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Despite falling demand from homebuyers, experts have maintained that the US real estate market is healthy.
But recent data on homebuilding highlights a dark storyline brewing.
Builders are feeling the pain of tanking demand and are slowing down new construction, fueling a vicious cycle.
For months economists and housing experts have maintained that the US housing market is in relatively good standing despite a decline in affordability and buyer demand.
While it's not the foreclosure crisis of 2008, today's real estate market also has a dark side.
It all stems from the fact that fewer and fewer Americans can afford to buy the limited homes available, especially as interest rates rise. Homebuilders are feeling the pain of tanking demand and are slowing down housing construction — contributing to the housing crisis vicious cycle.
Peter Schiff, the chief economist at investment company Euro Pacific, told his more than 800,000 Twitter followers that soon "new home construction will almost completely shut down."
"That's because it will be too expensive to build new homes that most buyers can actually afford," he said in a tweet. "The housing market will consist almost exclusively of existing homes that will sell for less than the cost to replace them."
Although dramatic, Schiff's pessimistic tweet may foreshadow what's to come in the real estate market.
In July, residential housing construction plummeted 9.6% to an annualized rate of 1.4 million units, according to the Census Bureau. The decline marked the slowest rate of home construction since February 2021 and highlights how rising costs are leading to less affordable housing options for Americans.
"Affordability is the greatest challenge facing the housing market," Robert Dietz, the chief economist at the National Association of Homebuilders said in a housing report. "Significant segments of the home buying population are priced out of the market."
Indeed, higher housing costs have dampened affordability for many Americans. Data from the US Census Bureau shows that an increasing number of people are falling behind on their rents.
Americans have a volatile economy to blame for surging housing prices. Inflation and interest rate hikes have increased the costs of everything from construction to mortgage lending. It has made it harder for builders to construct more low-cost homes and as a result, buyers' ability to afford home purchases. This has led to increased rental demand and ultimately higher rents across the nation — it has also created a downturn in the US real estate market.
With fewer people competing for homes, the real estate market is losing steam. In July, nationwide new home sales fell to a six-year low, declining to just 511,000 units. During the month, existing home sales — a measure of sales volume and prices of existing housing inventory — declined for the sixth consecutive month, falling to a two-year low as only 4.81 million units were sold.
In August, Diane Yentel, the president and CEO of the National Low Income Housing Coalition, testified in front of the US Senate Banking committee that the nation's housing ecosystem has taken a turn for the worse.
"Pre-pandemic millions of extremely low-income households — disproportionately people of color — struggled to remain housed and more than half a million people experienced homelessness," she said. "Now as resources are depleted and protections expire, low-income renters are faced with rising inflation, skyrocketing rents, and eviction filing rates are reaching or surpassing pre-pandemic averages."
As emerging data points to a possibility of a housing recession, Yentel is not alone in her concerns — more economists are giving warnings.
"The whole housing sector is now in retreat," Ian Shepherdson, the chief economist at Pantheon Macro, "told Forbes, adding that housing construction will likely continue falling until early 2023 — and that could mean the US housing affordability crisis is just getting started.
If you don’t like the weather in Chicago, wait a few minutes…it’s likely to change.
Another thing that is seeing a fair amount of change is the overall sentiment for CRE in Chicago. Last year’s DePaul Real Estate Center Mid-Year Report found that 60% of industry participants were generally optimistic about the industry as they looked ahead. But in 2022? The DePaul-ULI Chicago Report found that 65% are trending toward concern when looking at 2H2022.
Headwinds have gained steam locally, nationally, and internationally, as professionals are concerned about construction costs, labor issues, inflation, interest rates, and speculation of a recession. There’s also less confidence that related issues like crime and the effectiveness of the local political system can be resolved quickly or easily. But through it all, one asset class has remained largely untouchable. Industrial.
According to DePaul, Hugh Williams, Principal, MK Asset Brokerage, and Director of Entrepreneurship/Strategic Relationships for Sterling Bay, when asked about the health of the market, pointed to Prologis’ initial offer to acquire Duke Realty. Prologis was offering a premium, plus upside.
“When you see that, and with vacancies in the sub 4% range, it signals strength and optimism,” Williams said. “We are at one of the high water marks. No one knows if we are at the top, but over the recent long-term, the strength of the market has only gone in one direction, and new baselines have been established.”
That’s not to say the market is exempt from concerns, though. Even the strongest markets must remain creative and be willing to approach issues a little differently.
