Here’s How Capital Markets Are Likely to Look in 2023

One of the largest questions in CRE — maybe the single biggest one — is what will happen with capital markets. Valuations and rents can go up or down, but it’s the cost of financing that most likely makes or breaks deals.

Right now, the biggest problem is uncertainty in future Fed moves and also with a lack of pricing discovery as markets realign.

“As the Federal Reserve continues its rate hikes to curb inflation, the capital markets have responded with overwhelming caution until there is clarity on when the Fed will stop and where interest rates are likely to settle,” says Marcus & Millichap in a special report. “Several questions compound this uncertainty, including volatility in the stock market, geopolitical risk, decelerating rent growth, falling home prices, and cap rate inflation.”

The firm recently undertook a survey of its clients to gauge their concerns. “Lenders and investors alike are taking an observant pause to avoid ‘catching a falling knife,’ while using this time to raise funds for what they believe will be impending distress in the commercial real estate market, much like they did in 2020 after the onset of the pandemic,” they said. “In 2020, the capital providers that took the risk to lend or invest tended to come out on top, while much of the market missed the opportunity, due to an abundance of caution.”

But, as the saying goes, past performance is no guarantee of future results. The massive amounts of liquidity injection by the Fed and pandemic aid from federal and state governments are not available this time. Quite the opposite. The Fed is drastically reducing liquidity to slow economic growth in an attempt to rein in inflation, and Congress is having major trouble passing a budget and addressing the debt ceiling.

The firm took a stab at a prediction, based on the Fed slowing its pace of rate hikes some, a modestly weakened economy, and no other big and unexpected surprises appear.

The first, cash is king, seems a safe bet, if conditions become worse. Preferred equity and mezzanine debt will become prevalent and available for debts coming due. Financing for construction will be hard to get until construction costs retreat, but as they’re still up more than a third since 2019, that could take a long while. Bridge lenders will prioritize distressed purchases because their lower prices are closer to current valuations. Once the Fed eases on rate hikes, improved bond investor sentiments will lead to tighter CMBS and CLO tranche spreads. Borrowers will eventually refinance construction loans with condo inventory loans to keep things afloat long enough to sell.

And, eventually (whatever that means in this market), investors will release a lot of capital that they now have sitting on the sidelines.