Whereas 2022 was a year where the real estate debt market bordered on dysfunction, Heitman’s David Maki is optimistic that 2023 will be a more balanced year.
The year 2022 ended very differently for the real estate debt market than it started.
In February 2022, the Federal funds effective rate in the United States stood at a historic low of 0.08 per cent.
But everything was about to change, and rapidly so.
In March that year, the Federal Reserve kicked off the start of a series of rate rises that still hasn’t seen the end yet, increasing the effective rate to 4.33 per cent in January 2023, less than a year after the central bank kicked off its rate rise program.
This dizzying speed of rate rises left the real estate market reeling, unsure of how this would affect valuations, and by the time the fourth quarter came along it could be said the market was in a state of dysfunction.
“If you go back to the early part of 2022, the belief was that rates would rise to a level that was moderate, maybe three per cent or less. And it would rise in a much more gentle way,” David Maki, Senior Managing Director and Co-head of Real Estate Debt at Heitman, says in an interview with [i3] Insights.
Part of the fear of the fourth quarter was that we just saw this steady escalation of long rates and it gave people more of a perspective of: ‘Okay, I can live with a five per cent cost of debt’. But the industry isn't really built to finance stabilised real estate at seven per cent
“Everybody knew there would be an increase, but the expectation wasn’t this almost vertical line which is what the actual rate [change] became.
“It was about the sheer pace of what the Fed was doing. It’s not 50 basis points; it’s going to be 75. It’s not going to be 75 bps one month with a pause for two or three months, no, it’s going to be another 75 [next month]. All of this new information kept getting put into place.
“Part of the fear of the fourth quarter was that we just saw this steady escalation of long rates and it gave people more of a perspective of: ‘Okay, I can live with a five per cent cost of debt’. But the industry isn’t really built to finance stabilised real estate at seven per cent,” he says.
At the same time, Russia invaded Ukraine, which in economic terms meant a steep increase in energy prices, thereby fuelling the flames of inflation. But it wasn’t until the third quarter of that year that markets understood the full implications for monetary policy and inflationary forces.
It caused the market to stumble and transaction activity came to a halt.
“I wish we could just organise ourselves and say: ‘Let’s all take a 60 day break, but instead we all sat around worried and nervous, trying to figure out what was happening in the world,” Maki says.
The dysfunctional state of the market was further heightened by what Maki says was effectively a tightening of lending criteria by the US bank regulator, The Office of the Comptroller of the Currency (OCC).
The OCC regulates and supervises all US national banks and federal savings associations, as well as federal branches and agencies of foreign banks.
“It is our belief, the OCC went from being exceptionally accommodative in the early quarters of the pandemic, to adopting a much heavier scrutiny of banks,” Maki says. “It may not overtly say: ‘Stop lending’, but through their actions of regulatory oversight the banks curtailed risk-taking.
“It really has changed the way banks are willing to provide capital,” he says.
This increased scrutiny of banks was especially noticeable in banks’ willingness to provide advance financing for real estate projects. But for Heitman this meant an opportunity to step in.
“The banks have really reduced their risk tolerance, which showed up in the loan cost advance rate against the total project budget. Whereas previously, it might have been 55 or 60 per cent, today that is probably 40 to 50 per cent,” Maki says.
“When that happens it creates a gap for large-scale developers, who would traditionally want 60 per cent. If they can only get 40 or 45 per cent, then they have got to find that 15 – 20 difference somewhere else. So we found the opportunity to provide that through subordinate debt structures,” Maki says.
Maki Sees Balanced Year
Whereas 2022 might have finished in near disarray, Maki is much more positive about the start of 2023 and believes the market is gradually returning to more of a moderately disrupted state than an outright dysfunctional one.
Partly, this can be deduced from recent data on unemployment and inflation.
“It is still days early, but the first month of the new year seems to be showing some remarkably good trend lines for the [inflation] data, whether you measure the total rate, or excluding energy and food,” he says.
“I know it’s hard to look at inflation without including energy and food but the sort of core numbers in the US seem to be trending strongly in the right direction,” he says.
The risk of a recession is still very much present, but if it is to unfold it is likely one that will not come at the expense of large scale layoffs.
“My colleague Mary Ludgin (Head of Global Investment Research at Heitman) speaks of a ‘job-full recession’, the idea that you could have a recession that won’t be labour focused,” Maki says.
“I think there’s a general view that the markets are healing, in the sense that there is a repricing of the hot assets in the hot sectors, such as residential and logistics. It is really just taking the top off of what were some remarkable gains,” he says.
here is more price discovery and disruption to be had in office. That is the one sector that concerns us the most
Maki is worried about the office sector.
Apart from the questions around the usage of offices in a post-pandemic world that is much more comfortable with employees working from home, there is still little price discovery taking place in the sector, raising questions around the valuations of existing assets.
“There is more price discovery and disruption to be had in office. That is the one sector that concerns us the most,” he says.
But even here, Maki is more optimistic. Although there is still some way to go, there are early signs that sellers are willing to explore new price levels.
“There is only the very beginnings of a buy/sell reconciliation of what assets are worth and what the risks you’re taking are, but even in the early weeks of 2023 it feels like there is just a higher level of confidence. At least, there are people trying to get to that price,” he says.
“It feels like this should be a year that has maybe more balance.
“If you look at 2020, it was obviously a year of downside and nobody expected 2021 to rebound as strongly as it did, based on optimism. Then as the reality of the pandemic set in, 2022 brought us back to something that was this back and forth between optimism and pessimism.
So I’d love to think that 2023 can be a little more balanced between those two,” he says.
This article is sponsored by Heitman. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.