The ongoing economic uncertainty caused by rising interest rates, inflation and looming recessionary fears have caused volatility and disruption in the overall real estate market. But maintaining perspective is essential. The short-term dislocation will resolve and provides an opportunity to assess long-term strategies. Challenging macroeconomic conditions and the pervasive supply-demand imbalance are factors causing CRE investors to pivot towards workforce and affordable housing.
The current market is difficult to navigate. In an effort to tame inflation, the Fed has increased interest rates rapidly over the past year. The good news is that historically we see that the faster rates go up, the faster they will go down, which suggests rate cuts in late-2023. But the bad news is that these actions increase the potential of a recession, further disrupting debt markets.
Interest rate volatility, in particular, is proving to be the most challenging factor today. While the debt markets remain liquid, many capital providers are underwriting more conservatively and factoring in recessionary and interest rate risks, which ultimately increases debt rates and reduces proceeds.
As the market digests the rate increases, the relationship between the cost of debt and cap rates are affecting overall valuations. Buyers must factor in these higher costs and lower leverage, as well as lower projections of future rent growth. In this period of price discovery, uncertainty breeds caution where some buyers have moved to the sidelines, and unless driven by a capital event, sellers are generally holding tight.
In the long-term, the market will adjust to higher rates. Most agree that the low-rate environment we experienced in 2020 and 2021 is an anomaly that we are unlikely to see again. As stability returns, deal flow will pick up. But with limited new construction in the pipeline, the supply/demand imbalance for affordable and workforce housing will continue for many years to come.
Housing affordability in the U.S. is at a new national low. Affordable rental options are extremely limited and home ownership is increasingly unattainable. The high-cost coastal markets like Los Angeles, San Francisco, New York City and Miami have been facing affordability issues for a very long time. But accelerated migration trends are playing an increasing role in causing affordable housing to be out of reach in markets that have historically been more affordable, such as Dallas-Ft. Worth, Phoenix, Salt Lake City and Orlando.
Getting supply on the ground is not easy. In fact, since the early 2010s, housing production has slowed. Construction activity had been picking up but delays in active construction projects have increased and new deliveries are expected to drop further in the coming years. Project feasibility is harder to achieve as inflation has caused construction costs to accelerate in 2022 alongside rising labor and land prices, cumbersome entitlement processes and escalating operating costs. The liquidity compression has also hit the development sector with market rate units drying up, causing continued strain on all income levels for housing supply. As development of conventional assets slows, any future “trickle down” supply is in danger.
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