Quarterly market review - Q3 2022

The Federal Reserve’s quest to halt inflation is wreaking havoc across public equity and fixed markets. Heading into this quarter, investors were certainly expecting rate increases. However, the rapid rise in rates has not factored into the inflation data as of yet, and the Federal Reserve seems unwilling to pivot from its hawkish stance until the lagged inflation data shows signs of breaking. The good news is that headline inflation did retreat as the price of oil, lumber and shipping costs all showed significant declines. Additionally, the labor market remains extraordinarily tight, which is typically a sign of strength in the economy. That said, the tight labor market is leading to wage growth that the U.S. has not seen in decades, adding to inflationary pressures. Fortunately for commercial real estate, employment growth is a driver of demand.

Speaking of commercial real estate, we continue to believe the asset class remains well-positioned in the current environment. Returns have certainly moderated as cap rates have increased, but the rent growth across multi-family and industrial have largely offset the valuation declines seen to date. We expect this moderation to continue and believe that returns will normalize moving forward, which has historically been 6-8% annualized. Rent growth remains strong which has not been fully realized but will be in the coming quarters as leases renew. As a reminder, through most economic environments, private core real estate has generally delivered consistent positive returns – the exception being when commercial real estate markets were over levered and over supplied, neither of which are present today. As such, high quality commercial real estate remains in high demand.

Below is a brief summary by property type:

• Industrial properties’ return greatly moderated during the quarter. Cap rates did rise, especially in properties with longer dated leases, but rent growth remains strong and demand in the best markets across the U.S. continues to exceed supply.
• Multi-family saw strong appreciation. Strong rent growth persists and is likely to continue as many potential homebuyers are not able to purchase homes with residential 30-year fixed rate loans topping 7%.
• Office properties largely remained flat over the quarter. We are seeing increased leasing activity within certain markets. Furthermore, many companies continue to implement return to office plans as the impact of Covid-19 fades.
• Retail properties continue to experience meaningful increases in net operating income (NOI). Grocery anchored and necessity-based centers continue to perform well, and experience-based Class-A retail is benefiting as the economy has now fully reopened.
• Specialty: We continue to see strong demand from institutional investors for more specialty type property sectors such as self-storage and single-family residential. While these sectors currently represent a small portion of the NFI-ODCE, their returns have been very strong and added to the strong overall performance.

Will office survive?

A common question we receive is regarding office space although it is now less than 20% of the NFI-ODCE index. While the mainstream media loves to paint a picture that no one will return to the office, it is quite a bit more nuanced and not what is taking place. In fact, New York City, one of the slowest markets to recover from the pandemic, had the strongest period of leasing activity in Q3 2022 since before the pandemic began. That said, availability remains high, but what is clear is that office properties that offer best in class amenities are going to win in this environment.

Definitions:

Cap rate represents the rate of return on based on the income that the property is expected to generate.