Deep Dive
Shownotes Transcript
Welcome to Inside Economics. I'm Mark Sandy, the Chief Economist of Moody's Analytics. I'm joined by my two trusty co-hosts, Marissa DiNatale and Chris Dridis. Hi, guys. Hi, Mark. How are things? Yeah, doing all right. You hanging? Hanging in there. You too, Marissa? You're hanging? Yeah, I was a little sick at the beginning of the week, but I'm taking a recovery. You doing okay? A little cough still, but yeah, I'm fine. Just a bad cold. That's what you get for...
paddling in the Pacific Ocean on a regular basis. Oh, big news there. Really? What's the news? Marissa has a new hobby. I am not paddling in the Pacific Ocean this season. I am taking a break. I have taken up pickleball.
Oh my goodness. Are you like a phenom in the pickleball world? Not at all. I am horrible. Oh, don't be modest. No, I am really bad. I've never won a game. And usually the score is like 11 to 1, 11 to 2, 11 to 3, 11 to nothing.
Yeah, I'm just starting out. So I'm just, I'm learning, but I have a friend we try to play once or twice a week and we just play singles right now because I'm not fit for public consumption to play with other people. But yeah, so I'm learning, but it's so fun. Can I ask why you are taking a break from the Pacific Ocean and decided to do pickleball? It's, yes, sure. Because I've been doing it for seven years now.
Every year for seven years, six months out of the year. It's every single Saturday morning getting up at five o'clock to either practice for three hours or drive to a race. It's just really very onerous for something that is a hobby. So I just need I just need a break from it both mentally and physically. Got it. Got it.
Makes sense. I think Chris did that once with his bocce ball. He was getting bocce elbow. You got to be careful. Bocce elbow. Yeah, exactly. That was a therapeutic year off, wasn't it for you, Chris? Absolutely. Came back and were powerhouse. I'm on top. Okay.
Talking about a powerhouse. Did you know we won a major, at least I think it's major in our world, forecast accuracy award? Did you know this? Yeah. Big news. Yeah. I heard a rumor. Yeah. Oh, you heard a rumor. Yeah. Marissa, you want to tell us like what happened here? Yeah. I hope it's true because I reposted it on LinkedIn. Yeah.
We won for the United States and three other countries, but the US is the big deal. Most accurate forecast over the last two years for US GDP and CPI from consensus economic forecasting. So we submit, there's a bunch of private sector forecasters, right? Submit their forecasts every month.
And consensus tracks those forecasts for accuracy over the years. And we just won for 2024. But really, it's over a 24-month period. So...
That's a really big deal. I think the last, Chris said the last time we won for the US was 2018. That's right. So it's a GDP and inflation. That's right. Over a kind of a rolling two year period. So that would be 23 and 24, I guess.
Right. And the previous time we won would be, I guess, 2017 and 2018 pre-pandemic. Yeah. So it went from January 23 through December of 24 over that period. Got it. Got it. Got it. Well, Chris, do you think that's a big deal? That's a big deal. It is? Yeah. Yeah. It's an award. You know, aren't all awards? Yeah. We take them, right? Yeah. Absolutely. Yeah. Yeah.
You know, why do you think we won in 23-24? What's behind the win, do you think? I've got a few ideas, but I'm just curious what you think was behind it. Skill. Skill. Insight. Intelligence. I thought you were going to say the chief economist. Charm. Who refused to put a recession in the forecast. No? Of course. Of course. There's also luck. There's luck. Totally. Totally. Yeah. Yeah.
i mean i think though the reason 23 24 that was obviously a period when most economists were saying recession right you know which would be consistent with historical experience in the sense that you know we had this high the period of high inflation in 21 22 the fed started jacking up interest rates aggressively raised rates in 2022 going to 23 the yield curve inverted
And if history was any reasonable guide, I would say recession. And most economists said recession and put it into their forecast. We did not do that. You can go back and listen to the podcast in that period and get your fair dose of reasoning as to why we didn't. But-
Most fundamentally, I'm guessing, I don't know, but I'm guessing that's why we won, right? You can see, actually, they have a cool chart on their website that shows us, you, us, our forecast for GDP tracked against all the other forecasters and...
