A lot has changed since my year-end update, four major banks have collapsed, and the market is now signaling a recession with interest rates beginning to fall. What does this mean for real estate in the second half of the year? Are there any big changes to my original predictions?
Before getting into my predictions for next year, there are three crucial factors to discuss that will shape the real estate market in 2023 and beyond Interest rates, inflation, and consumer sentiment. All three are intertwined as they influence each other, but it is important to discuss each one individually to understand how each unique variable will influence real estate in 2022 and beyond.
What happens to Inflation in 2023?
Inflation continues to run at almost 2.5 times the Federal Reserve target of 2%. There should be some break in the continued price acceleration as supply chains “catch up” with demand. Furthermore, we are seeing in the latest retail numbers that prices are starting to dampen demand a little, which will help. Unfortunately, there are a few categories that will remain elevated for a while: housing and wages that will factor into the price of goods.
Rent: Remember rent is a lagged indicator meaning we don’t see the effect of rent increases for up to around a year. With the sudden surge in rates, many would-be homeowners have been priced out increasing demand for rentals. Rents will come off their highs, but I do not see them plummeting which will mitigate a quick drop in inflation. Remember housing makes up over 30% of the CPI calculation.
Wages also look to continue higher as the workforce remains constrained either from retirements or others not reentering the workforce for several reasons. For example, as inflation and wages increase, so do childcare costs which makes it more difficult for many to justify working if they are spending close to what they are making on childcare. I do not see this issue getting resolved until possibly late 23 which will lead to continued upward pressure on wages, but likely not as much as in 2022 as demand wanes a little.
Where do mortgage rates head in 2023?
The Federal Reserve finally came around that inflation is not transitory and as a result, they accelerated the wind-down of their bond purchases which will put them in a position to pause hiking rates into 2023.
Some are predicting a quick reversal in the fed late this year. I do not see this happening as they are forced to hold rates higher for longer due to the stickiness of inflation. This will keep mortgage rates in the 6% range for the remainder of the year.
There is a 50% probability that rates will need to go even higher; here is a quote from Michelle Bowmans who is on the FOMC “ Should inflation remain high and the labor market remain tight, additional monetary policy tightening will likely be appropriate to attain a sufficiently restrictive stance of monetary policy to lower inflation over time,”
What happens to Consumer confidence in 2023
Even with huge inflation and predictions of a downturn, the consumer keeps spending. I think in late 23 the consumer starts to get “tired out” and will eventually slow spending down as they work through built up pandemic savings. This should help slow inflation, but will not lead to a quick reversal.
The recent bank collapses are a wildcard. So far, the contagion seems to be isolated, but if this spreads consumer confidence will take a large hit.
What are my predictions for real estate in 2023?
Overall, there are no huge changes to my original forecast last year. 2023 still looks to be a transition year, but likely will not happen exactly as economists have planned. Unfortunately, there are more negative than positive risks for real estate heading into the second half of 2023.
In the first half of the year, I do not see the bottom dropping out of prices. There will be some softening with prices dropping in the 5-10% range, some markets will hold steady while others could still increase further. The real test comes in the second half of the year when consumers exhaust their pandemic savings and the bills come due for all the spending.
On the commercial side, rising real interest rates should continue to put pressure on cap rates. Remember that the higher the cap rate the lower the value (they work in inverse to each other). On A properties I don’t see huge risks, but on B/C office there will continue to be softness. Retail and Industrial will also come off their highs as cap rates continue to rise to keep up with the rise in treasuries. Rents will not be able to rise fast enough to compensate for the higher cap rates.
The wild card is what happens in late 2023 as higher interest rates continue to dampen demand; furthermore, the federal reserve must hold rates higher for longer which will keep rates from falling back to their lows. Worst case scenario 10-20% price drops, likely is somewhere under 15% reset in prices. This will not occur until late 2023 or early 2024. Some larger commercial properties are at much higher risk for larger price drops. For example, a large class B office will need a huge reset in prices which could be in the 40%+ range.
Will there be a recession in 2023?
I’m not 100% convinced it will come as the markets are planning. I think the consumer is holding up better than expected and digesting higher interest rates without too many problems so far. Unfortunately, the risks of recession are mounting as there is always a lag in the economy. If a recession is to hit, I don’t think it happens until late 2023 or possibly even early 2024.
Although the roses are out and the birds are singing in the first half of 2023, there is trouble ahead. There is a lot more downside than upside risks ahead. For example, I don’t think we are done with inflation based on projections for rents/housing and the tight labor market.
Furthermore, I am skeptical based on history that the federal reserve can engineer a soft landing as the economy has gotten considerably hotter than they anticipated with inflation far outpacing any projections. The federal reserve will need to keep rates higher for far longer than the market is pricing in. This will ultimately lead to a (recession?) correction, but a correction will not occur immediately as it will take time for the economy to finally digest the news.
Look for the big changes in the market to happen in late 2023 or early 2024. For now, enjoy the relative calm in the real estate market, but keep an eye on the wind that is signaling the start of a storm. Also, note the banking crisis could radically change the depth and timing of a recession if the contagion spreads and/or banks substantially reduce credit availability.
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