US Economic Outlook
Nearly two years after the Federal Reserve started aggressively tightening monetary policy, inflation remains elevated while the labor market continues to show its strength. The US economy continues to grow at a faster pace than expected, growing by 4.9% in the third quarter, the fastest pace in more than two years. While a stronger economy is typically good news, it complicates the Fed’s efforts to bring inflation down.
Inflation continues to trend lower. However, September’s core CPI growth of 4.1% remains twice as high as the Fed’s long-term target of 2%. The Fed has embarked on an aggressive rate hike strategy since March 2022, raising the Fed funds rate from near zero to a range of 5.25-5.5%. The Fed has acknowledged that the existing tighter credit conditions are likely weighing on economic activity, hiring and inflation, but the extent of the impact is still uncertain. Presently, consumers continue to ramp up spending on both goods and services and the labor market continues to show surprising strength, increasing the likelihood that the Fed will keep the Fed funds rate higher for longer.
The expectation that the Fed will keep rates higher for longer, combined with growing concerns about the ballooning national debt, has driven a sharp rise in the 10-year Treasury yield, which increased from around 2% in early 2022, to 3.5% in early 2023, to over 5% in mid-October, a 16-year high. Borrowing costs for debt benchmarked to the 10-year treasury, including mortgages, auto loans, credit cards, student loans and corporate bonds, have increased as well, with mortgage rates reaching 8% in October, the highest level since 2000.
Prolonged tightened financial conditions will strain consumers and businesses. Although consumers continue to spend, consumer health is declining. Inflation has depleted savings from the pandemic and reduced the personal savings rate, which has declined every month from 5.3% in May to 3.4% in September. Consumers have turned to taking on record levels of debt to maintain current spending patterns at a time when borrowing costs have risen substantially. Credit card balances increased by $45 billion to over $1 trillion in the second quarter of 2023. Additionally, Federal student loan payments resumed in October for the first time in nearly three years, affecting nearly 30 million people.
There is also uncertainty surrounding the health of the banking sector. Many banks are heavily invested in government bonds and are sitting on billions of unrealized losses caused by rising bond yields, which weaken a bank’s ability to meet unexpected liquidity needs. Following the collapse of several regional banks earlier this year, regulators are considering increasing debt requirements for banks, which would further squeeze bank margins that are already under pressure from rising interest rates, forcing banks to compete for deposits and new business.
Additionally, there are growing political and geopolitical risks stemming from Congressional dysfunction and infighting and the conflicts in Europe and the Middle East. Threats of a US debt default and government shutdown and mounting tensions abroad have added uncertainty and market volatility.
The Commercial Real Estate Landscape
Higher interest rates continue to weigh on the near-term outlook for commercial real estate. As of September, pricing remains 16% below the March 2022 peak, which is unchanged from last quarter. Transaction volume is down 61% as of August. The magnitude of transaction volume decline compared to price decline shows the continual bid-ask spread between buyers and sellers. Buyers, factoring in the financing available today, want larger price adjustments, while sellers are still anchored to prior peaks.
In most cases, the pace of interest rate increases over the last two years has outpaced net operating income (“NOI”) growth, which has slowed due to near-term economic uncertainty, increased supply in certain markets and asset types, and rising operating expenses, namely from wages and insurance. Properties with floating-rate debt have struggled with the sharp rise in interest expense. Despite the burdensome borrowing costs that, in some cases, have exceeded NOI and necessitated capital calls to fund interest shortfalls, owners are fighting to hold assets since the current capital markets environment is unfavorable.
From a buyer’s perspective, new loans that are sized to meet minimum debt service coverage requirements often result in less debt proceeds compared to prior years, requiring more equity. At the same time, while cap rates have expanded, they generally have not increased as much as interest rates. Many transactions trading today have “negative leverage” where the cost of debt is greater than the going-in cap rate. This means buyers must be well-capitalized and willing to accept lower cash yields in the short term for the long-term upside potential.
Commercial real estate pricing has leveled off in 2023, following a decline from 2022. However, it is uncertain whether pricing has started to stabilize or will decline further. $488 trillion of commercial real estate loans are maturing in 2024. The current sentiment is that rates will remain elevated in 2024. Some owners will have difficulty securing new financing proceeds that can repay the maturing loan. While some lenders will work with borrowers to modify and extend the existing loans, other lenders will not, forcing borrowers to refinance at higher interest rates with potential equity injections, or sell assets, potentially at discounted or distressed pricing, to repay the maturing debt.
The Alpha Investing Strategy
Alpha Investing significantly slowed our acquisitions pace since the onset of the rate tightening cycle, as we generally believe pricing has not sufficiently adjusted to compensate for higher interest rates. Our focus is on acquisitions that have high in-place yield where the going-in yield is higher than the cost of debt, and utilizing lower leverage, fixed-rate financing. We have launched five acquisitions since the spring of 2022.
Historically, Alpha Investing has targeted multifamily, senior housing and single-family rentals. We continue to believe in the fundamentals of our target asset sectors. Four of our five recent acquisitions have been within our tax abatement multifamily strategy, which were acquired with long-term, fixed-rate financing that provides strong current cash flow and downside protection. The recent run up in bond yields, however, has eliminated the spread between the going-in yield and financing costs. As such, we do not expect any new acquisitions within this strategy until either acquisition cap rates adjust for the still rising cost of debt or interest rates fall.
The fifth acquisition was a senior housing investment. Senior housing has been the strongest performing asset class within Alpha Investing’s portfolio since the current rate tightening cycle began. On the acquisitions front, we are seeing opportunities where cap rates have risen more in lockstep with interest rates, preserving the risk premium. This is due in part to the operationally intensive nature and fragmented ownership of the asset sector. Food and labor, which account for a large portion of operating expenses, have risen substantially over the last few years and remain elevated, making operational expertise paramount for effective ownership going forward. Owner/operators who are unable to navigate the higher expense costs are looking to offload assets. We have seen cap rates in the high single digits and low double digits, which are in excess of interest rates and provide a stable going-in yield.
With the sharp rise in interest rates, we are presently seeing the most compelling opportunities in senior housing. While other asset types have seen compressing to negative spreads between cap rates and interest rates, there are targeted opportunities within senior housing where the spread is expanding. These transactions offer strong in-place cash flow and may present further opportunities to improve cash yield with Alpha Investing’s experienced senior housing operator.
We remain active on the acquisitions front but are cognizant of the current challenging investing environment. We remain disciplined in our underwriting and will wait for transactions with attractive risk-adjusted returns and strong downside protection. We also continue to focus on the active asset management of our current portfolio to improve and maximize NOI.
 Source: Green Street CPPI
 Source: Colliers
 Source: Trepp