That's true. We're significantly above kind of everybody else, particularly in 2023. Oh, interesting. And into 2024. So it was kind of like we were always up here and then everyone sort of rose, came up to match us by the end of 2024 because they were all...
Like the average growth rate as of like July of 23 for GDP that other people were predicting was 0.5% year over year. And we were at above one, you know, so we were double that.
Oh, interesting. I have to go take a look at that. I didn't look at that. Yeah.
That, you know, we have a, I sound a little bit like an advertisement, and I guess it is, a process which, oh, I should mention we have a guest coming up here shortly, Richard Barkham of CBRE, the large commercial real estate firm. We'll talk a little bit more about this in that conversation, but-
We have a process where we have to be – if we're making any major changes to kind of our underlying assumption or forecast, we have to be highly confident in that. And so it reduces the odds that we get what I call whipsawed in terms of the forecasting, which was in that period certainly very easy to do. So that process – and we've got a great team of folks. Obviously, we've got economists –
focused on all the different aspects of the forecast and Scott Hoyt does consumer, Mike Brisson does auto. We've got Martin Worm doing monetary policy. We've got Justin and Brendan doing fiscal. I can go on and on and on. They're really focused on their sector. So I think that really helps as well. But Chris, I think you just said this. I think a big dose of this
is just luck, don't you think? - There is some luck, certainly. Because of the policies and there are other aspects of the forecast that go beyond the data itself, right? - Right. Well, I was gonna say, the one thing that I think allowed us to get through without a recession, or one big thing that allowed us to get through that period, '23, '24, without a recession, despite the run-up in rates,
was actually the surge in immigration. You know, the surge in immigration, you know, it had all kinds, I've said this many times in the past, has all kinds of costs, you know, economic and as we can see political costs.
But the one benefit was it added a lot to labor supply when the labor market was very tight and the Fed was jacking up rates in an effort to cool things off. And because of all that immigration and all that labor supply, it allowed the Fed to forestall even more aggressive rate hikes. And that was probably a key reason why we kind of navigated through without actually experiencing an economic downturn.
And we did not, nor did anyone, expect the kind of immigration that we got. You know, the number of people that came across the southern border, I think I'm making this up, but I think it's right, in 2023 was huge.
like 3 million people. Typically we get a million immigrants, legally illegal. We were, we got 3 million plus and it's came in on in 2024, you know, president Biden passed an executive order making it more difficult for asylum seekers. And that brought things down, but still even in 2024, you know, uh, we had a high level of immigration and that really helped, um, and allowed us to kind of navigate through without that downturn. And again, uh,
That's not something we predicted. We didn't expect that, but that's what happened. Does that resonate, Marissa? Yes, absolutely. I mean, that certainly changed the game in the labor market, right? I mean, it's a reason why we saw job growth as high as it was and had this sort of seemingly endless supply of labor for employers to draw from. And now we're on the backside of that and we're seeing...
what awaits us for the future with much lower levels of immigration. But yeah, I mean, it certainly helped. Right, right. Helped with wage pressure, right? So that went right into inflation as well. Right, right. And then, you know, of course, the chief economist had a lot to do with this. You know, I just have to say, no? He did. Of course, of course. Yeah.
As well as the rest of the team. Yeah, great team, rest of the team. Okay, any more else on that win, that award that we won? Any other comments on that? Chris, anything else? Yeah, I think it's a great achievement, but the luck is part of it. And I would emphasize, of course, I think it's the process and the scenarios. I always love the scenarios, right? Really add a lot of the value. And unfortunately, I don't know that we...
uh evaluate scenarios uh to a great degree but i think around a time like this i don't know how else you operate unless you have scenarios i mean goodness gracious i mean the world the future revolves around the tariffs you know how high how long which countries what's the retaliation good luck with that one talk about luck whoever wins the forecast award for 2025 that's going to be
What? Just 90% luck getting that right. Unless it's us again. Unless it's us again. Yeah. Then it's 50% luck and 50% economic forecasting acumen. Yeah, exactly. Exactly. Anyway, okay. Well, anything before we bring Richard into the conversation, guys? Any other issues, topics that we want to talk about? No? Marissa? I don't think so. Okay. Well, let's bring Richard Barkham into the conversation.
Well, good to see you, Richard. Good to see you, Mark. And I'm looking forward to being interviewed by somebody more nerdy than I am. Is that a possibility? More nerdy than you are? Yeah. I mean, your degree of enthusiasm for data is right up there. Are you excited about next week's data, Richard? Moderately. Moderately. Yeah. There are other things in my life as well. Right. Right.
Congratulations. Congratulations. Richard, Senior Economic Advisor at CBRE and formerly Chief Economist of CBRE, which one of the largest. Are you the largest? We're the world's largest real estate services company. And, you know, I think about Fortune 120, something like that. And, you know, we provide brokerage, property management, insurance.
um, uh, uh, fund management. If there's any service that, that occupies an investor's need in commercial real estate, it's kind of what we do. And CBRE, uh,
It used to be an acronym for something, right? Do you remember what it is? Yes, I do. The CB is Caldwell Banker. Caldwell Banker, right. Which is an American brokerage company originated in the early 20th century in San Francisco. And the RE is Richard Ellis, which is also what we would call a chartered surveying or a property consultancy company that goes back to the mid-18th century.
So it's quite a venerable corporate identity, I would say. And how long have you been at CBRE, Richard? Maybe you can just give us, I'll just open it in a question, very curious about your career and how...
it progressed and how you got to be chief economist and senior economic advisor. How did that happen? Well, I mean, I've been with CBRE for 11 years. I joined as chief economist in 2014. And in 2017, I moved to the United States and I became global head of research. And the CBRE research team is six or 700 people strong. So I was managing a big department.
But prior to that, I mean, I started my career as an academic. I did a PhD in economics at the University of Reading in the UK. Actually, my PhD was entrepreneurship and new business creation. But I was teaching real estate economics to make a living as a graduate student. And I became more interested in that. So I transitioned into lecturing in real estate finance and economics and
And I transitioned from that into providing consulting services, you know, on a part-time basis to, you know, what was then the booming London market.
And by my mid-30s, I'd got fed up of my students going to higher paid jobs than I actually had as a professor. And so I moved into the private sector and I went to work for a fascinating company, a big private real estate company called Grosvenor.
Oh, sure. Which is the private property company of the Dukes of Westminster. The core holdings are Mayfair and Belgravia. That company's got a 300-year history.
And I had a very happy 14 years as chief strategist, chief economist, and latterly as a director of their fund management business. So always, you know, practicing real estate economics. And as I say, in 2014, CBRE asked me to become their chief economist.
And that's probably in real estate economics the biggest job in the world. So, you know, I took that up. It's a very large team. How many folks kind of in your world across the globe? Because you're across the globe. Yeah. I mean, as I say, the whole research team. Yeah.
It varies over the cycle, but, you know, anywhere between 600 and 700. Oh, my gosh. I didn't realize. Including, you know, probably 20 professional economists. Wow. In and amongst that. And, you know, a fair smattering of PhD qualified economists as well. Right. You've got a full global...
We're not macroeconomists by specialization, but we've got plenty of expertise in macroeconomics and we translate that into real estate forecasts around the world. Well, I think your accent may have served you very well in your job. It's kind of like a James Bond-ish kind of accent. Would you agree?
Well, I mean, you know, that's for you to say and me to continue to enunciate, I guess. You'll take it, though. James Bond, how can you not take that? I'd run with it. I'll take it. Yeah, I'll run with it. Absolutely. And it's served me well in the United States anyway. Absolutely. Where in the UK are you from? Where's that accent from?
Well, is it London? I come from the south of England, but I lived for 30 years in Oxford. Oxford. There is a sort of Oxford English. I'm not certain mine is quite that, but I would say I have a...
A neutralish accent by British regional standards. People can't pinpoint where you're from. No, that's right. Matter of fact and classes. Definitely James Bond-ish in my view. Well, it's good to have you. And I thought we could just start kind of with the broader, let's call it macroeconomic picture, just to get your sense of the lay of the land. How are you? It feels like the world has changed a lot in the last,
few months, few weeks. Days. Yeah, exactly. How are you thinking about things? How pessimistic or not are you? Well, I'm fond of saying to folks, when I joined CBRE in 2014, I used to refresh my deck with new ideas every quarter. Then during COVID, we moved to sort of refreshing the deck every month.
And now I almost, when I'm speaking, I have to have my analyst refreshing my deck in real time, you know, in order to stay current with what's going on. It's changing so rapidly. But, you know...
Just getting down to the kind of basics of the economy, I don't sense, I mean, there's a lot of noise out there, but I don't think we're in recession yet. All of the kind of real-time indicators are holding up reasonably well. You know, consumer spending, it's more difficult to get a read on business spending.
But the high frequency data that we got used to using during COVID, such as pass-through airports, which is quite sensitive to economic conditions, seems to be holding up. There's been a little bit of a dip in eating out. But I think we're not in a recession yet.
But as I think you've clearly observed and most people observed that the confidence indicators have dropped like a stone. So for all that we're not in a recession, if the uncertainty doesn't ease,
and we have the full impact of tariffs feeding through into prices in the May-June period, then we're looking at a much slower second half than we had thought at the start of the year. Maybe not a recession, maybe something closer to stagnation, but definitely a slowdown in GDP in the second half. If the uncertainty doesn't ease and the uncertainty
the effective tariff rate doesn't drop through negotiation. So Richard, kind of a popular way of economists communicating kind of their perspective on the world and where we're headed is what probability would you attach to a recession starting at some point, let's say this year? And let's just focus on the U.S. because obviously there's a lot of things going on overseas as well, but just on the U.S.,
Do you have a probability in mind? Yes, and it's been moving up over the last month or so. I probably think 50-50. 50-50. In the second half, yeah. I think we can still get out of this situation without a recession. But clearly, that's contingent on progress being made in trade deliberations and then that feeding through into a lower level of...
some, some, some highest, it's a better sentiment numbers with, with possibly also some cuts to interest rates. Hey, Chris, which are possible. I think that, you know, they're, they are possible. And, you know, we could, could get out of it, but could get out of it. So 50, 50 Chris, where are you on the probability of recession? Might as well do that right up front since we're talking about it. All right. I'm just curious. What was it before last time we chatted? And what is it now?
It was 50-50 and you booed me. Boo. Exactly. I don't do that to the guests. I noticed. I noticed. It's very kind of you. Yeah. Yeah. But I bumped it up now to 55. 55. Oh, why did you move it up? Things are not going well on the trade negotiation front, at least from my perspective. Who knows the reality, but.
There's a lot of discussion that maybe there's some kind of resolution or deal or cut the tariffs, but so far that's just off. And then it gets immediately reversed. Yeah, right. And I also fear that even if we get a deal, it's going to be a substantial increase in the tariff, right? I don't see any deal that's taking us back to where we were, certainly. Right. Well, some of this may be already baked in.
there's some price increases and some disruption to supply you know shortages are coming regardless of what happens here yeah hey marissa what about you i'm sticking at 60. 60. yeah i i you know as of yesterday maybe would have moved it down when i saw or two days ago when i saw the news that perhaps chinese tariffs were coming down but today the news is that that isn't happening and there is no negotiation going on so
I'm just sticking with 60. And we're also seeing data now, right, on shipping and pricing and stuff like that that does not look good. Does not look good, yeah. I'm at 60 as well, and that's where I've been, 60. Hey, Richard, let me ask you, this may be a little unfair, but I'm just curious, kind of a forecast philosophy question. I'll let you know how we approach this, and I'm just curious what you think. So, yeah.
In our base our baseline forecast currently for the US economy does not have a recession built into it you know we are
assuming that the administration takes an off ramp here on the tariffs, you know, soon in the next week, two or three, four maybe, and deescalates the trade war. And to your point, you know, we haven't really seen anything show up, certainly not in the labor market. We can make our way through. But you could just heard me just say, and Marisa and Chris, all of us are above a 50% probability in terms of a recession.
