The State of The Market

2022 marked a transitional year for the commercial real estate landscape and the broader market. Entering the year, real estate valuations and rent growth remained robust. However, inflation was at the top of investors’ minds even though interest rates remained at historic lows and the U.S. Federal Reserve had not yet started its restrictive monetary policy campaign.

As the Fed executed several large fed funds rate hikes throughout the year, commercial real estate investment activity and valuations began to react accordingly. Transaction volumes, particularly in industrial and multifamily, compared to recent boom years have decreased. Buyer pricing expectations have come down markedly in conjunction with rising borrowing costs.

Negative leverage and the widening gap between cap rates and the cost of borrowing have made many new investment opportunities less desirable. Uncertainty surrounding how the economy will adjust as continuingly restrictive monetary policy works through the economy has remained a market headwind.

Global real estate investors remain concerned with other major events such as the ongoing Russian-Ukrainian war, energy uncertainty, China’s economic slowdown, and ongoing tensions in other autocratic regimes adding to geopolitical concerns. The outcome of the U.S. Midterm Elections was a major focus for much of the year, but a divided Congress starting in 2023 has decreased the likelihood of drastic legislation impacting commercial real estate.?

As we enter 2023, here are some of the key topics that the Westmount team and I are monitoring:

1.????Potential Market Dislocation

While buyers’ pricing expectations for new acquisitions have adjusted downward, the same cannot necessarily be said with many sellers. Oftentimes, sellers we have tried to acquire real estate assets from have not adjusted their pricing expectations from where valuations were at the beginning of 2022. This has led to wider bid-ask spreads, often leading to sellers’ preferences not to transact. Many owners who originally intended to sell but are not currently in forced or distressed situations have opted to continue owning and operating. Lenders have also generally become more hesitant and restrictive with new loan originations. With reference rates, such as SOFR, for floating rates expected to continue rising into 2023, borrowers’ ability to comfortably service debt could become more difficult and lead to defaults. In my experience across multiple market cycles, great investment opportunities for high-quality real estate assets at attractive cost bases and cap rates often arise when there is market disruption. In the coming year, sellers could face more pressure to sell and meet the market for reasons including needing to pay off a maturing loan or recycling limited partner capital into another fund investment vehicle. Regardless of seller circumstances, 2023 will likely continue to be a challenging economic and transactional environment and we will be increasingly selective in our acquisition process.

2.????Slowing Economic Growth

Because of the Fed’s aggressive stance on interest rate hikes to slow inflation and its recent signaling that more rate hikes are projected (albeit at a smaller pace than 2022), 2023 growth expectations have come down and recession fears have become more commonly discussed. Company CEOs across industries, including the largest global banks such as J.P. Morgan and Goldman Sachs, have suggested that 2023 could prove difficult. For commercial real estate investors, forecasted projections for key value drivers such as rent growth will likely need to moderate, even though some operating expenses such as property insurance are expected to continue increasing. We will also continue to monitor existing constraints and the potential easing of supply chains and the labor market to assess how the availability and cost of key inputs impact investment returns.

3.????Heightened Focus on Tenants and Resident Relationships

Westmount has been fortunate to have a diverse and strong mix of tenants and residents who have remained resilient. We continue to focus on how slowing economic growth may impact the businesses and creditworthiness of our commercial tenants. Our hands-on approach to asset and property management enables us to work and establish relationships with tenants and foresee any potential disruptions, akin to our engaged approach to operating during the 2020 global pandemic. For our multifamily residents, we remain aware of the potential impact job layoffs and stagnant wage growth could have on residents’ ability to comfortably afford rent. Heavy involvement with our residents during the pandemic also helped us prepare for the uncertainty ahead. Our heightened focus on our tenants and residents, along with robust day-to-day management of our portfolio will be necessary to weather any upcoming economic slowdown.

4.????Future Pace of Federal Funds Rate Increases:

Because of persistently high inflation and low unemployment, the Fed has placed more emphasis on its price stability mandate given the U.S. economy’s current state of maximum employment. Since mid-June of 2022, the Fed has hiked rates 75 basis points four times, which were well above traditional movements during other previously restrictive periods. In December, the Fed moderated its hike to 50 basis points, but indicated future hikes in 2023, although at a slower pace than 2022 because inflation indicators have started to moderate. Despite rising shorter-term rates led by Fed policy, long-term rates have not increased in an expectedly corresponding way. Since June, the yield curve for U.S. treasuries has been inverted and the spread between short and long terms rates, such as the widely watched 2 to 10-year rates, has continued to widen. Inverted yield curves have traditionally been a leading recession indicator.

5.????Global Investor Demand for Commercial Real Estate Investment:

In 35+ years in business, Westmount is fortunate to have developed relations with investors across 11 countries in many parts of the world. We speak with many of them on a consistent basis, which provides us with diverse perspectives. While much is made of U.S. inflationary and economic growth concerns, investors remind us that their home countries are often experiencing similar, if not worse, investment environments. Therefore, many of our investors continue to view placing capital in the U.S. as a flight to quality. Investing in a large, diversified economy with a stable world reserve currency and legal system that emphasizes and respects the rule of law remains appealing. Many other foreign investors, including large institutions and individuals, maintain a similar view of the U.S. when considering global investment allocations. Steady and increasing foreign capital flows into U.S. domiciled commercial real estate investments, could serve as a demand driver that partially offsets the expected rise in cap rates that typically correlates with rising interest rates.??

While we expect 2023 to be a challenging year, we expect new opportunities to arise and look forward to continuing adding value to all our stakeholders.

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