United States economic outlook
US activity and labour market data show few signs of distress. The latest payroll report points to stronger-than-expected hiring in recent months. However, headwinds to growth are building. Pandemic-era savings will eventually run dry and, along with restarting student loan repayments and tightening financial and credit conditions, this will weigh on consumption. Businesses will feel the pinch from higher borrowing costs. These will weigh on margins and profits, which will eventually trigger job losses. That is why we still forecast a recession – although shorter and milder than previously feared – around mid-2024. However, the runway for a soft landing has clearly widened.
Subdued consumer price index (CPI) and personal consumption expenditure (PCE) inflation over recent months has fortified hopes for a soft landing. We think the summer soft patch overstates the deceleration in inflation. Underlying inflation dynamics are firmer when we account for disinflation from more volatile components. Fundamentally, we think wage growth remains too hot to be confident the US inflation shock is over. It is possible that inflation continues to ease without a significant labour market adjustment. But, on balance, we think further easing in activity and the labour market will be required to deliver a sustainable return to the Federal Reserve’s (Fed) 2% target.
The Fed held rates unchanged in September, but continued to signal one more hike this year in its updated policy forecasts. Strong short-term data supports the case for a hike, but the recent tightening in financial conditions could persuade the Fed that this is not required. Thereafter, we think rates will be on hold until the economy starts to roll over, with a first cut in June 2024, followed by a pronounced easing cycle. We now expect rates to trough at 2%, with a milder downturn necessitating less policy support. A soft landing would leave rates higher for longer.
Source: abrdn September 2023
Forecasts are a guide only and actual outcomes could be significantly different.
North American real estate market overview
As we head into the final quarter of this year, there is some light at the end of the tunnel. Inflation has slowed down and we expect another rate hike in November to end the cycle. This should be followed by rate cuts from mid-2024.
Despite interest rates remaining elevated for a bit longer, we are observing cap-rate expansion starting to slow down across sectors. That said, we are finally seeing valuation data reflect the sentiment of office assets in the market.
The latest valuation for Chicago’s Aon Centre demonstrates the lack of conviction in a full return to the office. Aon Centre is now valued at $414 million, a 47% drop in value from its first review.
Distressed opportunities within the multifamily sector could take a while to play out. But opportunities should be most prevalent in places where smaller investors, with a value-add focus, have bought assets over the past two years. This is predominantly the Sunbelt, but traditional gateway markets, such as New York, have not been spared either. Recently, seven loans from Emerald Equities’ 28-property portfolio across the Bronx have been transferred to special servicing.
In the retail sector, we are still seeing positivity in strip retail. But we are cautious about the near-term risk of falling consumer confidence and consumption, as households are braced for the return of student loan repayments.
That said, student loan repayments are unlikely to have a significant impact on the wider economy. More comprehensive measures of household finances, such as cash-in-hand and a rise in home equity, suggest that the finances of many American consumers could be more resilient than previously thought.
North American real estate market trends
Office defaults are becoming more visible in the US. While office sales are muted, we are coming to a point in time where hope is colliding with reality.
Several high-profile valuations are bringing expectations down to more realistic levels. For example, Chicago’s Aon Centre fell from $780 million to $414 million, amid a loan modification and extension for three years. In terms of defaults, we’ve seen firms, such as Shorenstein properties, defaulting on a $350 million loan on a 1.1 million square feet office asset in Times Square. Bridgerton Holdings also defaulted on an office asset in San Francisco that was 75% leased to WeWork.
In terms of occupation rates, we are still seeing negative net absorption. This has pushed vacancy rates up by 90 basis points (bps) since the end of 2022 to 18.2%, a 30 year high. The additional pressure of WeWork potentially collapsing has also put pressure on future vacancy rates and rental growth. This is particularly a concern in New York, as it’s doubtful that WeWork’s competitors will be able to fill the gaps that it will leave behind. We expect a significant number of these spaces to remain empty for an extended period of time.
Industrial and logistics
Robust renewal activity has been the backbone of leasing activity this year. About 35% of all transactions in the second quarter of 2023 consisted of renewals. Leases for huge warehouses (over 300,000 square feet) have seen the greatest slowdown, falling by 29% year-on-year. Smaller warehouses (25,000 square feet and less) are up year-on-year.