CRG President Shawn Clark noted that, on a recent project in Country Club Hills, the increasing cost of steel prompted CRG to purchase the necessary steel for the 1,033,450-square-foot building before they closed on the 70 acres of land, based on the report. But if the steel had been purchased as typical, the cost would have been more than double.
From the perspective of Molly McShane, CEO of The McShane Companies, “Going from just-in-time to just in case is a real strategy businesses are using, and it is driving demand. As long as that continues, the market is in a good place.”
So while it’s true that there are concerns about the remainder of 2022, 50.9% said they are bullish or optimistic about market conditions in 2023. And despite headwinds, there are investors who continue to believe in the future of Chicago. DePaul said while it may be based, in part, on a “right corner, right project” viewpoint, there remains an appeal about Chicagoland and a belief that all issues will soon be resolved.
The top investor concerns for the next 12 months are, not surprisingly, interest rates and inflation.
Despite the Federal Reserve increasing interest rates by 225 basis points in the last six months, 74 percent of investors indicated this is not affecting their investment plans.
The market is going through a recalibration with the rising cost of capital, but the survey numbers aren’t telegraphing a significant market change as investors continue to adapt their investment strategies.
The last 12 months through the second quarter of 2022 were by far, the most active CRE transaction year on record.
Interest rates are staying but there’s some welcome easing of commodity prices.
The Federal Reserve’s September Beige Book—more formally known as the “Summary of Commentary on Current Economic Conditions by Federal Reserve District”—is not going to make commercial real estate professionals jump for joy. But the bad news is already known and the good provides hope for some relief in construction.
First, the obvious bad, that inflation is still proceeding, as “price levels remained highly elevated.” That means don’t hope for an early cessation of interest rate hikes.
“Substantial price increases were reported across all Districts, particularly for food, rent, utilities, and hospitality services,” the report said, although nine of the Fed’s 12 districts “reported some degree of moderation in their rate of increase,” indicating that at least the rate at which inflation was increasing had slowed. That’s an important sign of eventually prices coming back under control. But that is still apparently some way off.
“The Fed still has an inflation problem and is committed to front-loading rate hikes as aggressively as possible,” Jeffrey Roach, Chief Economist for LPL Financial, said in an emailed statement. “The likelihood of a 75-basis point hike later this month could increase if next week’s inflation report surprises to the upside.”
Also, the Fed noted that parts of real estate continue to face challenges. “Despite some reports of strong leasing activity, residential real estate conditions weakened noticeably as home sales fell in all twelve Districts and residential construction remained constrained by input shortages,” the report said. “Commercial real estate activity softened, particularly demand for office space. Loan demand was mixed; while financial institutions reported generally strong demand for credit cards and commercial and industrial loans, residential loan demand was weak amid elevated mortgage interest rates.”
Among the districts that specifically mentioned real estate, Boston saw the outlook worsen, in Richmond activity was flat to moderately down, Atlanta had mixed commercial real estate activity, construction and real estate declined modestly in Chicago, and residential activity eased in San Francisco.
There was also some positive news in an important area: materials. “While manufacturing and construction input costs remained elevated, lower fuel prices and cooling overall demand alleviated cost pressures, especially freight shipping rates,” the report noted. “Several Districts reported some tapering in prices for steel, lumber, and copper.” But most contacts outside of the Federal Reserve system though price pressures would continue at least through the end of the year.
The slowdown in the otherwise red-hot housing boom has been stunningly swift.
The U.S. housing market surged during the pandemic as homebound people sought new places to live, boosted by record-low interest rates.
Now, real estate agents who once reported lines of buyers outside open houses and bidding wars on the back deck say homes are sitting longer and sellers are being forced to lower their sights.
That has both potential buyers and sellers wondering where they stand.
"As recession concerns weigh on consumer outlooks, our survey shows uncertainty has made its way into the minds of many buyers," said Danielle Hale, chief economist at Realtor.com.
Here are the major factors behind the topsy-turvy housing market.
Mortgage rates
The main driver of the slowdown is rising mortgage rates. The average rate on the 30-year fixed mortgage, which is by far the most popular product today, accounting for more than 90% of all mortgage applications, started this year right around 3%. It is now just above 6%, according to Mortgage News Daily.
That means a person buying a $400,000 home would have a monthly payment about $700 higher now than it would have been in January.
High prices, low supply
The other drivers of the slowdown are high prices and low supply.
