U.S. Real Estate Outlook 2023

There are signs that inflation has peaked

Inflation should remain the key economic factor in 2023. Encouragingly, we have already begun to see signs that inflation has peaked. On a year-over-year basis, the headline consumer price index (CPI) likely hit a high watermark in June 2022 and has decelerated every month since. The core CPI has also showed tentative signs of peaking in recent months. However, both are still uncomfortably near four-decade highs. Nonetheless, further slowing seems likely. Moreover, the global supply chain, significantly disrupted over the last few years, continues to recover, and will continue to improve in 2023. This will help to alleviate supply-side inflationary pressures. 

Demand-side pressures on inflation show signs of stabilizing. While consumer spending has remained resilient, demand-side pressures on inflation should also ease in 2023. Wage growth is slowing, outsized fiscal stimulus from the last couple of years continues to fade, and excess savings are burning off relatively quickly under the weight of higher prices and a desire to spend. Consequently, we anticipate a more pronounced slowdown in inflation during 2023, likely heading toward 3% to 4%. Even so, this means inflation will stay above the Fed’s target level for the year. We envisage additional slowing in inflation in 2024 and 2025 as it falls to near the Fed’s flexible target rate of 2%.

No rate cuts expected until end of 2023 at the earliest

With inflation running at four-decade highs, the Fed took bold steps in 2022 to tamp down inflation. After beginning the year with the Fed Funds rate in a target range of 0% to 0.25%, the Fed embarked on its most aggressive tightening policy in four decades. After hiking by 50 basis points (bps) in March, the Fed then began a run of 75bps hikes that brought the target Fed Funds rate to a range of 3.75% to 4.0%. 

However, it appears that the Fed is not yet done. With inflation anticipated to remain above target in 2023, we expect the Fed to continue tightening into the first half of 2023, but at a less aggressive pace. The Fed Funds rates should peak around 5%. After that, the path will continue to be incredibly uncertain. The Fed will undoubtedly need to see clear evidence that inflation is headed toward target before easing. This raises questions about how long the Fed will stay at the terminal rate before cutting. At best, it likely means no rate cuts until the latter half of 2023, but it could mean no rate cuts until 2024. By 2024 we anticipate the Fed will cut rates in order to restabilize the economy and get growth moving in the right direction again amid lower inflation. 

Government policy set to turn even tighter in 2023

After a period of incredibly stimulative fiscal policy, with trillions in government spending, the situation seems likely to shift in 2023. The appetite for very stimulative fiscal policy diminished in 2022 across the political spectrum with high inflation prevailing. But the situation now looks set to turn even more cautious. With the Republicans retaking control of the House of Representatives, government spending is expected to become more contentious and challenging. Practically, this means for the first time in decades the U.S. economy should head into a period of slowing without the benefit of fiscal stimulus to help soften the blow. 

Slowing growth will therefore not likely be supported by any meaningful government safety net. Yet this also means that some of the government spending supporting demand-side inflation will also wane in 2023. Together with higher interest rates, overall government policy seems set to be even tighter in 2023. While some government spending, such as infrastructure, will occur over the next decade, the prospect of purely stimulative fiscal measures appears low in the near to medium term. 

A healthy labor market should enable the economy to weather the slowdown

The economy is headed into 2023 with a tight labor market. Demand for workers continues to exceed supply. Slowing net job gains averaged roughly 375 000 in 2022. Yet, a tight labor market represents both positives and negatives. On the negative side of the ledger, the Fed will continue to see excess demand contribute to demand-side inflation. Wages grew by around 5% on a year-over-year basis for most of 2022. Coupled with such strong job gains, this helped enable consumers to continue spending, supporting inflation to an extent.

On the positive side, a healthy labor market should enable the economy to weather any slowdown relatively well. While we expect job and wage growth to slow, and we should see some upward pressure on the unemployment rate (which still hovers at a half-century low), we do not foresee the kind of massive deterioration experienced during the last two recessions. Any job losses should resemble a more typical post-war downturn, in the low millions. This should help to limit the severity and duration of any downturn.

Economic growth likely to be near zero in 2023

The economy is downshifting. The U.S. clearly could not sustain 2021’s 5.9% real GDP growth in 2022, a product of the release of pent-up demand and strong fiscal and monetary stimulus. After contracting in the first half of the year, the economy rebounded in the third quarter, and we expect growth once again during the fourth quarter. Although the economy heads into 2023 with some positive momentum, we forecast additional slowing in 2023, probably near zero growth. Nonetheless, a recession is not a foregone conclusion. We anticipate the likelihood of recession in 2023 at 40% to 50%. Why? Because inflation is already slowing despite the economy remaining on a firm footing. Falling inflation should help to propel real consumption. 

This presents a narrow path for the economy to avoid a recession. If the economy contracts in 2023, we expect it would prove comparatively short and shallow. The Fed would start cutting rates to support a recovery, removing the major constraint on growth. Beyond 2023 we predict a relatively quick return to more normalized GDP growth closer to 2% in 2024 and 2025. 

What is the outlook for the U.S. Real Estate Markets?

