Conventional wisdom states that real estate is a great hedge against inflation. In some cases, yes, but the adage if far from a truism. Case example: the divergence between the housing market and commercial real estate is the widest I’ve seen in a long while. Many pundits are humming a ​ housing recession tune, yet CRE continues to transact without huge price reductions. What gives?

For the housing market, it’s all about affordability. With increased rates and inflationary fears comes less purchasing power. For CRE, it’s all about a suitable return on investment.

Let’s start with housing. It wasn’t long ago that the housing market was going gangbusters with surging home prices, historically low interest rates and unrelenting demand. However, data suggests to some experts that the market is statistically in a "housing recession."

Home prices haven’t declined in most markets as inventory remains tight and nearly 40% of sellers still getting full asking price, according to a recent CNBC report. In fact, the median price of a U.S. home in July hit nearly $404,000, up 10.8% from July 2021, according to the National Association of Realtors (NAR).

But here’s where it gets concerning: sales of existing homes fell by nearly 6% in July -- the sixth straight monthly decline — and represented a drop of more than 20% from this time a year ago. Buyers are increasingly cautious, still feeling priced out of the market. They’re also increasingly uncertain about their job security and finding it tougher to find (much less qualify for) affordable mortgages to boot. There have also been layoffs and slower job growth in the housing industry as homebuilder sentiment has turned negative and buyers are canceling contracts in the face of mortgages rates surging to the high 5’s from the low 3’s at the beginning of the year.

Bottom line: sellers, may need to temper their expectations as housing affordability has plunged to the lowest level since 1989, NAR said.

With the Federal Reserve hiking benchmark interest rates, “demand fell sharply in May and June as buyers were absolutely freaked out,” Redfin CEO, Glenn Kelman, told MarketWatch in an interview last week. “It’s a remarkably uncertain time.” New listings for homes have fallen 15% in the four weeks ending Aug. 21, a report published last week by Redfin said. That was the biggest decline in listings since the start of the pandemic.

Commercial real estate on cruise control?

While the residential mortgage market is wearing out the brake pads, CRE is still cruising within the speed limit. Commercial and multifamily mortgage loan originations increased 19% in the second quarter of 2022 compared to the same period last year, according to the Mortgage Bankers Association (MBA). In fact, borrowing and lending backed by CRE set another quarterly record in Q2.

Jamie Woodwell, MBA’s vice president of CRE research, told GlobeSt last week that major drivers of the originations were in retail (up by 108% year over year), hotel (37% increase), and multifamily (24% growth). According to MBA, dollar volume for depository institution-originated loans was up by 102%. Fannie Mae and Freddie Mac grew 29% and investor-driven lenders were also up, by 12%. The resilience of the multifamily sector shouldn’t be surprising since a nationwide housing shortage coupled with demographic shifts has demand outstripping supply. Sprinkle in a recession or inflation and either way you have lots of renters knocking on the door.

According to Woodwell, “Property owners, investors, and lenders continue to work through broader economic uncertainty that is affecting the space, equity, and debt market.” While MBA expects borrowing and lending to slow during the second half of the year, Woodwell thinks improving fundamentals and values in recent years will provide “significant support to properties with outstanding loans and continued financing opportunities for properties whose cash flows can support debt.”

In plain speak, CRE will continue to transact if buyers feel they can still win the IRR beauty contest with a reasonable rate of return in the makeup bag. Financing plays an important role, but if the fundamentals make sense, the loan will be there. In just a few short months, I’ve seen seller cap rates adjust accordingly to account for the cost and degree of lender leverage. There is inevitable pain coming in certain office assets, but that’s a conversation for another time.

Eisner Amper’s Richard Rubin told Mortgage Professional America recently that not only are CRE fundamentals good and generating cash flow, but with the exception of office, there’s plenty of demand for all sectors of real estate -- multifamily, industrial, even retail and hotels. In fact, empty retail space is now below pre-Covid levels, if not lower than at any time since the Great Recession, according to a new BisNow report of an analysis by CoStar.

What’s weighing on people’s minds are the big three “exogenous” economic issues: interest rates, inflation and recession. Rubin believes the biggest threat is interest rates, the next is inflation and the next is recession. “Real estate doesn’t actually correlate to GDP that much – hotels do, but the rest of real estate doesn’t,” said Rubin. “Real estate correlates to the job market, and the job market’s amazing. So, we’re coming into this with great strength: We have continuing job growth, which is the biggest fuel of real estate. The unemployment rate is at a record low, back down to 3.5%. So, we have this really robust jobs situation, and that’s going to cushion real estate fundamentally, from a lot of the whirlwinds going on around it,” added Rubin.

Rising interest rates are also a concern for real estate investors, but Rubin said the pain we’re feeling comes from “the transition from this artificially low interest rate environment that we’ve been in, to more of a market rate environment we’re coming out of the chute into.” And he said we don’t really know what that scenario looks like right now, much less predict it.

But once we get closer to the historic mean of 4.5% on 10-year Treasurys, and everybody adjusts to a new stable environment, “then you keep going,” said Rubin. Until then, I believe there’s uncertainty and the painful process of existing yields of low rates that will have to be refinanced at a higher rate, However, sales transactions will march on as long as investor yield expectations are met. ​ We’re already seeing that scenario priced in.

I’ve seen the real estate cycle sliced into four large slices:

1. Recovery.

2. Expansion (or Growth).

3. Hyper Supply (or Over Supply).

4. Recession.

JD Supra believes the real estate cycle is still in the expansion stage, despite increased interest rates and inflation. “However, the expansion might not involve as much new construction as occurred in previous expansion stages,” JD Supra reported. “Instead, repurposing real estate to better meet market demand and adding green and energy-efficient features to better appeal to investors and tenants appears to be the focus of the real estate market in the immediate future.”

Conclusion

As a big proponent of adaptive re-use, I hope JD Supra hits the mark. However, a dearth of urban office workers, and an inverted yield curve, has my arrow going a bit astray. Real estate by nature is cyclical. Depending on the asset class and leverage you’ll be securing – whether bridge or perm financing -- Team Kraus is here to discuss your needs.