Prices are now 43% higher than they were at the start of the coronavirus pandemic, according to the S&P Case-Shiller national home price index. The supply of homes for sale is growing, up 27% at the start of September compared with the same time a year ago, according to Realtor.com. While that comparison seems large, it's still not enough to offset the years-long shortage of homes for sale.
Active inventory is still 43% lower than it was in 2019. New listings were also down 6% at the end of September, meaning potential sellers are now concerned as they see more houses sit on the market longer.
Paul Legere is a buyer's agent with Joel Nelson Group in Washington, D.C. He focuses on the competitive Capitol Hill neighborhood, and he said he saw listings jump by 20 to 171 just after Labor Day. He now calls the market "bloated." As a comparison, just 65 homes were listed for sale in March.
"This is a very traditional post Labor Day inventory bump and seeing in a week or so how the market absorbs the new inventory is going to be very telling," he said. "Very."
Inventory is taking a hit nationally because homebuilders are slowing production due to fewer potential buyers touring their models. Housing starts for single-family homes dropped 18.5% in July compared with July 2021, according to the U.S. Census.
Homebuilder sentiment in the single-family market fell into negative territory in August for the first time since a brief dip at the start of the pandemic, according to the National Association of Home Builders. Builders reported lower sales and weaker buyer traffic.
"Tighter monetary policy from the Federal Reserve and persistently elevated construction costs have brought on a housing recession," said NAHB Chief Economist Robert Dietz in the August report.
Some buyers are hanging in
Buyers, however, have not disappeared entirely, despite the still-pricey for-sale market and the equally expensive rental market.
"Data indicates that some home shoppers are finding silver linings in the form of cooling competition for rising numbers of for-sale home option," said Realtor.com's Hale. "Especially for buyers who are getting creative, such as by exploring smaller markets, this fall could bring relatively better chances to find a home within budget."
Home prices are finally starting to cool off. They declined 0.77% from June to July, the first monthly fall in nearly three years, according to Black Knight, a mortgage technology and data provider.
While the drop may seem small, it is the largest single-month decline in prices since January 2011. It is also the second-worst July performance dating back to 1991, behind the 0.9% decline in July 2010, during the Great Recession.
Affordability woes
Still, that drop in prices will do very little to improve the affordability crisis brought on by rising mortgage rates. While rates fell back slightly in August, they have risen sharply again this week, making for the least affordable week in housing in 35 years.
It currently takes 35.51% of median income to make the monthly principal and interest payment on the median home with a 30-year mortgage and 20% down. That's up marginally from the prior 35-year high back in June, when the payment-to-income ratio reached 35.49%, according to Andy Walden, vice president of enterprise research and strategy at Black Knight.
In the five years before interest rates began to rise, that income-to-payment ratio held steady around 20%. Even though home prices surged in the 2020 and 2021, record-low interest rates offset the increases.
"Given the large role affordability challenges appear to be playing in shifting housing market dynamics, the recent pullback in home prices is likely to continue," Walden said.
A new report from real estate brokerage Redfin showed that while homebuyer demand woke up a bit in August, the latest increase in mortgage rates over the past week put it right back to sleep. Fewer people searched for "homes for sale" on Google with searches during the week ending Sept. 3 – down 25% from a year earlier, according to the report.
Redfin's demand index, which measures requests for home tours and other home-buying services from Redfin agents, showed that during the seven days ending Sept. 4, demand was up 18% from the 2022 low in June, but still down 11% year over year.
"The housing market always cools down this time of year," said Daryl Fairweather, Redfin's chief economist, "but this year I expect fall and winter to be especially frigid as sales dry up more than usual."
At a moment marked by inflation, slowing growth and recession fears, CRE asset categories that offer long-term potential for reliable returns are in the spotlight. Those most often cited by experts reflect a wide range, from steady perennial performers to vibrant, cutting-edge specialties. A connecting thread among these diverse examples: long-term demographic and economic trends that can withstand shorter-term shifts in conditions.
Retail stalwart
Grocery-anchored centers remain the retail category that is least impacted by online shopping. At midyear, online grocery sales accounted for 13.6 percent of the total grocery market, according to the latest Brick Meets Click/Mercatus Grocery Shopping Survey. That’s up 1.5 percent year-over-year, a sign of gradual growth, but the modest share of online sales points to robust demand for brick-and-mortar grocery stores.
A principal reason is that shoppers still like seeing and touching perishable items before purchase. And grocery visits drive customer traffic at adjacent inline retailers and service businesses, such as liquor stores, dry cleaners and nail salons and similar.
Such national grocery chains as Trader Joe’s, Whole Foods, Aldi, Harris Teeter and Stop & Shop make particularly effective anchors, said Mitch Rosen, managing director & head of real estate for YieldStreet. “These grocers appeal to a more affluent consumer base,” he said. “Look at where pricing has gone in that sector; it remains very strong.”
Life science leaders
Robust growth of a wide range of health-care-affiliated scientific advances, together with the aging of the population, demographic trends, favor life science as a safe ground-up development or conversion play. Despite an 18.5 percent year-over-year decline, venture capital investment totaled $20.8 billion during the first half, according to a report from Newmark. In the four leading hubs alone—Boston, San Francisco, San Diego and Raleigh-Durham—the renovation and construction pipeline totals 33.2 million square feet.
Investors have multiple geographic and investment category options as the demand for space continues unabated and markets of all sizes vie to participate. Ground-up development, expansion and adaptive reuse are all on the menu for R&D and manufacturing facilities, as well as for office support space.
“We are seeing tremendous interest from early and mid-stage life science companies doing small-batch manufacturing . . . that don’t need enormous factories,” said Aaron Jodka, Colliers national director of capital markets research. The three dominant hubs offer diverse opportunities and distinctive characteristics for makeovers. Greater Boston often favors conversions of older properties with good bones, while in San Diego and the San Francisco Bay Area, one-story, 1980s-vintage buildings are frequently eyed for makeovers, he added.
Industrial potential
Multiple indicators speak to the staying power of industrial assets, even in a downturn. At midyear, vacancy stood at 4.7 percent nationwide, a 120 basis-point year-over-year decline, according to CommercialEdge data. Although the general conditions that have made the sector an investor magnet are well known, the factors that shape prudent industrial investment deserve a nuanced examination.
“We rank industrial as offering a moderate hedge against inflationary effects,” said Ian Formigle, chief investment officer at CrowdStreet. Providing that hedge are typical lease terms of five to 10 years, and when tenants also assume operating costs like insurance, property taxes and maintenance in triple net leases, that helps insulate operators from inflation.
Decades of underbuilding is an often underappreciated factor in the sector’s current appeal. Until the middle of the last decade, Class A urban infill industrial properties were typically 1970s-era structures, noted Aaron Appel, co-head of New York capital markets for Walker & Dunlop. A mismatch between project costs and rents hampered development for years. That started to change only when demand finally enabled projects to pencil out.
“Tenants said, ‘I can pay 25 to 75 percent more than I have, and my business will benefit from a brand-new building,’” Appel recalled. “That building may have more bays, higher ceilings, fewer columns or allow simpler egress.” The pandemic and the closely related rise of ecommerce have further advanced the trend since early 2020.
Growth factors
Moreover, newly built Class A facilities provide efficiencies that permit manufacturing closer to the final distribution of goods. That trims transportation costs and reduces the risk of supply chain disruption. Chris McKee, principal and chief development officer for development firm CRG, identifies distinct regional factors that may offer hedges against an economic slowdown. The Sun Belt offers population growth; the Midwest has an abundance of skilled labor, lower living costs and stable economies; and in the Northeast, the limited supply of sites and long entitlement periods generate high demand for new product.
Acquiring and developing infill logistics properties near population centers is a common but still-reliable strategy. Dwight Angelini, co-founder & managing partner at Longpoint Realty Partners, names geographically diverse locations—northern New Jersey, Los Angeles, Dallas and Miami—as offering the greatest imbalance between warehouse supply and demand. “The challenge and opportunity is (that) these top-tier infill markets are inherently supply-constrained due to … challenges associated with sourcing, acquiring and developing” industrial product, he said.
Some experts favor advanced logistics and distribution facilities in markets with expanding populations. They cite the well-known trends of e-commerce expansion and reshoring manufacturing. Arizona Land Consulting is buying land in the western Phoenix suburb of Buckeye, Ariz. Its clients like the market’s comparative proximity to the Ports of Los Angeles and Long Beach, about four and a half hours away, reported the firm’s CEO, Anita Verma-Lallian.
Coastal markets where port authorities are investing in robust upgrades are sometimes overlooked indicators of long-term potential. East Coast ports are attracting increased container volume following much-discussed bottlenecks on the West Coast, noted Stephen Evans managing director at Black Salmon.
