\n<\/p>\n
The \u201cDoom Loop\u201d<\/strong> could cause banks, businesses, and commercial real estate to crash<\/strong><\/a>. With real estate valuations down, property owners begin to default<\/strong>, and credit tightens<\/a>, causing the same cycle to repeat itself again and again, pulling banks and balance sheets down until we reach a bottom<\/strong>. But is this \u201cDoom Loop\u201d scenario just feeding the fear of a housing market crash<\/strong>, or are we months away from this becoming our new reality?<\/p>\n We asked Richard Barkham<\/strong>, Global Chief Economist of CBRE, his take on what could cause a \u201cDoom Loop\u201d<\/strong> and what we should be prepared for. Richard\u2019s team handles some of the planet\u2019s most comprehensive commercial real estate data. When the masses run away in fear, Richard\u2019s team sees opportunity, and if you listen to today\u2019s episode, you\u2019ll know exactly where the prices are too low to pass on<\/strong>.<\/p>\n Richard gives his economic forecast<\/strong> for the next year, when the US could enter a recession<\/strong>, how high unemployment <\/strong>could get, and where commercial real estate prices <\/strong>are heading. While some commercial real estate sectors are facing dramatic price declines, others are looking surprisingly strong. But with a weaker economy and fear of a \u201cDoom Loop\u201d taking hold, are everyday investors safe from this potential economic catastrophe?<\/strong><\/p>\n Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: James: Dave: Dave: Richard: Dave: Richard: Dave: Richard: Dave: Richard: Dave: Richard: James: Richard: Dave: Richard: James: Richard: James: Richard: Dave: Richard: James: Richard: James: Richard: Dave: Richard: Dave: Richard: Dave: Richard: James: Richard: James: Richard: Dave: Richard: Dave: Richard: Dave: Richard: James: Dave: Richard: Dave: James: Richard: Dave: Richard: Dave: James: Richard: Dave: Richard: Dave: Richard: Dave: Richard: Dave: Richard: Dave: James: Dave: James: Dave: James: Dave: James: Dave: \u00a0<\/p>\n \u00a0<\/p>\n<\/div>\n Help us reach new listeners on iTunes by leaving us a rating and review! It takes just 30 seconds and instructions can be found here<\/a>. Thanks! We really appreciate it!<\/p>\n Interested in learning more about today\u2019s sponsors or becoming a BiggerPockets partner yourself? Email <\/em>[email\u00a0protected]<\/span><\/em><\/a>.<\/em><\/p>\n Note By BiggerPockets:<\/b> These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.<\/p>\n
Hey, everyone. Welcome to On The Market.
James Dainard, what\u2019s going on man? Good to have you here.<\/p>\n
I\u2019m happy to be here. Just landed on a Red Eye in Naples, Florida. So I\u2019m in a random hotel room right now.<\/p>\n
Why are you in Naples, Florida?<\/p>\n
It\u2019s for a sales retreat. We\u2019re having a bunch of guys meet at one of our partner\u2019s houses, so it is pretty cool. But I literally landed, got in the Uber and pulled over to a random hotel to hop in for the podcast.<\/p>\n
Oh, my god. So that\u2019s not even where you\u2019re staying.<\/p>\n
No, this is halfway mark.<\/p>\n
You just rented a room to record the podcast.<\/p>\n
Got to get that good wifi.<\/p>\n
Wow. Oh, my god. Wow. You stay at nicer hotels than me. My wifi is always terrible there. But that is dedication, we greatly appreciate that. Well, today we have a great show. Let me ask you, have you heard the term \u201cdoom loop\u201d recently?<\/p>\n
It is on repeat. It is the term of the month, at least. I know that much.<\/p>\n
Well, if you haven\u2019t heard it, to our audience, doom loop is the scenario that a lot of journalists and analysts are talking about where commercial real estate defaults start, banks stop lending, credit tightens, which puts more downward pressure on prices, more people default, and it becomes this negative downward spiral. And this has happened in the past. This is not fiction or theory. This has happened and a lot of analysts are thinking that it could happen in the U.S. with commercial real estate.
So today we have brought on an incredible guest. It is Richard Barkham, who is the Global Chief Economist and Head of Global Research for CBRA, which if you\u2019re not familiar, one of the very biggest commercial real estate firms in the entire country. He maintains a massive team of analysts and economists, and we have an incredible conversation with him about the doom loop, about what\u2019s going on in the international property market, and how it could impact the U.S. And so I think we\u2019re going to hear some really fascinating stuff in this conversation.
James, do you have any questions you\u2019re particularly interested in asking Richard?<\/p>\n
Yeah, where are the deals going to be? We haven\u2019t seen the huge deals yet.<\/p>\n
Give me those deals.<\/p>\n
Where are they going? Let\u2019s go find them.<\/p>\n
Yeah. All these economists, they talk a lot about theory. They\u2019re wonderful guests and they\u2019re super helpful, but I don\u2019t think they\u2019re going to be showing you any properties that are going to be big deals for you.<\/p>\n
They drop you those little gold nugget hints that you should start looking.<\/p>\n
Yeah, they inform your strategy.<\/p>\n
Yeah, take notes and go dig on all the sectors he\u2019s going to talk about.<\/p>\n
Before we get into our conversation with Richard, I just wanted to call out that you\u2019re going to hear two different terms that you may not know. One is cap rates. We do talk about that a decent amount on the show. But cap rates are one way that commercial real estate is often valued. And it\u2019s basically just a measurement of market sentiment and how much investors are willing to pay for a particular stream of income, or a particular asset class. The higher the cap rate, the less expensive the building is. So buyers usually like high cap rates. The lower the cap rate, the more expensive the building is. So sellers typically like that. So just keep that in mind as we go through this interview.
The other thing we are going to talk about is IRR. If you\u2019ve never heard of it stands for Internal Rate of Return, and it\u2019s basically just a metric that real estate investors really of all types use, but it\u2019s used particularly often in commercial real estate, and it is a preferred metric for commercial investors because it is a very sophisticated one. I\u2019ve written about it in my book, but I can\u2019t even tell you the formula off the top of my head.
Basically what IRR does, in the most simplistic sense, is allows you to factor in all the different streams of income that you get from a property. So a lot of people look at cashflow and cash-on-cash return ,or they look at their equity growth and look at equity multiple. What IRR does is it looks at the different cashflow that you\u2019re getting, the different equity that you\u2019re building, the timing of that income, and gives you one solid number to understand your overall return. And it is a great thing to learn if you\u2019re a real estate investor. We talk about it in Real Estate by the Numbers. Just know that Richard and James and I are going to talk about IRR and that\u2019s what it means.
All right, James, with no further ado, let\u2019s bring on Richard Barkham, the Global Chief Economist for CBRE.<\/p>\n
Richard Barkham, welcome to On The Market. Thank you for joining us.<\/p>\n
Very glad to be here.<\/p>\n
Let\u2019s start by having you tell our audience a little bit about yourself and your position at CBRE.<\/p>\n
So I\u2019m Global Chief Economist at CBRE, and CBRE is the world\u2019s biggest property services company. I\u2019ve occupied this role for eight years. Prior to that I was with a very well-known English company called Grosvenor, and prior to that, for my sins, I was a university professor.<\/p>\n
Excellent. And can you tell us a little bit about what you, and I presume your team as well, work on at CBRE in terms of economic forecasting and analysis?<\/p>\n
Yeah. So my team is 600 people around the world, and we are primarily engaged in collecting and managing data about real estate markets. Now just keeping connected with global real estate markets is what we do, and we like to be first in the market with commentary on recent trends in real estate, and we like to have the best big ideas about the forces that are driving real estate.<\/p>\n
Oh, good. Well, we want to hear about your big ideas. Let\u2019s start though with just a general outlook. Everyone has a different opinion these days about where the U.S. economy is heading. What\u2019s yours?<\/p>\n
The U.S. economy has been surprisingly resilient, but we still expect a recession to come. We\u2019ve got it penciled in for Q4 of 2023 and Q1 of 2024. But given the resilience in the economy we can\u2019t be exactly certain with that. I could see us pushing that out a little bit, but the sharpest rise in interest rates in 40 years eventually will bear down on the economy. It\u2019s already bearing down on certain sectors, real estate\u2019s one of them. Global conditions are worsening as well, which points us more in the direction of a recession.<\/p>\n
And what are some of those global conditions that you\u2019re referencing that you think will have the biggest impact on the U.S. economy?<\/p>\n
Well, I think first and foremost, we\u2019d expected China when it bust out of Ziglar, that covid lockdown, to take off into really rapid growth. And it did for a quarter. But in Q2 the Chinese economy has slowed up quite a lot, and it\u2019s partly because people spent all of their money in Q1 and have restrained themselves a little bit in Q2. But I think there are more fundamental issues in China to do with the weakness of the housing market, particularly in tier two, tier three cities. And also the Chinese economy is running into its normal channel of growth is exports, but western markets are very sluggish.
So I think the Chinese economy has got problems. Now why does that affect the U.S.? It\u2019s because behind the scenes over the last 20 years or so, China\u2019s been an increasingly important driver of global demand. And although the United States is a fairly isolated and resilient economy it can\u2019t completely get away with weakening global demand. And that\u2019s the big thing about China. But I also noticed Europe has weakened as well. Germany, France, Italy, all had negative GDP growth in Q2. So the bigger developed economies are beginning to feel a pinch as well.<\/p>\n
Glad you brought that up because I\u2019ve actually been reading up on the Chinese economy quite a bit and how much it\u2019s been cooling down and possibly heading towards stagflation. That\u2019s a huge deal because it\u2019s a massive economy that\u2019s been emerging. What is that going to do to our possible recession locally? A concern of mine is that could actually send the world into somewhat of a spin which could keep rates a little bit higher. Do you think that that\u2019s going to affect rates going forward for the next 12 months with the impact of any kind of global slowdown as well?<\/p>\n
No, I think it\u2019s the reverse in the case of China. I think China\u2019s going to send a deflationary impulse, a slowdown in China, because China\u2019s a very heavy user of resources and commodities in the world economy. If the Chinese economy slows up then that puts downward pressure on commodities and that helps to reduce inflation in the developed world. And I also think China drives a lot of the emerging markets. China and the emerging markets together may be 35% of the global economy. U.S. companies export to those markets. So I think through that there\u2019s a slow down impulse sent to the United States economy and the other developed markets. But I don\u2019t think it\u2019s inflation, I think it\u2019s deflation.<\/p>\n
So one question I keep asking some of our guests is, for those who believe a recession is in the future, what is going to change between now, which you described as resilient, to one that actually dips into a recession? What do you think some of the drivers are going to be that tip the scales?<\/p>\n
I think at some point corporates will want to reduce their headcount. If demand slows up corporates will want to let labor go, and I think what we\u2019ll start to see is unemployment ticking up. We\u2019ve got incredibly low unemployment. It\u2019s been at 3.5. The last number was 3.8, but I think over the course of a recession that could easily get up to 4, 4.5. And indeed, it was much higher than that in the great financial crisis. So fewer jobs, harder to get a job, longer between jobs, and that feeds through into consumer sentiment. And I think then that triggers households being much more cautious about what they spend. And we\u2019re beginning to see some element of that, because at the moment the U.S. economy is continuing to add jobs, the new jobs that is offsetting the slowdown in spending from people who are already employed.<\/p>\n
So Richard, when do you think\u2026 The jobs report is starting to turn. I think this last month was indicating that it\u2019s starting to cool. It\u2019s definitely starting to cool down, and as far as what I understand is a lot of the interest rates that are being hiked up is high, it\u2019s to (a) battle inflation, but also to cool down the labor market. Do you think, until we see more unemployment, do you believe that the Fed is going to continue to keep raising rates to try to battle the labor market? Or is it something that they can make it more of a soft landing to where we\u2019re not going to have to see a ton of unemployment to get rates under control? Because right now cost of money is excessively high. I know I\u2019m paying it in all my daily activities in real estate. I think we\u2019re all waiting for them to come back down, and we\u2019re seeing inflation starting to tick down. The job market\u2019s starting to slow down, but do we really need to see a break in the labor market for that to start changing the other way?<\/p>\n
I think the Fed would love to slow the economy up without actually impacting the labor market. So I don\u2019t think the Fed is attacking the labor market, but at the moment today\u2019s data shows that the employment cost index was revised up. So the cost of labor is still higher than is ideal. And one simple way of expressing that is the rate of growth of hourly wages in the U.S. economy right now is 4.4%. The Fed would like to see that at about 3.5% because, and this is a technical economics answer, 3.5% wage growth plus 1.5% productivity growth gives you 2% growth in unit labor costs, and that\u2019s the rate that is consistent with 2% inflation. So 4.4% is above the rate that\u2019s consistent with 2% inflation, and indeed, actually productivity is flat lining, so that impulse from the labor market.
