2022 Q3 Quarterly Databook

The US economy, and thus commercial real estate markets, are facing a period of uncertainty as the Federal Reserve continues to signal it will do everything in its power to bring down inflation.   Using short-term rates as their hammer, the Fed is sifting through economic data to try to gauge how high rates will have to go and how long they will have to stay there to tame price growth.  Both the Fed and market participants are also working through what damage those actions are likely to cause to the economy.  The impacts on commercial real estate markets are likely only beginning to show up.

ECONOMY

The U.S. economy, as measured by the seasonally adjusted annual rate of change in the real gross domestic product (GDP), grew at what appeared to be – of the surface – a strong 3.2 percent clip in the third quarter, ending two quarters of negative growth.  It’s important to note that the previous quarters’ negative growth rates were driven by declines in items generally seen as “one-time” aberrations -- associated with net exports and/or changes in inventories -- and also that growth in the third quarter was similarly pumped up by changes in net exports.

The labor market has continued to show top-level strength, but with some mixed signals underneath.  Companies reported adding (net) 537,000 jobs in July, 292,000 in August, 269,000 in September, 284,000 in October and 263,000 in November.  Conversely, a sister-survey of households showed the number of people reporting being employed declined by 328,000 in October and 138,000 in November, edging the unemployment rate up from 3.5 percent to 3.7 percent – still among the tightest levels in history.  Average hourly earnings in November were 5 percent higher than they had been a year earlier.

The labor market strength, coupled with still strong checking and savings accounts, has supported continued growth in consumer spending, although that growth has been slipping.  On a year-over-year basis, retail sales were 12 percent higher in July, 10 percent higher in August, 9 percent higher in September, 9 percent higher in October and 6.5 percent higher in November.  The November figure was 0.6 percent lower than that of October.  The overall growth in consumer spending added 1.7 percentage points to real GDP growth in the third quarter.

Taking all this into consideration, the Federal Reserve has continued to signal a strong will to fight inflation – raising the lower-end of the Fed Funds target rate from 0.00 percent in January 2022 to 4.25 percent in December.  The Ten-Year Treasury reacted by rising from an average of 1.76 percent in January 2022 to a high of 4.23 percent in October before settling in the 3.5 to 3.6 percent range in mid-December.

COMMERCIAL REAL ESTATE (CRE) FUNDAMENTALS

Commercial real estate fundamentals are varied, with each property type having its own set of drivers.

It’s hard to escape headlines about the challenges facing the office market.   According to data from Moody’s REIS, office vacancies are higher than they have been in at least 20 years.  Much of the focus is on the rise of hybrid work and its impacts on office demand.  (For a framework on how to think about long-term changes in office demand, see our recent paper).  Because of the long-term nature of many office leases, any changes will be playing themselves out over a decade or more.  It is also clear that different markets, submarkets, properties and companies are reacting very differently to the changes.  Regardless, the uncertainty about office property performance is having a marked impact on the amount of deal activity in the market.  

After facing considerable challenges during the worst of the Pandemic, retail is again finding its footing.  There are considerable differences in the performance of different subtypes of properties – with class B and C malls at one extreme and neighborhood and strip centers at another.

Industrial and multifamily remain the most sought-after property types, with vacancy rates below long-term averages.   As one example on the industrial side, ProLogis reported Q3 occupancy of 97.7 percent, up from 96.6 percent a year earlier, and net effective same store NOI growth of 8.3 percent over the year.  In multifamily, Census reported a vacancy rate of 6.8 percent, flat from a year earlier and among the lowest levels in the series history.  Asking rents have begun to slow and, in some cases, reverse but in-place rents likely have further to climb to catch-up.  The interest in both property types has brought the value of new multifamily and industrial construction put-in-place to record highs.

COMMERCIAL REAL ESTATE (CRE) SALES

After a rapid start to the year, sales of income-producing commercial real estate began to slow during the third quarter.  Q1 and Q2 CRE sales were 73 percent and 39 percent higher, respectively, than a year earlier.   Q3 sales were 20 percent lower.  On a year-over-year basis, property sales were down 9 percent for retail properties, 17 percent for multifamily, 18 percent for industrial and 33 percent for office.

