Q2.

In addition, seeing an upsurge in recapitalization requests, they have taken the initiative to provide rescue capital to select apartment sponsors.

This trend is predicted to continue throughout 2022, giving some investors an optimistic view of what 2023 holds regarding market opportunities.

There are signs of a healthy CRE market.

Some industry analysts also believe that in 2023, buyers and sellers can enjoy a more balanced market due to a slight increase in inventory.

The market is no longer solely in the hands of owners and landlords—a trend that is incredibly beneficial for those looking to buy or rent.

Such positive developments may indicate that things are moving through the usual cycle, indicating good overall health for the Commercial Real Estate market.

$1 trillion in loans will come due in the next two years

Because of the sheer amount of senior debt about to expire, investors are presented with an array of exciting investment prospects in commercial real estate. Over a trillion dollars in loans is expected to fall due in the next two years.

In addition, according to Newmark's report, current interest rates may cause repayment conditions to be more complex, with commercial bridge loans and office/retail loans being among the most vulnerable.

In addition to rents and construction costs rising, political pressure exacerbating the market conditions, and debt levels increasing exponentially, CRE (especially in NYC) has to be replenished with capital for refinancing assets at a reduced rate, paying down existing debts, or finishing current projects.

Price discovery by the end of the first quarter

Currently, there are significant gaps between buyers and sellers between the bid/ask spread (the difference between the ask and bid prices of CRE assets). However, this spread should correct itself as market anxiety rises, with greater clarity expected by the close of quarter one.

Some business owners with high-risk floating rate debt already have difficult conversations with their hard money lenders for commercial real estate.

Additionally, there are concerns about leasing demands for office properties and multifamily/industrial asset supply in specific markets. This could lead to reduced property performance in the short term and decreased investment volumes by 2023.

As the market enters Q2, the maximum federal funds rate and general economic status should become more evident.

Long-term yields and increased spreads will play an instrumental role in reducing capital costs while simultaneously allowing for better underwriting decisions. These developments are expected to gradually improve activity within capital markets starting from the Q2 period onwards.

The demand for construction financing should rebound.

Analysts suggest that sales activity will experience a resurgence during the early part of 2023 as participants in the investment industry come to terms with what the so-called new normal looks like in terms of interest rates and cap rates.

Although forecasts surrounding financial markets have been less than optimistic, loan maturities, cash-outs for repairs or partnership buy-outs, and general sale activity are expected to drive capital demand. Equity is forecasted to re-enter the scene come late Q1 or early Q2.

Lenders are optimistically anticipating a rebound in demand for construction financing, with minimal new projects that will be prepared by mid-2023.

However, pricing may remain unpredictable; loan-to-costs can reach an upper limit of 50%-65%, and sponsor experience will play a significant role.

Particular loans have to be taken off balance sheets.

Some industry experts believe that in a tightening lending market, only banks and life insurance firms will offer off-balance-sheet financing. Non-performing loans must be sold off, while underperforming and non-performing loans must be removed from balance sheets.

Miami and Austin are expected to fare better than NYC, Chicago, or San Francisco. However, as unemployment rises and January brings lower corporate earnings reports, it is clear that prudence is necessary for this period of financial uncertainty.

A year of caution

According to the 2023 CRE outlook (reported by Aegon Asset Management), it's not a matter of whether the economy in 2023 will suffer, as that is almost assuredly going to be the case.

Instead, the real difficulty lies within just how much damage there will be—and unfortunately, experts say that we are likely due for some tough times ahead.

Based on the Blue Chip Economic Indicators survey from November 11th, 2022, only 22% of forecasters believed the economy would have a 'soft landing.' In contrast, the remaining 78% predicted that a recession would most certainly happen.

Surprisingly, the impact of higher interest rates on commercial real estate has yet to be reflected in capitalization rates but has decreased transaction volume.

The weakening demand for commercial space is the main factor to watch in 2023. CRE pricing already showed the impact of higher interest rates in 2022 (though the response was muted).

Cap rates on completed transactions did not widen significantly through October, but there was a sharp slowdown in the pace of transactions, according to reports. The sluggish transaction pace resulted from the uncertainty that ultimately undermined price discovery.

As a result, investors were reluctant to commit their funds as it became increasingly hard to determine the real value of properties.

The current economic climate of elevated interest rates, the unpredictability of inflationary pressure, and concerns about the depth of a potential recession all add risk to the system.

The upward pressure on capitalization rates across many markets leads to decreased property valuations. As a result, price discovery should take longer than expected.

Uncertainty remains on essential metrics such as absorption rate, vacancy levels, rent increases (and the ability to sustain them), and new supply (which depends on financing availability and labor scarcity along with demand for it).

In addition, geographic location and property type will ultimately determine how successful a project will be.

However, all of this relies upon the economy's overall health. If analysts anticipating a mild recession are correct, then the CRE market should perform positively in 2023.

The absence of excessive new supply should contribute to this success, with occasional exceptions.

All CRE segments must catch their cap rates up with higher interest rates and slower growth. However, there should still be some opportunities in Class B apartments, where supply remains more limited, as well as grocery-anchored neighborhood retail outlets.

Going forward

After the past three years, it's difficult to make any specific predictions about what 2023 may bring; other than that, we should prepare for the unexpected.

This year will be a repeat of 2022 in many ways. Of course, it won't be all gloom and doom, but there might be a lot more surprises along the way.

Clearly, there is a lot of uncertainty going into the new year—uncertainty at a level that the market hasn't seen in a while.

All this said, there is room for optimism in the current climate. Seasoned investors often make the best deals during times like this, after all.

Commercial real estate investing is not only capital intensive but also requires courage and determination.

The next year may very well be a year of opportunity for those who take action while many choose to wait.

The key to making better CRE investment decisions during this time is to continue tracking indicators that can provide insight into how market trends will likely unfold.