MBA CREF Forecast - July 2023

Higher and volatile interest rates, uncertainty about property values and questions about some property fundamentals have led to an impasse in commercial real estate (CRE) property sales and mortgage originations activity this year.  Sales of commercial properties were 60 percent lower than a year earlier in Q4 2022, 53 percent lower in Q1 2023 and 63 percent in Q2 2023.  Commercial mortgage originations were 54 percent lower than a year earlier in Q4 2022, and 56 percent lower in Q1 2023.

To estimate where mortgage originations may go from here, MBA relies on a forecast model that looks at past economic conditions and how they have flowed through to commercial real estate factors like cap rates, NOIs, property values and originations.  MBA then runs its baseline macro-economic forecast through those models to see what that forecast implies for future originations.

MBA MACRO-ECONOMIC FORECAST

MBA’s macro-economic forecast anticipates that over the next year – partly driven by the Federal Reserve Board’s interest rate policies – the U.S. economy will slow, unemployment will rise and interest rates will moderate. 

More specifically, we anticipate that tight credit conditions will lead to negative GDP growth and a sharp rise in the unemployment rate in the second half of 2023.  After its latest increase, the Fed is expected to hold its Fed Funds Rate at an elevated level through the end of the year while weakening economic conditions are likely to draw longer-term Treasury rates lower.  In 2024 and beyond, with inflation falling, major economic variables – inflation, GDP growth, unemployment, the Fed Funds Rate -- should all begin to move closer to their expected longer-term norms.

MBA CREF FORECAST

MBA’s updated CREF forecast is built on a base case that a moderation in interest rates next year will help break the current logjam in commercial real estate transaction activity, with our baseline economic forecast anticipating that interest rates will decline significantly over the next year-and-a-half – bringing relief to CRE financing costs and property valuations.

One of the challenges in the market today is a palpable uncertainty about where property values sit.  The low number of sales transactions make finding comparables difficult, which makes it hard for potential property buyers and sellers to gauge the market, which brings fewer property sales transactions.  As a result, many measures of prices and cap rates appear to be lagging the market. 

One result is that cap rate spreads to the 10-year Treasury appear in many data series to be nearly as tight as during the run-up to the Great Financial Crisis (GFC).  We find that difficult to accept given current conditions.  Based on past relationships between cap rate spreads and macro-economic conditions, we expect data series tracking cap rates to eventually catch-up and show a significant premium to what some series are currently reporting – with cap rates, on average, modeled to top out at levels roughly 150 basis points above their record lows.

After that adjustment, however, cap rates are likely to fall in coming years – tracing the declines we anticipate in long-term Treasury yields – falling roughly 100 basis points by the end of 2025.

From a model perspective, property values are the primary determinant of CRE sales and mortgage origination activity.  Taking anticipated cap rates and property incomes into account, our model predicts an average peak-to-trough decline in CRE property prices of 27 percent – and also that by the end of 2025 moderation in cap rates and growth in NOIs will have pulled prices back up to 3 percent higher than their 2022 peak levels and 40 percent higher than their 2023 trough.  Note that these modeled prices are an average across all property types, are driven by broad macro-economic conditions and do not take into account many property-type-specific space-market trends taking place.

Driven by the significant drop and bounce-back in CRE property values, MBA’s CREF forecast anticipates commercial and multifamily mortgage originations will fall 38 percent in 2023 before beginning to rebound in 2024 and 2025.  The 2023 figures anticipate first-half activity well below (strong) 2022 first-half levels and 2023 second-half volumes roughly in line with (weak) second-half 2022 levels.  As interest rates decline and property values rebound, the forecast model sees volumes return to longer-term trend lines.

ORIGINATIONS UNDER AN ALTERNATIVE INTEREST RATE PATH

Different interest rate paths would lead to different forecast outcomes. 

Commercial mortgage originations have historically followed property prices – with increases in values pushing mortgage borrowing and lending volumes higher and declines pulling them lower.  If interest rates and cap rates fall, as we anticipate, that should help boost values and promote borrowing.  If they remain higher for longer, that would suppress activity. 

To better understand how sensitive CRE mortgage originations might be to different interest rate scenarios, MBA ran its CREF Forecast using an alternative interest rate path – one in which longer-term Treasury yields remain higher for longer – ending 2025 at 3.4 percent as opposed to MBA’s baseline forecast of 2.5 percent.

The differences are significant.

Using the alternative rate path, cap rates on CRE properties would rise and remain higher throughout the forecast period – ending 2025 210 basis points above their 2022 lows (compared to 80 basis points higher in the MBA baseline forecast).

That difference in cap rate paths means that rather than returning to 2022 peak values by the end of 2025, as is the case in the MBA baseline, forecast property values in the alternative scenario would remain 17 percent lower than peak and up just 15 percent (versus up 40 percent) from the 2023 trough.

Under this alternative rate path, commercial mortgage originations would regain only a portion of the lost volume – with 2025 activity 14 percent lower than 2022, compared to a 22 percent increase in the baseline MBA forecast.

Different interest rate paths could lead to significantly different futures for commercial real estate transaction markets. With the Federal Reserve likely at the end of its tightening cycle, our expectation – and hope – is that greater clarity will now come to the future path of interest rates, and with it, relief to longer-term Treasury yields and CRE transaction markets.