United States economic outlook

Activity: US growth has been more resilient than anticipated, given policy tightening by the Federal Reserve (Fed) and banking sector stress. Consumers continue to spend at a solid clip, helped in part by large stockpiles of pandemic-era savings. The labour market also remains tight. Even those aspects of activity worst affected by rising rates last year, such as housing, have stabilised. We still think a recession is coming, but we have pushed the start date of this out to the start of 2024.

Inflation: Inflation continues to run at strong rates. While headline inflation has fallen because of slower energy and food price inflation, there has been less progress in cooling core price pressures. These dynamics reflect excess demand in the economy, particularly the labour market, which continues to deliver strong wage growth. This excess demand looks set to persist a little longer, given our delayed recession call, meaning underlying services inflation should remain robust during 2023. But we think these pressures will ease quite sharply next year as a downturn takes hold.

Policy: The Fed left policy unchanged in June, breaking a run of 10 consecutive hikes. However, this was a hawkish hold, with the median Federal Open Market Committee member expecting two more 25-basis point (bps) hikes during the course of the year, with one hike being delivered in July despite weak June consumer price index data. But we are not convinced a second move will materialise as activity slows later this year. Once it is clear a recession is taking hold, we expect rates to be cut, and to fall from January 2024 to around 1%.

Source: abrdn June 2023

Forecasts are a guide only and actual outcomes could be significantly different.

North American real estate market overview

Since our last outlook at the start of April 2023, the North American real estate market has continued to deteriorate. So far this year, transaction volumes have fallen 61% year-on-year. This now outstrips the period of decline seen at the beginning of the pandemic. Activity fell during that time because of uncertainty, but it’s now falling because financing is restricted.

In light of higher-for-longer interest rates, we also expect more cap rate expansion from the more tightly wound sectors, such as industrials and multifamily.

Transaction-based cap rates for these sectors rose on average by around 30bps quarter-on-quarter, with the most significant yield shifts coming from Inland Empire industrials and Los Angeles industrials.

This is not a surprise as the West Coast has lost a significant amount of shipping and freight traffic because of union negotiations at ports. Most shippers have shifted inbound shipments into the Gulf and East Coast ports, given fears of disruption or a potential strike. This has boosted demand in the port markets and surrounding logistics hub markets, such as Atlanta and Dallas.

Research from Real Capital Analytics suggests that we are also about to see a substantial amount of distress from the US real estate market, especially in the office sector. We are expecting around $42 billion of potential distress in offices. This is followed closely by the retail sector (mostly malls) and the multifamily sector, with around $30 billion of potential distress. This pressure is unlikely to be alleviated through refinancing, so sales at discounted prices are anticipated in the second half of 2023.

Distressed opportunities within the multifamily sector might occur in select areas. In a scenario where refinancing interest rates for interest-only loans increased to 5.5%, the Washington-Arlington-Alexandria and New York-Newark-New Jersey areas have the highest percentages of multifamily properties going under a 1.25% debt-service-coverage ratio (at 43.7% and 28.9% of loans respectively).

In the retail sector, we are seeing a streak of positivity in terms of strip mall retail. Demand for retail space has outpaced net deliveries for eight consecutive quarters, and supply isn’t picking up to levels that will satisfy demand. Vacancies are now at record-low levels for small- to mid-sized strip centres and freestanding single-tenant properties.

North American real estate market trends

Offices

Office leasing remained sluggish in the first half of 2023, which has led overall office vacancy rates to rise to a record 13.2%, overtaking their previous Global Financial Crisis-era peak.

The sublease markets hold more dire news. There is currently 216 million square feet of space available for sublease, over double the amount at the end of 2019. This is particularly troubling in markets such as San Francisco, where sublease availability represents 6.7% of inventory. Even markets that have been relatively resilient, such as Austin and San Jose, have around 4% of inventory available for sublease.

The large sublease availability has also put downward pressure on rents. Frequently, sublease spaces are being offered at 30-50% below direct-let rates. This has also led some landlords to give longer rent-free periods (one month for every year of lease term) and higher tenant improvement allowances. Essentially, this means landlords are giving up nearly half the value of the lease in concessions in exchange for a 10-year lease.

Industrial and logistics

We are now coming into a period of slowdown for industrials across most markets. We are seeing big increases in available space for existing properties in Los Angeles, Inland Empire and Las Vegas.

The slowdown has also led to weaker rental growth, but landlords and brokers continue to offer very low levels of rent-free concessions, at around one-to-three months for a lease term between five-and-seven years.

The ports of Savannah and Houston have increased their share of inbound shipments. Retailers have diverted to these ports to avoid potential disruptions on the West Coast because of the International Longshore and Warehouse Union (ILWU) negotiations. The International Longshoreman Association, responsible for labour contracts on the Gulf and East Coast, seems to be keen to keep negotiations short and not follow in ILWU’s steps.

However, Houston’s supply pipeline has started to look a bit concerning as completions for the coming year stand at 4.1 million square feet, far above the three-year completion average.

Retail

Retail has been through a challenging few years, but it seems to be at a turning point. We still have a negative view on malls, but standalone retail with triple-net leases are showing strength. Strip retail is continuing its turnaround post-covid, with waning supply and a lack of developer interest over the past few years. Retailers looking for an omnichannel strategy have limited choices.

This has led to around 4% rental growth year-on-year in strip centres. The Sunbelt markets, such as Phoenix and Austin, dominate the leaderboard for retail rental growth. Midwestern markets, such as Cincinnati and Cleveland, are just a few places behind as population growth strengthens in those areas.

Despite some opinions that Bed, Bath and Beyond’s bankruptcy would lead to a flood of retail supply, these spaces have been leased fairly quickly.

Multifamily

Rental growth for Sunbelt multifamily assets has slowed given strong supply. At the current rate, the Sunbelt markets are poised to account for 52% of new supply nationally, which is 10% higher than in 2019.

Landlords in the Sunbelt have been increasingly awarding concessions. Around 25% of apartment buildings in the Dallas Fort Worth area are now offering concessions, such as a month’s free rent. This is up from 10% of properties in 2021.

On a more positive note, things are looking better on the East Coast. Completions in Boston have remained flat over the past four years, which should help to boost rental growth. In New York, the Rent Guidelines Board voted to increase rents by up to 3% in more than one million rent-stabilised apartments.

Outlook for performance and risk

We continue to be bearish on US offices, as occupiers struggle to get employees back into the office. Daily 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.

We are positive about the East Coast and Midwestern multifamily markets, especially New York, Boston and Washington DC. This is because of positive supply and demand dynamics, and certain policies driving rental growth prospects.

Similarly, we like strip retail, particularly grocery or discount-store-anchored properties in the Midwest, which should benefit from the higher population growth and limited supply pipeline.

We are bullish about Gulf port markets and their surrounding areas. We think that the Gulf and East Coast ports should be able to retain the business that they have attracted from the West Coast amid the ILWU negotiations. The Atlanta market and the I-85 corridor should continue to benefit from the potentially permanent increase in freight traffic to the port of Savannah. Logistics in Chicago are also set to benefit from the new transcontinental intermodal rail freight service that utilises Chicago as its main interchange.

Despite the positivity in the Gulf, we are cautious about the supply pipeline for the Houston industrial market, which could hamper rental growth. We also recognise that the ILA negotiations on the Gulf and East Coast ports have a risk of running the same protracted course as the ILWU negotiations.

Source: abrdn June 2023

Forecasts are a guide only and actual outcomes could be significantly different.