With inflation on the rise, the Federal Reserve continues its attempt to reel it in by hiking up interest rates. One of the main impacts of that is the subsequent rise of mortgage rates, which have soared above 6.5%. Several financial institutions are tapering down their housing segment and taking on a more conservative approach to home loans.
Commercial real estate (CRE) investors are also getting nervous. Investment firms, endowments, and pension funds are pulling money out of real estate fund and exploring safer alternatives such as bonds (fixed income) which are now also more competitive given the Fed's interest rate increase.
Wells Fargo (NYSE: WFC), for instance, is tapering down its mortgage lending business - the bank will now only offer home loans to existing customers and families from underrepresented communities. Real estate investment managers, Blackstone (NYSE: BX) and Starwood (NYSE: STWD), are protecting themselves by placing redemption restrictions on their non-traded REITs (real estate investment trusts) as investors increasingly seek to pull their money out. For November alone, Blackstone received $3 billion of redemption requests (equal to 2% of the REITs net asset value). Nontraded REITs typically limit withdrawals to a monthly or quarterly basis, however; if numerous investors request to redeem their funds, the firm could potentially be put in a position where it will have to sell other assets to cover the requests.
REITs have historically underperformed at times of rising interest rates as they typically fare better during strong economic conditions when they are able to collect rent and witness property price increase. REITs are also heavily levered which means that rising interest rates increase the cost of loans.
Heavy investor withdrawals indicate sentiment on housing and commercial real estate is still very bleak amid fears of a recession. An increasing number of office and retail spaces continue to remain empty as retailers end expensive leases, tech layoffs continue, and pandemic-induced work-from-home continues. Many landlords across top cities such as New York and San Francisco, where many tech companies are headquartered, are having trouble finding tenants for their empty buildings. As demand for commercial real estate declines, prices soften compared to the beginning of 2022.
Economists predict a 70% chance that the economy will fall into a recession in 2023. The recession is partly intentional - a response to rising interest rates which the Federal Reserve is attempting to reel back down to 2% (level deemed consistent with achieving stable prices and maximum employment) by hiking up interest rates. Moody's Analytics chief economist Mark Zandi pointed out, "We've seen this story before. When inflation picks up and the Fed responds by pushing up interest rates, the economy ultimately caves under the weight." Fed Chair Jerome Powell acknowledged that there is potential for a "soft landing", however, a recession would be unavoidable.
Transaction volumes for homes and commercial real estate have fallen to below January 2019 levels. A Deutsche research team noted that "Real estate is one of the key levers the Fed can use to slow the economy; higher rates are dramatically reducing U.S. real estate activity". The Federal Reserve monitors several price indexes to gauge changes in inflation. The Fed primarily relies on the Personal Consumption Expenditures (PCE) index as it includes a broad range of spending categories. Few sectors of the economy are immune to increasing interest rates however some fare better than others, and we are witness an exodus out of real estate and into safer asset classes.