The leasing slowdown comes at a time when new supply has exceeded 100 million square feet for the fifth consecutive quarter, as at the second quarter of 2023. A significant amount of that supply is more than 300,000 square feet blocks.
Rental growth has also shifted from the west coast markets to the Gulf and east coast markets. This was expected, as we noted an increase in available space in Los Angeles and the Inland Empire in our last quarterly outlook. Shippers seem to have made their decision. They are using east coast ports and those in the Gulf, as imports shift to countries with easy access to the eastern seaboard. That said, some shippers are even going out of the way, crossing the Panama Canal to get to ports such as Houston, Savannah, and New Jersey.
The supply chain is shifting to be more land-transport reliant because of the effects of near-shoring/on-shoring. This is putting more demand on the land borders. We expect demand to be strong over the next few years for markets with intermodal terminals that sit in the path of newly formed freight rail lines. This includes the Falcon Premium Service, which links Mexico, the US and Canada.
We have a negative view of malls, as fundamentals remain poor. However, overall retail strength is strong, led by strip retail and standalone retail spaces in the Sunbelt and Midwestern markets. Retail space is finding a foothold at around 8%, which demonstrates strong demand.
Ten consecutive quarters of positive demand and limited deliveries have pushed the US retail market to its tightest position in nearly 20 years. Overall, 4.9% of total retail space was available for lease as at September 2023. This is 150 bps lower than the 10-year average for retail.
But this strength is beginning to look like a double-edged sword. The lack of desirable available space is preventing tenants from expanding, especially in the Sunbelt markets. This has led to the lowest leasing levels in over two years.
While lower levels of leasing activity usually don’t sit too well, the current slow demand should be positive over the next three years. With little new supply and tenants competing for the limited options, landlords should retain pricing power.
Development is historic but mostly in the Sunbelt. We expect a total of around 400,000 units to be completed this year, which puts annual inventory growth at 2.1%. Markets such as Austin, Jacksonville, Nashville and Raleigh are on track for 5% or more inventory growth. But the largest population hubs, such as Boston, New York, San Jose and San Diego are probably going to register 1.5% inventory growth for this year.
Demand for the east coast hubs is expected to remain strong. Despite concerns over living costs, cities such as New York and Boston have had lower inflation than the national average since March. Combined with the high barriers to homeownership and the limited supply mentioned above, vacancy rates for the east coast markets should stay tight.
In terms of defaults, there is a heightened risk of default from smaller multifamily investors. We’ve seen a couple of cracks starting to show, such as MF1 capital filing to foreclose on Rockstar Capital’s multifamily asset in Houston. The investor defaulted on a $51 million loan tied to a property on the east coast. We’ve also mentioned the seven loans from Emerald Equities’ portfolio being transferred to special servicing.
On a brighter note, insurance hikes paired with higher debt costs have also stalled a few project proposals and created delays at building sites. This means that supply could normalise quickly next year.
Outlook for risk and performance
We are bearish on US offices, as occupiers struggle to get employees back into the office. Weekly physical occupancy is still less than 50% of pre-covid levels nationally. Effective rental growth will be weak as sublease availabilities force direct landlords to entice occupiers with increasingly large concessions. The likely departure of WeWork will cause some significant problems for landlords who have exposure to the co-working platform.
Dense coastal multifamily markets in the east coast seem to be the straightforward play. They have a relatively low supply compared with the Sunbelt markets. With inflation running below national levels, they should be able to drive demand and rental growth. There could also be select multifamily properties that could be picked up for attractive prices. Alternatively, they could be a debt play.
Similarly, we like strip and standalone retail, particularly grocery or discount-store-anchored properties in the Sunbelt and Midwest. These should benefit from the higher population growth and limited supply pipeline.
We are bullish about industrial and logistics markets surrounding the Gulf and east coast ports. We think these ports should be primed to capture more shipping volumes as friend-shoring becomes more prominent. Recent infrastructure upgrades to the ports of Savannah and New Jersey should attract more shippers because of nearshoring/onshoring opportunities. Land border traffic is expected to grow, too. We expect Atlanta and northern New Jersey to have strong rental growth, as a result. We’ll likely see markets with developed intermodal terminals, such as Dallas and Atlanta, post strong rental growth over the next three years.
North American three- and five-year forecast returns
Source: abrdn, October 2023
Forecasts are a guide only and actual outcomes could be significantly different.