Data on property cap rates and property values do not appear to be keeping pace with the market, with published cap rates generally holding or even declining during the third quarter.   Despite the market disruptions, Real Capital Analytics’ (and many others’) data showed cap rates at record lows during the third quarter.  RCA’s commercial price index recorded a 0.1 percent price decline in Q3 after a 1.7 percent increase in Q2.   An index from Green Street Advisors reported a 4.9 percent decline in Q2 followed by a 1.2 percent decline in Q3.  It is likely prices will continue to adjust in the coming quarters.

CRE FINANCE (CREF) ORIGINATIONS

After a strong first half of the year, rising interest and capitalization rates began to affect deal volume during the third quarter.  Increasing yields across investment alternatives – including the 10-Year Treasury yield more than doubling during the first nine months of the year – have shifted property financing and values, and it will take time for the market to fully absorb these changes. Volatility has been equally impactful, making the sizing of transactions extremely difficult. The result has been the first of what may be many quarters of depressed borrowing and lending activity.

Different capital sources have felt the slowdown in different ways – with third-quarter originations in the CMBS market down almost 75 percent from a year earlier, while originations by banks and other depositories were 25 percent higher. A broad decline in transaction activity is likely to impact all capital sources, although perhaps not equally.

Compared to a year earlier, a fall in originations for office, multifamily, and retail led to the overall decrease in commercial/multifamily lending volumes. By property type, office decreased by 44 percent, multifamily decreased by 16 percent, retail decreased 6 percent, and industrial decreased 4 percent. Lending backed by hotel properties increased 24 percent, and health care increased by 61 percent.

Among investor types, the dollar volume of loans originated for Commercial Mortgage-Backed Securities (CMBS) decreased by 71 percent year-over-year, life insurance company portfolios decreased 42 percent, government sponsored enterprises (GSEs – Fannie Mae and Freddie Mac) decreased 15 percent, and investor-driven lenders decreased 8 percent. Originations for depositories increased by 25 percent.

MORTGAGE DEBT OUTSTANDING

The amount of commercial and multifamily mortgage debt outstanding increased during the third quarter, driven almost entirely by a large increase in the portfolio holdings of banks and other depositories. The increase in bank holdings was the largest quarterly increase of any individual capital source in the history of MBA’s series. For most other capital sources, their holdings of commercial and multifamily mortgages grew at a slower rate than during the second quarter of 2022.

The results generally match those of MBA’s Quarterly Originations Index, which showed third-quarter 2022 originations down 13 percent on a quarterly basis, with depositories the sole major capital source to see an increase.

The level of commercial/multifamily mortgage debt outstanding increased by $70.0 billion (1.6 percent) in the third quarter of 2022.  Total commercial/multifamily mortgage debt outstanding rose to $4.45 trillion at the end of the third quarter. Multifamily mortgage debt alone increased $36.1 billion (1.9 percent) to $1.93 trillion from the second quarter of 2022

Commercial banks saw the largest gains in dollar terms in their holdings of commercial/multifamily mortgage debt – an increase of $55.9 billion (3.4 percent). Agency and GSE portfolios and MBS increased their holdings by $7.5 billion (0.8 percent), life insurance companies increased their holdings by $7.0 billion (1.1 percent), and state and local governments increased their holdings by $1.0 billion (0.8 percent).

The $36.1 billion increase in multifamily mortgage debt outstanding from the second quarter of 2022 represents a quarterly gain of 1.9 percent. In dollar terms, commercial banks saw the largest gain – $26.6 billion (4.8 percent) – in their holdings of multifamily mortgage debt. Agency and GSE portfolios and MBS increased their holdings by $7.5 billion (0.8 percent), and life insurance companies increased by $2.0 billion (1.1 percent).

LOAN PERFORMACE

Commercial and multifamily mortgages continued to perform well through the third quarter. A much smaller share of loans backed by the property types hardest hit at the onset of the pandemic – lodging and retail – were delinquent. For those property types, very few new loans faced difficulties and lenders continued to work through those that had. Additionally, loans backed by property types that have been performing well throughout the pandemic – including multifamily, industrial, and office – continued to see few delinquencies.

The balance of commercial and multifamily mortgages that are not current decreased in September 2022 (compared to March 2022).

Based on the unpaid principal balance (UPB) of loans, delinquency rates for each capital group at the end of the third quarter of 2022 were as follows: