U.S. Part 1- Are We Past the Bulk of U.S. Value Declines?U.S.Part1-AreWePasttheBulkofU.S.ValueDeclines?

That average masks substantial variation by property type, with office the notable outlier with an additional 18% of decline to go. All other major property types are in much better shape. We forecast industrial and apartment will decline by an additional 6% and 8%, respectively, as cap rates adjust to the current era of higher interest rates. By contrast, we estimate that some property types, including manufactured housing and senior housing, have already been fully repriced.

The most important assumption behind our value decline forecast is the Federal Reserve (Fed) signaling the end of rate hikes. A piece of corroborating evidence is the Fed staff’s new financial services conditions index¹, shown in Exhibit 2, which captures the combined effects of monetary policy, bank lending standards and other factors.

Right now, the Fed’s new index indicates their prior rate hikes continue to work through the financial system. It states financial conditions are now more restrictive than at any time since 2009, the peak of the Great Financial Crisis, with a drag on gross domestic product of roughly 50 basis points. The timing of the release of the new index coincides with their recent messaging that the rate increases since last year are working to slow inflation, and the lagged effects of prior interest rate hikes have mostly worked their way through property valuations.

That leaves us with another component of property values –income growth expectations. This is where we may be on shakier ground. Consensus has largely coalesced around a “soft landing” for the economy and, by extension, income growth in commercial real estate. That’s a plausible but by no means high confidence scenario. Notably, as shown in Exhibit 3, on the top chart, consumers have been spending down the savings they built up in the 2020-2021 period. It’s unclear how willing they will be to spend once those checking account balances shrink.

Coincident with the savings drawdowns, the moratorium on student debt repayments is coming to an end in October. This will leave many households that have spent down savings accumulated a couple of years ago with additional debt burdens. In particular, we are paying close attention to the metro areas in the upper right corner of the bottom graph in Exhibit 3, which have high concentrations of college graduates and 25-34 year olds, both of which have the highest propensity to carry student debt.

Despite these risks to the tenant demand outlook, labor markets remain supportive of a soft landing scenario. As shown in the left chart in Exhibit 4, 25-64 year olds are rapidly replacing older workers who may have left the labor force permanently. The former age group supports both residential and commercial leasing, whereas retirees may fuel leisure spending that supports hospitality and some retail formats. A recent increase in legal immigration, shown in the right chart, is also responsible for labor force growth, providing additional capacity for expansion at a time when unemployment is very low.

While risks remain tilted to the downside, the most likely path forward for property values is for only moderate declines over the next few quarters. That is an upgrade from our forecasts in May², as we now expect interest rates to have peaked and property incomes to gradually grow in an economic soft landing.

¹See https://www.federalreserve.gov/econres/notes/feds-notes/a-new-index-to-measure-us-financial-conditions-20230630.html for methodology.

²See https://www.pgim.com/real-estate/global-outlook.