CRE Sales Plummet in Q1 as Expected; Here’s What to Focus on Next

Data confirms what CRE professionals suspected over the first quarter of 2023: CRE sales have stalled.

Transaction volume was off significantly for office, retail, multifamily and industrial assets combined, contracting by -60.3% quarter-over-quarter and -64.3% year-over-year, according to CoStar, the publisher of LoopNet. Dollar volume moved from $116 billion to $46 billion and $129 billion to $46 billion respectively.

Year-over-year volume declined the most for office assets (-72.2%) and quarter-over-quarter volume declined most for industrial properties (-69.4%)

“We're in a stale period where people are waiting to see what happens, which is why there's no transaction volume,” said Chad Littell, national director of U.S. capital markets analytics at CoStar. But for perspective on these first quarter figures, he noted that they are being compared to last year’s peak transaction numbers.

“We’re coming off really robust transaction volume in the fourth quarter of 2021,” with $239 billion trading hands, making the first quarter contraction appear starker. “The decline in transaction volume is less pronounced when comparing the first quarter of 2023 to the five-year pre-outbreak period.”

Key conditions contributing to the decline include flat or falling rents, higher operating costs from rising inflation and increased capital costs that have caused values to decline. Sellers and buyers can’t agree on pricing and lenders have pulled back significantly from CRE lending.

Littell pointed toward a lesser discussed dynamic in the current cycle that is contributing to the current sales freeze: it’s not just the level of rate hikes, but also the pace at which they occurred. “The interest rate move was the fastest that pretty much any of us have seen in our working professional lives, and that basically ground the market to a halt,” Littell said.

Historically, he said Federal Reserve Economic Data (FRED) shows that the most recent significant rate hike was between 2004 and 2006, when rates were raised by about 4.2 percentage points over roughly two years. By comparison, the recent move, so far, involved 4.6 percentage points over 12 months.

While quickly adjusting to these new levels is difficult for most assets — and impossible for some — these hikes signify that “we're reverting to the mean,” said Steve Martin, managing principal at SDM Partners, a developer, investor and operator of CRE in the southeastern United States. We've had a 15-year run of 10-year U.S. treasury yields that ranged between 1.5% and 2.0% “but if you look at the 50- or 60-year average it’s just over 5.0%,” Martin said.

With rates rising, “whatever spread we all thought we had is gone,” Martin noted. Now, instead of asking “how much money am I going to make,” owners are focused on the money they put in and how much of it they will be able to get out; said differently, return of equity not return on equity.

For owners in asset classes like industrial or multifamily, “if they bought in 2019 or 2020, for example, they've likely built an equity cushion from price appreciation and loan paydown, so they've got some room to maneuver,” CoStar’s Littell said. “I don't want to paint a picture that every single owner is faced with this challenge. Many of them will be able to sell, and probably not get what they were hoping a year ago, but they'll still be able to get out okay.”

Littell added that for those facing a refinancing, the days of loan-to-value (LTV) ratios of 70%, or more, are over. Today, if your bank agrees to loan to you, the ratio will likely fall closer to 55% to 65%, Littell said, meaning that owners may need to write a check to refinance a property.

Some owners are just riding this out, Littell said, adding that those that had planned to sell in the fourth quarter of 2022, or the first quarter of 2023 have discovered that buyers are faced with the same interest rate and LTV challenges that they are. He said that sellers with positive cash flow and no debt coming due are simply waiting, figuring they can hold on and see how things play out.

Meanwhile, owners staring at higher rates as loans mature are hoping that interest rates will go down, Littell said. ”They're waiting as long as they possibly can, hoping that inflation will continue to decelerate and they'll see the Fed cut rates.”

Martin noted that “real estate is capital intensive and traditionally very highly leveraged,” so it’s no surprise that these rate hikes are having an outsized effect on the CRE industry. But, he added, there is a domino effect downstream that affects banks, commercial mortgage-backed securities (CMBS), and pension funds, among others. "It's very bumpy out here and it's going to get bumpier.”

Littell agreed that higher interest rates are indeed impacting businesses outside of real estate. “There's an entire economy of businesses that use debt to fund operations,” growth and inventory, he said. So, as interest expense goes up for businesses, their profits tend to slow.

“Basically, our entire economy is now dealing with higher interest rates,” and that means slower growth and negative earnings for some, Littell said, adding that “as this happens, companies start laying people off.”

Earnings have already been slowing in tandem with interest rate hikes, he said. “If you look at S&P earnings year-over-year, they went negative in the fourth quarter and they're going to be more negative in the first quarter of this year,” indicating for Littell that a corporate earnings recession is coming.

Littell believes CRE professionals need to focus on quarterly earnings to monitor corporations as they start to feel the heat of rising interest rates amid a slowing economy, since they too must borrow to keep their companies operating.

Many professionals, as well as the media, are focused on the employment rate when it comes to signs of some future economic contraction or recession, said Littell. But he believes that instead, they should focus on the health of the consumer, their spending patterns and real wages, as well as corporate earnings.

He said that a common refrain is “we're still doing okay because employment is strong.” But FRED shows that generally, the unemployment rate rises slightly or stays flat as we transition into recessions. “I think people are waiting for weakness in the labor market before we hit a recession,” he said. In fact, however, labor contraction has historically been a lagging indicator. “We usually don't see this big, leading ramp up in unemployment to sound the alarm.”

In this cycle, where the rapidly rising cost of debt is largely responsible for the decline in CRE sales, Littell said corporate earnings are a meaningful leading indicator. “If corporate earnings are falling, what are the chances that they're going to expand their real estate footprints? What's the chance that they're going to hire more people? These questions deserve more attention.”

Everyone is still focused on interest rates, Littell said, but he believes that over the next two years, the focus will shift toward the broader economy and the financial health of the tenants supporting commercial real estate cash flows.

“That's the next question, and if I were actively allocating capital, that's what I'd be focused on.”