Q4 2022 Commercial real estate outlook: Recalibration in process

The team assesses the drivers of an ongoing recalibration in the CRE market, points to areas of opportunity amid economic uncertainty and more.

About this episode

We’re continuing with our Q4 outlook series! Investment Research Director Kara O’Halloran is joined by Investment Research Director Andrew Korz to discuss the state of the commercial real estate market. The 2022 rising interest rate environment has necessitated a recalibration in many asset classes, real estate included. Plus, we dive into opportunities in CRE as the macro backdrop screams “get more defensive.” Finally, the team addresses concerns around a real estate-led downturn as investors increasingly worry about something “breaking” in markets.

Want more from our CRE experts? Access the full outlook at https://fsinvestments.com/fs-insights/q4-2022-commercial-real-estate-outlook/.

Transcript excerpt:

[00:00:00] Kara O’Halloran: Welcome back to Fireside, a podcast from FS Investments. My name is Kara O’Halloran. I’m a director on the investment research team here, and on today’s episode, we are continuing with our Q4 outlook content, this time focusing on the commercial real estate market. So, we will cover what higher financing costs mean for the market, what a defensive allocation looks like in CRE right now and whether or not we think commercial real estate is going to be the thing that metaphorically breaks in markets. So, to walk through all of this, I’m excited to be joined by Andrew Korz. Andrew, thanks for joining.

[00:00:52] Andrew Korz: Yeah, thanks for having me, Kara.

[00:00:53] Kara O’Halloran: Sure. So, I wanna start at the very highest level. So obviously this year has been dominated. Rising interest rates. Right. And we’ve talked a lot about how this really just makes everything more challenging. You have to be a lot more discerning, when you see rates rising, when you see higher rates. So, you called your outlook a recalibration in progress. What does that mean?

[00:01:16] Andrew Korz: Yeah, so I, I chose the word recalibration, purposely because I think it implies sort of a necessary adjustment to an external shift or, a shock in the external environment. The analogy that I’ve sort of used is, [00:01:30] let’s say you buy a surround sound audio system, right? And when you install it, you have to think about the acoustics of the room, the dimensions of the walls, the furniture. And then if you move to a new home with a bigger room, you have to, recalibrate and adjust to all those different dimensions.

[00:01:44] Andrew Korz: Right. And I think that’s sort of what we’re seeing in today’s commercial real estate market. The interest rate move that you’ve mentioned driven by a Fed that’s sort of been on its heel. Fighting inflation, is obviously having knock-on effects, by slowing the economy. And we’re really seeing this play out right now in real time. The impacts are starting to become clear in price growth where if you look at sort of the month-over-month annualized rate of price growth, we were at almost 30% annualized rates at the end of 2021. Right now, we’re running at about 4% and it’s decelerating quickly. You’re seeing it in transaction volume.

[00:02:19] Andrew Korz: So, August is the last data that we have. It was still solid, but it’s a clear deceleration from the beginning of the year, and it’s actually the lowest level of sales for an August [00:02:30] since 2016, if you take out the 2020 Covid-impacted year. And we’re, we are starting to see a bit in cap rates, it generally takes some time for higher interest rates to flow through, to cap rates, but CBRE does a semiannual cap rate survey and we saw the first uptick in cap rates, in six or seven years, during the first half of this year. So, we’re really seeing, these impacts from higher interest rates starting to flow through, into the market, into the data, and really, look like mortgage rates could be up more than 300 [00:03:00] basis points.

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Andrew Korz, CFA

Executive Director, Investment Research

Kara O’Halloran, CFA

Director, Investment Research

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