One example is the Port of Mobile, noted James Huang, president of eXp Commercial, eXp World Holdings. The port is engaged in a $368 million project that will deepen its channels 50 feet. When work is complete in 2025, the port will better serve Birmingham’s emerging distribution some 250 miles to the north.
Even in areas whose industrial markets are thriving overall, some categories may be underbuilt and offer superior safety. Such is the case in Contra Costa County, Calif., where the focus has been on larger, order-fulfillment warehouses at the expense of smaller, multi-tenant buildings. Combined with development costs 20 percent higher than will pencil out in the area, that is a formula for a low volume of new multi-tenant product.
“One can forecast that with little new supply and strong demand, rents will continue to climb for smaller-sized units in industrial buildings,” said Eric Rehn, vice president at Kennedy Wilson Properties.
Future snapshot
Growing construction costs may lead investment to thin out in coming months. “Rents have continued to rise to offset increased costs,” CRG’s McKee said of the industrial sector. “If that stops, we’ll see a significant downward pressure on construction starts. For now, we can’t build fast enough to meet the demand.”
The widespread bid-ask gap stemming from rising interest rates will be brought into alignment during the next few quarters. For many asset classes, that adjustment will occur in the next half year, but it will “take longer on CBD office buildings and convention center hotels as we adjust behaviors” in a post-COVID world, predicted Terranova chairman & CEO Stephen Bittel.
Jodka says his firm is seeing gaps between buyers and sellers, price adjustments due to higher borrowing costs and deals slowing down. “A slowdown is not unexpected, [nor is] a resumption early next year when interest rates have settled and buyers can more confidently underwrite borrowing costs.”
Private real estate is often an attractive investment option for investors seeking tax efficiency. It creates some opportunities for tax deductions, but investors can also defer capital gains taxes on the sale of an investment property by engaging in a 1031 exchange. Doing so allows you to reinvest your entire sales proceeds into a new replacement property and creates the ability to “buy up,” purchasing a new property of higher value or better quality.
Since there are no limits to the number of times you can engage in a 1031 exchange, it’s possible to repeatedly roll your gains into upgraded property holdings, continually deferring capital gains taxes, and potentially growing your wealth through additional capital appreciation.
Engaging in a “Like-Kind Exchange”
The rules for a 1031 exchange are defined under Section 1031 of the U.S. Tax Code. A 1031 exchange allows investment property owners to defer their capital gains taxes on a property sale by purchasing a “like-kind” replacement property. However, the definition of a “like-kind” property is far broader than you may think.
The IRS defines like-kind properties based on the "nature or character" of the property rather than on the "grade or quality.” Therefore, virtually any real estate property is considered “like-kind” to any other piece of real estate property.
This means that you could exchange a single-family rental home for an industrial warehouse, a piece of raw land for a shopping complex, and so on. Since this definition provides significant leeway, it can also create opportunities for additional portfolio diversification across various property types.
Working with a Qualified Intermediary
To protect the preferential tax treatment provided by a 1031 exchange, it’s imperative to work with a Qualified Intermediary (QI) from the very beginning of the exchange process. A QI is an independent, disinterested third party, that is a person, company, or entity that facilitates a 1031 exchange. During a 1031 exchange, a taxpayer cannot ever receive proceeds from the sale of the relinquished property. Therefore, when engaging in an exchange, the QI must perform the transaction.
In this scenario, the QI acquires the property from the taxpayer, transfers it to the buyer, and holds the sales proceeds. Then, when the taxpayer is ready to purchase the replacement property, the QI uses the funds to acquire the property from the seller and transfers it to the taxpayer.
1031 Exchange Timelines
In addition to working with an approved QI, investors must also meet specific time restrictions, known as the 45-day and the 180-day deadlines.
The 45-day deadline requires you to identify your potential replacement property or properties within 45 calendar days from the day you sell your relinquished property. This identification must be in writing and submitted to your QI. You can typically identify up to three properties. In some cases, you may be able to identify more as long as they fall within specific valuation tests.
The 180-day deadline requires you to close on one or more of the identified properties by the 180th day after you closed on the relinquished property. These two timelines run concurrently, so it’s important to note that if you take the full 45-days to identify your property, you’ll only have an additional 135 days to close.
Tax-Efficient Real Estate Investing
To learn more about the potential tax advantages offered by private real estate investments, download our complimentary ebook, “Tax Advantaged Investing: The Power of Private Real Estate.” Inside, you’ll find information about tax-advantaged income potential, Qualified Opportunity Funds, estate planning using 1031 exchanges, and more.
