Investors Stay on Sidelines Amid Capital Dislocation: ValTrends 1Q 2023

The Federal Reserve left interest rates unchanged on June 14, but the previous ten consecutive increases since March 2022 have left commercial real estate (CRE) markets reeling. Disruption in the flow of capital has led to a significant drop in transaction volumes, making it difficult to determine property values, and that uncertainty is driving investors to the sidelines, according to the latest quarterly ValTrends report, “Capital Dislocation." Peter Muoio, PhD, Head of SitusAMC Insights, and Jen Rasmussen, PhD, Vice President, SitusAMC Insights, discussed key findings of the 1Q 2023 report at the ValTrends webinar on June 14, 2023.  

"The preference for CRE dropped for the fifth consecutive quarter to a record low," Muoio said. "Investors are blaming the short-term economic uncertainty and declining CRE values." Stocks were rated slightly lower due to market volatility, he added.  

With interest rates hovering around 13-year highs, the preference for bonds was the second highest since 2007, when this data began to be collected. "Investors note that the relatively high interest rates on short-term vehicles are very attractive in a period of uncertainty like today," Muoio said. 

Within CRE, investors are favoring apartments, though the sector fell substantially quarter over quarter to the lowest level since the onset of the pandemic. "Investors are looking at this sector as relatively risky," Muoio said. "Conditions in terms of rents and vacancies really took a market downshift from the robust conditions we've seen over the last two or so years."

Investor preference for retail is up to 31% from just 11% a year ago. "That's quite a substantial improvement," Muoio said, noting that multifamily is competing with industrial for the best sector. "Clearly investors perceive the office segment as the riskiest relative to return among property types, and the first-quarter rating was the lowest we've seen in history for office space. Investors believe office will continue to retrench as remote and hybrid work reduces office space usage in coming years."

Meanwhile, capital availability trends are beginning to mirror those seen in the depths of the Global Financial Crisis. Equity capital availability remained unchanged in the first quarter, but was the lowest since at least 2014, when the survey data collection was broken out for debt and equity. Debt availability declined to a record low.

Both debt and equity capital became more restrictive, reaching record tight ratings. "Investors remarked that the availability of deal funds will likely decline as general market volatility continues to increase," Muoio said. "Also, the rise in interest rates, combined with concerns about bank liquidity, are causing lenders to reduce activity and causing debt costs to rise." 

In fact, demand for CRE loans plummeted among stricter underwriting standards. About 70% of banks expect CRE loan demand to fall as higher interest rates have slowed financing for acquisitions, and between 65% and 75% of banks plan to deploy stricter underwriting for CRE loans. 

Given the lack of capital, higher lending discipline and economic and pricing uncertainty, investors are hesitant. "With so much opaqueness in the market, 91% of survey respondents said they would hold, with 6% on the sell side and a whopping 3% looking to buy," Muoio said. Investors recommended a hold rating for the overwhelming majority of segments but were bearish on central business district and suburban office with a recommendation to sell, and more bullish on warehouse, with a recommendation to buy. 

Deal activity slowed across all major property types. Apartments accounted for the greatest share of deal volume in the first quarter at 30%, but that's the lowest percentage for apartments since 2015, with volume declining almost 52% quarter over quarter to $25.5 billion. Retail activity was flat, comprising 20% of transactions, but that's the highest level since 2014. 

The industrial segment has shown resilience in pricing, "but we do see a significant kink in the pricing in April, and so that resilience is starting to erode somewhat compared to apartment, office, and retail which have all been on a downward slope since the Fed began tightening aggressively." 

As for demand, office is expected to continue to retrench amid remote work trends, but "not all office is created equal," Rasmussen said. "They always say 'location, location, location' but it should probably be 'property by property by property' now." Leasing activity varies significantly by property age, with properties less than 10 years seeing strong activity. Vacancy rates reached record highs for Class A, B and C, but Class A has seen a much sharper increase, due to new supply. Net absorption was negative for the fourth consecutive quarter, on par with levels seen in the first year of pandemic.  

The ValTrends report, “Capital Dislocation," offers a comprehensive look at SitusAMC's proprietary insights on valuation trends and space market fundamentals, as well as exclusive survey data on investor appetites for CRE versus bonds, equities, and cash. Download the free, 28-page report here. Access the ValTrends Quarterly webinar presentation here. Learn more about SitusAMC’s research and data offerings here.