Now there\u2019s two ways that that can ease. One, we can get more workers back into the labor force. So labor force participation can rise, and that has been happening. But the other way that it can happen is through taking demand out of the labor market. And demand for jobs, jobs created is going down, but I think there are still something like 8 million vacancies in the U.S. economy. So for all that it\u2019s slowing up it\u2019s still a robust labor market, and I don\u2019t think the Fed wants to cause unemployment, but it\u2019s going to keep interest rates high until that wage growth eases back substantially, and that may then trigger a rise in unemployment.<\/p>\n
Yeah, I\u2019m hoping it cools down. We\u2019re still trying to hire right now and it is impossible to get people, like at the Pacific Northwest, it is just terrible. Every time we put a job ad up it takes us three to four months to fill it, rather than 30 days, like it used to be.<\/p>\n
Well, I think you\u2019re not the only business feeling that really. And there was a sense I think that manufacturing industry was slowing up. But if you look at surveys of manufacturing industry, the biggest issue is not cost of financing manufacturing, it\u2019s access to skilled labor. It\u2019s a real thing. One of the drivers of that, of course, is demographic. You\u2019ve got a lot of boomers leaving the labor market. On top of all of the cyclical stimulus and all of the macroeconomic cycle, you\u2019ve got demographics overlaying that, and you\u2019ve got boomers leaving the labor market. And some forecasts actually say the U.S. labor market is going to shrink over the next five years. So that needs to be replenished, I think, with I would say, legal migration of skilled people. And that is picking up, but it is, as you suggest, labor market conditions have cooled but they are still tight.
Getting back to the original question, that is of concern to the Fed. Absolutely it is.<\/p>\n
All right, Richard. Well, we\u2019ve peppered you a lot about macroeconomics, but we would love to hear, given your experience at CBRE, your take on the commercial real estate market. It seems every single day we read a headline about some doom and gloom scenario, and would love to hear if you feel the same way? Or what is your thought on the commercial market?<\/p>\n
Okay. Well, let me just put that in context for folks, just big picture, just before I start. Commercial real estate in the United States is worth about 10 trillion. It\u2019s a little bit more than that. Single family homes, or residential real estate, is worth 45 trillion. So the residential real estate market is much, much bigger, and that is in good health actually. Prices are going up and even construction is looking up, and that\u2019s really odd given that we\u2019ve got mortgage rates at 7.5%. I think what accounts for that is post great financial crisis. We\u2019ve just failed to build enough homes in the United States. There\u2019s a deficit of three to 4 million homes, so the demand and supply balance in the residential market is reasonably healthy.
Now we can come on to how that affects the apartment market. People talk about doom and gloom. Let\u2019s just get commercial real estate in context. And the real recessionary sector in commercial real estate is the office sector. And of that 10 trillion, offices may be 25% of that. So again, it\u2019s a big sector, it\u2019s very visible, it\u2019s in our face. And vacancy in the office sector is 19%, up from 12% a couple of years ago, which is a rate of vacancy we haven\u2019t seen since the savings and loan crisis in the early 1980s. Companies are really cutting back on the amount of space that they\u2019re going to use because of remote working.
And also, we\u2019ve got a delivery of new real estate into the market from the previous construction wave. So fundamentals in office, very weak right now. This is a nuance, I\u2019m going to talk about real estate stuff.<\/p>\n
Please.<\/p>\n
It\u2019s not true that the market in offices is completely dead. I\u2019d looked at the number of transactions that CBRE is doing in 2023, and it is only 5% down on the number of transactions that we did in 2019. But when companies are taking space which is 30% less than they took in 2019, so the market is active, just companies are taking lesser amounts of space, and they\u2019re also preferring the newer build. The real flight to quality and experience, I think. Market not dead, but the unoccupied stock has increased from 12% to 18%.
Looking across the rest of real estate, by which I mean apartments, by which I mean the retail sector, by which I mean industrial, and increasingly alternatives such as data centers, medical office, life sciences, I would say the fundamentals there are actually reasonably robust. It\u2019s really surprising when you look across it. Vacancy rates are notching up, demand is not quite what it was, but I would say fundamentals in all of those sectors are reasonably okay. By which I mean to say that people are active in the market, taking space, and there\u2019s not a big surge in vacancy rates and unoccupied space.<\/p>\n
Richard, have you seen much price compression? We\u2019ve seen it across some of the residential space, but now we\u2019ve seen the median home price creep back up. Have you seen much compression with interest rates rising and the demand? Like you were just saying, tenants are occupying less space. Have you seen much compression in all those segments, like industrial, office, retail and pricing? What adjustments have you seen? Because I have seen pricing start to tick down in those sectors, not as many transactions going on, but what kind of price adjustments have we seen year over year, based on the demand being smaller?<\/p>\n
Yeah. I mean, that\u2019s a complex story, so this\u2019ll be a bit of a long answer, but let\u2019s kick off with apartments. If you\u2019re a user of apartments the price you pay is the rent, obviously. In that period 2020 to 2022 when people really bust out of Covid, we saw apartment rents going up at 24%, on average across the States. It\u2019s terrible. I would say apartment rental growth has dropped to about 2%. So prices are still creeping up but it\u2019s below inflation. And there are certain markets I think where there\u2019s quite a lot of new apartments being built where you\u2019ve actually seen some price declines. But on average, I think prices across America in apartments are still creeping up slowly.
In the case of retail, that\u2019s another strange story. We haven\u2019t built any retail space for 15 years or so. And the retail sector has gone through Covid. It\u2019s cleaned up its balance sheets, it\u2019s reinvented itself as a omnichannel operator, very snick omnichannel and I think part of the fact the consumer exuberance has sent people into retail centers. So actually in the retail sector our brokers tell us there\u2019s not enough Grade A space. Companies are being held back from expanding because there\u2019s not enough good space. We haven\u2019t built enough. So rent\u2019s still creeping up in retail, actually. That\u2019s not to say there isn\u2019t a problem with Grade B and Grade C malls. I think everybody would see that in their daily lives, but even some of those are reinventing themselves as community hubs and antique mall destinations. And they\u2019re finding other uses, even flex offices are going into some B and C malls.
So that\u2019s apartment, that\u2019s retail. Industrial, that\u2019s got the tailwind of the digital economy, of e-commerce, still well and truly behind it, and we are going to see leasing in industrial down 30% this year from a billion square feet last year to maybe 750 million square feet, but it\u2019s still going to be the third-strongest year on record. So rents are moving up and more than a little in industrial, maybe around somewhere between 9 and 12%. So that\u2019s a very hot market. And of course, other things like data centers. There are folks here in Dallas, where I\u2019m based, leasing space six years out. There\u2019s really huge demand for data centers around Cloud computing, artificial intelligence, it\u2019s an incredibly hot sector.
So I\u2019ll pause there. There are other sectors I could talk about, but I think the fundamentals in real estate, apart from offices, are surprisingly strong, which is not to say that investors are active. If you make a distinction to people who use the real estate for what it\u2019s built for and they pay rent, and the people who own real estate, which are pension funds, life insurance companies, university trusts and other private capital, it\u2019s very quiet on the investment front right now. And prices are dropping. The actual price that you would pay for real estate as an asset will be down anywhere between 15 and 20% on where it was two years ago.<\/p>\n
So just in summary. Yeah, so demand among tenants, whether they\u2019re apartment tenant, retail tenant, seems to be holding up relatively well, but demand among investors is slipping. That is what we\u2019ve been seeing, and the data I\u2019ve been looking at shows that cap rates are moving up. Is that what you\u2019re seeing? And if so, outside of office, I think we all understand office as being the biggest hit, but our audience is particularly interested in multifamily apartment type of audience so I\u2019m just curious how cap rates are performing in that specific sector of commercial real estate.<\/p>\n
Well, I think it\u2019s like all of the other sectors. Cap rates would be out approximately 125 basis points to 150 basis points, depending on the type of asset and the location, from somewhere around 3.5% out to 4 or 5%, depending on the location. And maybe higher than that, depends what the starting point is. There are a range of cap rates reflecting the different gradings and the different locations. I would say, as a general, prices are out 150 basis points, and that is the equivalent of approximately a 20% drop in prices.<\/p>\n
And do you think that\u2019s going to continue?<\/p>\n
Yes, I do, actually. I see\u2026 Not forever.<\/p>\n
No, I just love someone who gives a direct answer. So usually when we ask something like that they, hey, well. Because it is complex, don\u2019t get me wrong, there are many caveats, but I do always appreciate a very clear answer like that.<\/p>\n
Yeah. I think there could be further loss of value, and it won\u2019t reverse itself until investors begin to see a clear glide path for interest rates. We began to see, I think maybe two months ago, just a little bit of a sense where people were\u2026 Looking at what I saw, which was actually offices, that\u2019s got a problem, but fundamentals in real estate actually not too bad, we seem to be getting on top of inflation. And those forward rates of return, take a 5% cap rate, add 2% rental growth and we\u2019ve got notionally a 7% forward IRR, and that equates to debt costs somewhere between 6.5 and 7.5%. People began to think maybe we\u2019ll start looking at deals again.
But I think the spike in the 10-year Treasury, when it went from 4.2 to 4.4 in the last two weeks, again brought that uncertainty about the glide path for interest rates front of mind. So people just put their pens down again and thought, well we\u2019re just going to wait and see what happens. We\u2019re in this world, I think, that good news is bad news, whereas between 2009 and 2020, for real estate bad news was good news because it kept interest rates down. Now we\u2019re in the opposite world, it\u2019s the same world but it\u2019s opposite. But good news is bad news because it increases the people\u2019s worries about interest rates higher for longer.<\/p>\n
So Richard, you\u2019re saying we could see some more buys over the next 12 months. I feel like the multifamily market has dropped a little bit, but the sellers are still hanging in there and there\u2019s not a lot of transactions going on because the cap rates, they\u2019re not attractive enough for us to look at them. Because I\u2019ve seen the same thing, we were seeing cap rates like 3.5, maybe low 4s, and now they\u2019re up to 5.5. It is not very attractive with the debt out there right now.<\/p>\n
No, no. I mean, I think if people had more confidence you wouldn\u2019t just look at, to get technical, you wouldn\u2019t just look at the cap rate. You\u2019d have to look at the IRR, which takes into account the rental appreciation that you would get.<\/p>\n
Right.<\/p>\n
And I think the IRRs, even if you assume 2% rental growth, 2.5%, it gives you an IRR that is getting in the ballpark. But I think when confidence evaporates people are not IRR investors. IRR investors involve making assumptions about rent in the future, and people don\u2019t want to do that. And just, as you say, there\u2019s no positive leverage right now and people are unwilling to accept negative leverage in the marketplace.
But it won\u2019t take much to tip that equation, I don\u2019t think. We\u2019d like to just get a bit more obvious direction on where inflation is going, a bit more obvious guidance that we\u2019ve reached the peak of the Fed funds cycle, the Fed have been very equivocal about that, then I think things will tip. Because on the leasing side, leasing disappeared in Q2 of 2022, just when interest rates started going up people dropped out of the market. Well, leasing is back. Q2 of this year leasing came back. And we\u2019ve got quite a high level of new construction, maybe 90,000 units per quarter, but the market is absorbing 60 to 70,000 units per quarter, at least based on Q2 evidence and Q3 trajectory.
So demand has come back up. Vacancy is probably increasing slightly. But with demand coming back it won\u2019t take too much, in terms of that expectations for people to say there are some bargains to be had here. I would say, just on your point about sellers holding out, if the Fed hadn\u2019t intervened and provided liquidity to the banking sector, which has allowed the banking sector to be able to transit through a period of loans. They might still be paying the interest but they\u2019re below water in terms of value. We might have had a different situation. The Fed has been very active in providing liquidity to the banking sector. And of course, I think that\u2019s kept pressure off the owners, and therefore you\u2019ve got this standoff between buyers and sellers, or owners and potential buyers.<\/p>\n
Richard, I do want to follow up on the banking sector and what\u2019s going on there. Just yesterday I was reading an article in the Wall Street Journal where they were positing about a \u201cdoom loop\u201d in commercial real estate. The basic premise is that their valuations are already down. It\u2019s put some properties under water and now people are starting to default on those loans. Bank credit is tightening up, which means people can\u2019t refinance or they can\u2019t purchase, which puts further downward pressure on valuations, and it creates the spiral that creates sustained downward pressure on prices in the commercial real estate space. I\u2019m curious if you think there is a risk of this doom loop, or whatever you want to call it, if there\u2019s more risk in bank failures and the lack of liquidity impacting the commercial market?<\/p>\n
I mean, what I\u2019m going to tell you is rather a complex argument, which is somewhere in between, there\u2019s no problem and there\u2019s a doom loop.<\/p>\n
Okay.<\/p>\n
I think, with great respect, the journalistic maxim is to simplify and exaggerate.<\/p>\n
Right.<\/p>\n
And I think, to a certain extent, with real estate that\u2019s what\u2019s going on. And I\u2019m not saying that there isn\u2019t an issue with loan impairment, but I think what we are hearing and what we\u2019re seeing is banks have got ample access to liquidity, and because of that they\u2019re not suffering deposit flight. So where they are making losses or they have to write down loans, they\u2019re able to bring that to their P&L account on a relatively orderly basis. There is no doubt that the cost and availability of credit for new financing is much tighter. It\u2019s incredibly tight. But I don\u2019t think the banks want to end up with real estate on their books. I mean, they\u2019ve been through this before. They don\u2019t want to put people into default and then they\u2019ve got the real estate that they\u2019ve either got to manage or they\u2019ve got to sell it at some discount to somebody who holds it for two years and then makes a profit two years down the line. They\u2019ve been through that before and they don\u2019t want to go through that again.
So I think what we\u2019re seeing is that, where possible, banks are extending. I\u2019d go as far as to say extending and pretending, but there are lots of creative ways in which banks can work with borrowers in order to get through the period of acute stress. And I\u2019m not saying there aren\u2019t going to be losses. Our own research tells us probably 60 billion of loans are likely to default. There\u2019s 4.5 billion of loans to commercial real estate. That 60 billion, maybe it\u2019s 1.5% of total bank assets. So it\u2019s going to be painful, but it is not going to bring down the banking sector. Therefore, the doom loop, it\u2019s not good, and making losses is never good, but I don\u2019t think it\u2019s quite as an aggressive doom loop as we have seen in previous real estate crises. We\u2019ve seen doom loops do exist in reality. They did in the savings loans crisis, they did in the great financial crisis, but at the moment, for a variety of reasons, I don\u2019t think we\u2019re there yet.<\/p>\n
There\u2019s definitely a lot of articles with that word doom loop going on. It\u2019s the new in-term I\u2019m seeing on every article, where it\u2019s doom loop, doom loop, that\u2019s all I\u2019m hearing.<\/p>\n
Just wait, James, the episode is now going to be called doom loop, and we\u2019re going to probably have our best performing episode of all time if we call it the doom loop.<\/p>\n
Can\u2019t we talk about virtuous circles rather than doom loop?<\/p>\n
Yeah, no one wants to hear about virtuous circles, they want to hear about doom loops, unfortunately. I would love virtuous circles.<\/p>\n
But if there is a doom loop coming, Richard, because it sounds like you feel confident in some commercial sectors going forward, what sectors do you feel are the most investors should be wary of right now? If you\u2019re looking at buying that next deal in the next 12 months, what sectors are you like, hey, I would cool down on that or be wary of?<\/p>\n
Well, it\u2019s very tempting to say offices, because offices, as I say, we\u2019ve got that jump in vacancy from 12% to 19%. We\u2019ve got no certainty about the return to work in U.S. office. We think the return to work will gather pace, but just over a longer period, but there is no certainty about that right now. On the other hand, as a professional in real estate of 40 years or so, you get the best bargains in the most bombed out markets. So amidst all of that repricing there are going to be some very good opportunities in the office sector. And if you really want to be contrarian you run in the opposite direction. All those people running one way saying doom loop, doom loop, you work out where they\u2019re coming from and move in the opposite direction.
I think also retail has got quite a lot going for it right now. We were seeing quite a lot of private capital. And it\u2019s not like office, the asset sizes can be smaller. It is possible for smaller investors to get involved in retail, and we are seeing a shortage of space, and we\u2019re seeing some very, very interesting trends in retail. The sexy sectors, if I want to put it in those terms, or the sectors that we are most confident on, I think, because of the tailwinds are the industrial sector and the multifamily sector if you want to invest in longer term rental growth. But once the market starts moving that\u2019s where the prices will rise quickest. So if you want to invest in that long-term story then you need to move quickly, I would say.
Don\u2019t get me wrong, there are certain parts of multifamily and apartment that I think will run into some problems. There was quite a lot of very cheap bridge financing in the multi-sector where people were, in the boom years of 24% rental growth, people were buying Grade C assets with very low debt, and they were looking to refurbish and reposition those as B or B plus or A Grade space. Given the general weakness and the level of interest rates, I think some of those could end up defaulting. So if you\u2019re a student of these matters there might be assets to be picked up or recapitalized in that segment of the market.<\/p>\n
James is going to start salivating now.<\/p>\n
Oh, I was. I was getting worked up.<\/p>\n
That\u2019s his wheelhouse.<\/p>\n
I was getting itchy fingers all of a sudden. I\u2019m like, yes, here we go. And I think Richard nailed it. It\u2019s like everyone was buying these deals on very tight performers and then they\u2019re debt adjusted on them in midstream, and your construction costs are higher, your permit times are longer, and then all of a sudden your cost of money\u2019s gone up and it\u2019s definitely got some trouble in that sector. It\u2019s like the stuff that\u2019s stabilized is still moving as well, but the stuff that\u2019s in mid-stabilization that\u2019s where we are seeing opportunities. And that\u2019s definitely where we\u2019re looking.<\/p>\n
That\u2019s right. And again, over a long career, people who\u2019ve made very good buying decisions have bought from troubled developers or troubled construction companies. We\u2019ve seen this one before.<\/p>\n
Well, I hope no one loses their shirt. I\u2019m not rooting for that at all. But I think it is helpful to recognize that this is happening and that there are likely going to be distressed assets that need to be repositioned by someone else other than the current owner.<\/p>\n
Yeah. I mean, the banking sector at the moment is writing off a lot of debt that\u2019s below water so there is an economic cost to this, but it\u2019s just not got out of control at the moment. And thankfully it hasn\u2019t quite hit the consumer sector, the housing market yet, because that then impacts ordinary people, and that\u2019s not very pleasant at all.<\/p>\n
Well, Richard, thank you so much for joining us. This has been incredibly insightful. I do want to share with our audience that you and your team have authored an incredible economic report, called The Midyear Global Real Estate Market Outlook for 2023. It\u2019s a fascinating read and there\u2019s a great video that goes along with it as well.
Richard, can you just tell us briefly about this, and where our audience can find it if they want to learn more?<\/p>\n
Yes, it\u2019ll be on the CBRE website, cbre.com. Go to Research and Insights, and click through on that. It might take two or three clicks, but it is there. I have my research experts from around the world and we try to be neutral and balanced and data driven. We just give a broad overview of real estate markets in the United States and around the world. Actually, I participated in it and I learned from it as well, actually.<\/p>\n
That\u2019s the best kind of research project, right?<\/p>\n
Yeah, absolutely.<\/p>\n
All right. Well, Richard, thanks again for joining us.<\/p>\n
It\u2019s my absolute pleasure.<\/p>\n
So James, Richard has told us that he thinks asset values are going down, which obviously is not great for anyone who holds real estate, but also, that there might be some opportunities, which I know you are particularly interested in taking advantage of. So how does this type of forecast or prediction make you feel about your business?<\/p>\n
Well, I like he gave me verification that you should be buying when other people don\u2019t want to buy, essentially. There were so many key little things when he was talking about how industrial the rents are going up, but the pricing\u2019s going down. So there is some opportunity in those sectors of going through and just looking for those opportunities right now, because you hear it all the time that people are like, \u201cAh, you can\u2019t buy anything. You can\u2019t buy anything.\u201d But that stat alone that he was talking about, industrial, rents are going up but the pricing\u2019s going down, that is where you want to go look at. So I am getting more and more excited for the next 12 months, and it\u2019s going to be a matter of being patient and finding the right opportunity.<\/p>\n
You mentioned on the show that cap rates where they are now, you said Seattle, what are they 5.5?<\/p>\n
Yeah, I would say 5.25 to 5.5, in there, somewhere there.<\/p>\n
But given where interest rates are, that\u2019s negative leverage, that\u2019s not something that\u2019s typically attractive to investors given where debt costs are. At what point would cap rates have to rise for you to feel really excited about the potential of the deals you could buy?<\/p>\n
Well, you can always get a good cap rate if you buy value add. That\u2019s where you can increase it. But I mean, in theory, I don\u2019t really like to buy below cap rate. I would want to be in that 6.5. If it\u2019s stabilized with little upside, I want to be around a 6.5 right now.<\/p>\n
And just so everyone understands, cap rates are a measure of market sentiment. And as James is indicating, it ebbs and flows based on cost of debt, how much demand, perceived risk. And generally speaking, cap rates are lower for stabilized assets. And when cap rates are lower that means that they trade at a higher cost. When cap rates are higher, they\u2019re cheaper. And usually you can get a higher cap rate as a buyer if you\u2019re buying, as James is saying, a fixer up or something that needs value add.
But sorry, James, go ahead.<\/p>\n
Yeah, I think that\u2019s what we\u2019re seeing right now. A lot of the transactions we\u2019re seeing in this last six months it\u2019s a lot of 1031 movement of money, but not a lot of new buyers walking in for that general 5.5 cap. If they have a purpose to go buy, they will. Other than that, everyone\u2019s chasing that value add where you got to roll up your sleeves, get to work. But there is some really good buys right now. I know our IRRs have increased quite a bit over the last nine months to where we\u2019re now hitting 17, 18%, and so those are all good things.<\/p>\n
That\u2019s a very good thing. Well, we\u2019ll just have to keep an eye on things and see how it goes, but I generally agree with Richard\u2019s assessment. Cap rates are up, and I do think they\u2019re going to continue to climb while my guess is that rents, at least in multifamily, which is the sector I understand the best, are probably going to slow down. They might keep above zero and grow, but I think these insane rent growth rates that we saw in multifamily are over for the time being. And so that combined with cap rates increasing we\u2019ll bring down multifamily values even further past where they\u2019re today, which might present some interesting opportunities. So we\u2019ll have to keep an eye on this one.
James, thanks so much for being here. We always appreciate it. And for everyone listening it, we appreciate you. If you like this episode please don\u2019t forget to leave us a review on either Spotify, or Apple, or on YouTube if you\u2019re watching it there. Thanks again, and we\u2019ll see you for the next episode of On The Market.
On The Market is created by me, Dave Meyer, and Kailyn Bennett. Produced by Kailyn Bennett, editing by Joel Esparza and Onyx Media, research by Pooja Jindal, copywriting by Nate Weintraub. And a very special thanks to the entire BiggerPockets team. The content on the show On The Market are opinions only. All listeners should independently verify data points, opinions and investment strategies.<\/p>\n