Look ahead at CREF (Commercial Real Estate Finance)

In 2022, the total amount of loans and borrowing for commercial and multifamily mortgages is expected to drop by 18%, to $733 billion.

It is anticipated that total borrowing and lending for commercial and multifamily mortgages will decrease by 18% to $733 billion in the year 2022. This is what the Mortgage Bankers Association's updated baseline forecast, which came out on July 19, says (MBA).

Multifamily lending alone, which is included in the total, is expected to drop to $436 billion in 2022, which is 10 percent less than last year's record of $487 billion. MBA thinks that borrowing and lending will pick back up in 2023, with commercial real estate lending reaching $872 billion and multifamily lending reaching $454 billion.

The space, equity, and debt markets are changing quickly, which has a big effect on the number of commercial and multifamily real estate deals. After a record start to the year, we expect new loans to slow down in the second half of the year. This is because rates are going up, there is still a lot of uncertainty about supply and demand for some types of properties, and people are worried about where the economy is going. Most of the fundamentals of the commercial real estate market are still strong, and the incomes and values of many properties have gone up a lot in the past few years. MBA thinks that because of these things, people will want loans again in 2023 and 2024.

The direction of the economy, which is still unknown, will have a big impact on the size and timing of market changes. If the economy goes into a recession, which is likely to happen in the first half of 2023, it will be even harder for businesses and apartment complexes to borrow and lend money.

MBA's commercial real estate finance (CREF) forecast is based on our baseline economic forecast (link), which says that the US economy will continue to grow this year and in the years to come, but at a slower rate than usual. It's important to keep in mind that this is just one possible path for the economy.

The prediction is that inflation will go down over the rest of this year, but it will still be high. This is because some of the things that caused big price increases to slow down, like low interest rates, rising oil prices, and high consumer balance sheets, while others stay stubbornly the same (some supply-chain difficulties, increasing shelter costs). According to the baseline forecast, price increases should slow down even more in 2023, and by 2024, they should be closer to the trend.

Slower-than-average economic growth is likely to make the job market less tight, which will cause the unemployment rate to rise from an average of 3.7% in 2022 to 4.0% in 2023 and 4.5% in 2024. Note that members of the Open Market Committee of the Federal Reserve Board expect (and aim for) a long-term unemployment rate of 4%.

Soon, the interest rates on short-term loans will go up. Interest rates on longer-term loans will probably go up and down, but slow economic growth and a return to more moderate inflation are expected to be the main things that move them. We think the average interest rate on a 10-year Treasury bond will be 2.9% in 2022, 2.8% in 2023, and 2.5% in 2024.

Based on what is expected to happen with interest rates and mortgage spreads, single-family mortgage rates and the rate at which home prices go up should also go down. For example, the year-over-year increase in home prices should slow from a high of 19% in the first quarter of 2022 to between 2.4% and 2.3% in 2023 and 2024.

What does this mean for getting money to buy commercial property? In the last few decades, the number of sales and mortgages has been most affected by the value of homes and how it has changed. In turn, property incomes and the capitalization (cap) rates that investors use to value those incomes affect property values.

The risk-free yield and the risk premium can be seen as two parts of the cap rate. The risk-free yield is the return an investor can expect to get from a government security or another very safe investment. Then, the risk premium is added to the return an investor wants for taking on more risk with a certain investment. The cap rate spread shows the risk premium for commercial real estate.

In the past few months, the risk premiums for many different kinds of investments have gone up. This is because the economy is uncertain, which makes risks higher, and because competing yields are generally going up. Cap rate spreads are likely to go up over the next few years, but they will still be lower than they were for most of this decade. When these cap spreads and 10-year Treasury yields are added together, we expect all-in cap rates to jump quickly and sharply.

Net operating incomes are also expected to go up at the same time that cap rates go up. Many parts of the commercial real estate market still have strong fundamentals, such as low vacancy rates and rising rents. Changes in NOI will depend on the type of property, but we think that, across all commercial properties, quarterly NOI growth will slow from recent highs but stay above longer-term averages. We use a NOI that comes from a variety of sources to predict that quarterly growth will drop from an average of 3.3% in 2021 to 2.5% in 2022, 1.5% in 2023, and 1.4% in 2024. In the 2010s, this measure of quarterly growth in NOI was, on average, 0.9%.

When you add up the projected paths of cap rates and NOIs, you get a short, sharp drop in the value of commercial real estate (as the market adjusts to higher interest rates and cap rates), followed by a return to rising property values. Because cap rates are going up, property prices could fall by 10% or more in 2022. In 2023 and 2024, prices could go up by 6% and 9%, respectively, if cap rates level off and start to go down while NOIs keep growing.

Based on how things have changed over the past 15 years, our baseline economic forecast says that commercial and multifamily real estate lending is likely to drop by 18% from 2021's record levels in 2022. In 2021, the fourth quarter was the most important for lending, while 2022 had the fastest start to a year on record. This means that the model predicts a big drop in volume (compared to last year) in the second half of the year.

As has already been said, the economy could go in a lot of different directions from here, and the commercial real estate finance markets could respond in a lot of different ways.

If the US went into a recession, which probably wouldn't happen until early 2023, the size and shape of the recession would determine how much lending and borrowing would happen in the commercial and multifamily sectors. The most likely result would be a bigger drop in volume than what is predicted here. The size of any further drops would depend on how much a downturn hurts or doesn't hurt property incomes, as well as how cap rates affect how investors value those incomes. During past recessions, different things happened. For example, the 2001 recession had a bigger impact on NOIs and a smaller impact on cap rates, while the 2007 recession had a smaller impact on NOIs and a bigger impact on cap rates. There are also paths where the economy is stronger and more money is borrowed and lent than what we talk about here.