The office sector remains under pressure with tenants looking to reduce footprints and improve efficiency

High-quality space will outperform as the flight to quality continues, with high rents and low vacancy rates for best-in-class assets. However, second-generation space will struggle to backfill, with an increase in demolitions and/or conversions. Sublease space remains at an all-time high, but not all tenants will find those options desirable. Landlords will grapple with rising costs of capital and deal costs, making some segments of the market uncompetitive and requiring financial restructuring. Tenants possess strong leverage in today’s market, but quality space options will quickly diminish as new speculative groundbreakings come to a halt. Vacancy will be concentrated in inferior, second-generation spaces, limiting future options for tenants that prefer high-quality space if they don’t act quickly. 

The industrial market will sustain its strong position in 2023

Widespread demand, led by logistics firms and retailers, has pushed vacancies to record lows. Such low vacancy has driven asking rental growth to a record pace. While rent growth in 2023 should slow from 2022’s scorching pace, it will stay elevated. With such strong demand, new properties are increasingly getting larger to capitalize on market strength. Roughly 20% of projects under construction are larger than 500,000sf, compared to roughly 5% of existing inventory. Consequently, construction activity will remain elevated but should moderate over the next couple of years. New deliveries will bring some relief to markets with vacancy rates less than 1%, although such tightness will continue to push many tenants to those secondary markets with greater availability. 

Retail continues to perform well overall despite the challenges consumers face

The retail sector has recovered faster than many anticipated and enters 2023 in a position of strength. Retailer bankruptcies and store closures have decreased. Consumers have returned to spending in physical locations, including bars and restaurants - which will benefit centers boasting such offerings. However, performance should continue to be uneven. Foot traffic at suburban shopping centers has returned to 2019 levels. But foot traffic at urban centers remains well below 2019 levels, reflecting the increased prevalence of working from home. 

The apartment market will face greater headwinds in 2023

The rental sector continues to benefit from the ongoing housing shortage in the United States. Outsized demand pushed down vacancy rates and drove robust rent growth. But toward the end of 2022, demand declined despite ongoing job creation and healthy consumer balance sheets. It appears that many young adults (between the ages of 18 and 29), including college graduates, who likely would have rented apartments, have moved back in with their parents. In 2022 nearly half of all young adults lived at home, a proportion unseen since the Great Depression. Why? The likely culprit seems uncertainty surrounding the economic outlook and labor market, especially in a period with high rents. After such a robust period, the market looks like it will head for normalization in 2023. 

Uptick in investment activity expected once there is more clarity around the Fed’s path

The rising cost of borrowing led to widespread repricing of transactions in 2022. The increased uncertainty has caused a number of institutional investors to sit on the sidelines, while private capital buyers have increased their share of acquisitions and have in many cases been among the most competitive bidders. 

The risk premium has been abnormally high as investors grapple both with the uncertainty around the Fed’s future interest rate increases while at the same time pricing in uncertainty around growth in fundamentals/the overall economy. As the Fed’s pace of interest rate increases slows, investors will face fewer unknowns when valuing assets and underwriting transactions, which is expected to lead to an uptick in capital markets activity. 

Furthermore, while signs point to depressed dealmaking volumes at the start of the year, dry powder earmarked for real estate transactions is near record highs, as more consensus builds around asset values, the market is likely to see a meaningful rebound as the year progresses. 

The market as a whole will not see considerable distress or indiscriminate selling. However, 2023 will see some distress for non-institutional office assets. The office sector is facing a combination of lower valuations, reduced investor and tenant demand, and lower availability of debt, which will all contribute to higher levels of forced sales and distress. Some assets that cannot be sold at a lower basis to another investor will almost inevitably be given back to the lender, and office assets with loan maturities in 2023 could also end up in distress if they are not able to secure extensions and/or financing. 

The proliferation of private capital will continue apace as private investors account for a larger share of overall fundraising through non-traded REITs, syndications, private wealth platforms and crowdfunding. This ‘democratization’ of capital formation is expected to be a durable trend because it is not just institutions that seek to benefit from the outperformance potential of commercial real estate. 

Cost management will be a key priority for occupiers in 2023 and will result in realignment of spend

Companies in industries that utilize multiple facility types will prioritize spending on facilities that drive business growth and are mission critical. For example, healthcare companies are reducing office footprints to focus their real estate capital on hospitals and clinics, as patient access is a critical driver of business growth. 

While the talent war will continue to subside, some companies are cautious not to cut too much, too fast. Some businesses are concerned that cutting too much talent will make a recovery in their business more challenging when the economy reaccelerates. Moreover, it is not cost effective to rehire and retrain. Yet some layoffs are occurring and will continue to do so. This will lead to a reduction in office footprints. In some cases, site closures are still being determined, while for others these sites are already known. Most are in tertiary markets where jobs will go remote.

Private capital should remain challenged, producing slower growth among startups. The impact on San Francisco is already being felt, but Boston is seeing some concerning fall-off in demand in the life sciences industry because of this. However, this slowdown in activity is expected to drive more M&A activity as established companies look for deals – targeting companies with compelling IP or growth opportunities but lacking the cash or debt financing to keep the lights on. 

Published 
24 January 2023

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