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Q1 2023 CRE Update: Uncertainty and Financial Risks Dominate

 Q1 2023: Pervasive uncertainty amid rising interest rates

At the three-year mark since the onset of the pandemic, the commercial real estate market is still trying to find that “new normal.” With lending restrained, pricing uncertainty and concerns over a recession, the market is navigating unchartered waters as the economy continues to rebuild. Among the top trends to watch are:

  • Uncertainty in the Financial Markets – Given the Fed’s aggressive increase in interest rates, deal flow has slowed
  • Lending Pull Back, Future Risks — Bank failures have led to significant tightening of financial conditions and fear of more failures
  • CRE Loan Maturities/Defaults — Growing fears of significant defaults, losses in office sector
  • Property Pricing Adjustments — A bid-ask spread is keeping deal flow limited, but how will new pricing impact owners, occupiers and investors?

Here’s a look at market metrics from industry technology and investment leader LightBox. These metrics provide an early indicator of trends in the investment, broker, valuation, lending, and environmental due diligence segments.

Record high inflation and rising interest rates

Record high inflation and rapid increases in interest rates created significant headwinds at the start of 2023. Investment activity stalled. Then 1Q23 ended with a gut punch from unexpected bank failures and doomsday headlines about massive defaults in the office sector.

The market had to digest a rapid mix of developments, including fundamental shifts in demand for real estate, and the first bank failures since the Great Financial Crisis, among other issues. Amid the most aggressive tightening of financial conditions by the Fed since the 1980s, investors and lenders are challenged to pencil deals confidently — or forecast future valuations. While the near-term forecast is in flux, there still is an even mix of headwinds and tailwinds for the near term.

In early February, the Fed signaled that slowing inflation, along with other indicators, warranted a pull back in the pace of rate hikes. An expected 50 bps increase became a 25 bps increase in February, followed by the same in March. This was a welcome dose of optimism as the market digested news of Silicon Valley Bank and Signature Bank failing and concern grew over the possibility of an expanded banking crisis.

The LightBox Commercial Real Estate Activity Index shows a broader market decline in commercial properties listed for sale (blue line), a divergence from typical market conditions where the peak in listings coming to market in 2Q22 would lead to an uptick in the services that support deal closings (environmental due diligence and appraisals). But 2022—and the start of 2023—has been anything but normal. Other key takeaways include:

  • Buyer profile shifts — While owners are listing properties for sale, the buyer universe is constrained and tends to be cash-only buyers, private capital or family funds rather than the typical investors. The buyer pool is still at historically low levels
  • Transaction indicators fell — Confidentiality agreements, an indicator of how the size of the buyer pool is changing over time, fell from a high of 131 per deal last January to only 65 by year-end 2022 as buyers were shut out of the market by higher capital costs or chose to wait on the sidelines. In 1Q23, the average number of CAs per deal increased slightly to 72, still well below the high-water mark of a year ago. CA levels for the main asset classes (office, multifamily, industrial and retail) are likely higher or lower given the significant variations by asset class.
  • Environmental due diligence and appraisal volumes decline – As measured by LightBox’s ScoreKeeper model (environmental) and C360/RIMS (appraisal) platforms, volumes declined in response to a slower transactions market, with environmental reports ending 1Q23 down 40% YOY and appraisal volume down 43% YOY.

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