So, you know, our philosophy has been that if we're going to make a major change in our forecast, and I would say adopting a recession is a major change, and major change in any assumption, monetary policy, fiscal policy, whatever it may be, we have to be very confident in that change.
because we don't want to get whipsawed back and forth. We've got clients like you, we don't want to get whipsawed. So our subjective probability for making a change is two-thirds. If we feel like a recession has a greater than two-third probability, we will adopt a recession forecast. Does that make sense to you? Does that resonate with you? How would you think about that?
Yes, it does. I mean, you know, I like the high bar that you set for adopting a recession. I mean, I think sort of theoretically, you know, if you had a set of outcomes and your probability weighted them, then, you know, you probably ought to be moving to a recession call if you're anywhere above 50% on the likelihood of a recession. You know, so you might be part of a
consensus that you know is even now refusing to actually articulate what what is actually you know what is actually happening because you know you want to be you don't want to be calling wolf or or um you know calling sort of seven out of the last four recessions right i think sort of you know intellectually um if you're above 50 likelihood of a recession um depending on what your sort of tail um
scenarios are, you probably ought to be moving to that as a central case. Right. Yeah, I guess we actually do a pen to paper, produce a forecast across everything that we do once a month around the globe, regionally, so forth and so on. And we do it right after the GDP number comes out. So next week, as I said, we get GDP. So we'll be doing the forecast again and we'll have to rethink all this. But at this point,
we would still hold to a non-recessionary baseline because we still aren't, especially in the current context, because the level of uncertainty is so high because it's so dependent on
what the president decides to do or not do on the tariffs, right? Yes, but not just that, but also the spending bill. I mean, I think we've got to factor in potentially stimulus coming through later on in the year through the spending bill. And, you know, combined with maybe not a complete...
uh wind down of the trade war but uh you know a move to a kind of sort of more medium term um tough position but you know negotiable position then i think we might be able to get get through it i think that's what i'm thinking and you know to a certain extent we'll get to this in a moment or two um yeah i talked to my team yesterday um
You know, I'm shocked really by how strong some of the consumer related real estate data is. You know, for instance, you know, Q4 multifamily net absorption and Q1 multifamily net absorption are just astonishingly strong.
So, you know, that speaks to me. Real estate data is lagged and it's not, you know, it reflects conditions, but you just don't get that sort of real estate data unless you've got some real robust kind of consumer sentiment and fundamentals, you know, wealth and income effects.
which we underestimated, I think, in 2024. I think it might give us the momentum to see us through some of the negative headlines. Right. So what you're saying is the data, you said multifamily, and did you also say retail? No, I said multifamily. You said multifamily. Multifamily. Well, I think multifamily...
Q4 was possibly one of the strongest absorptions on record. And in Q1, I think for the first time since 2001, every market in the country showed positive net absorption in apartments.
And, you know, that's just that's tells me something that, you know, about the continued resilience of the consumer. And, you know, I'm kind of using that to weight my thoughts on where the macroeconomy goes. Yeah.
Yeah, just to push back a little bit, of course, that's in the rearview mirror. I guess you said that. Sure, the real estate data is always lagged. Yeah. But it was only two months ago, and I don't –
You're saying it doesn't change that quickly, things like that. Yeah. I don't think so. You know, some of these relationships, you know, as well as I do, you know, you've got leads and lags within kind of all of these indicators and their time varying as well. So, you know, the lags that applied three years ago are not the same lags that apply now. So you've got to apply a little bit of judgment to it. But yeah,
Conditions in apartment markets are very robust. And that tells me something about where the consumer is actually at.
Well, let's turn to the property markets, the commercial real estate markets, and maybe you can look at it through the prism of the macro. You know, we've got all the trade war. It's already affecting, as Marissa pointed out, trade flows. I mean, the tariffs that the U.S. has imposed on China and the counter tariffs the Chinese have imposed on the U.S. have really, it does look like, if you look at all the shipping data, it's really doing some damage to
to trade. And it is hurt confidence and sentiment. It hurts. It looks like it's hurt travel, you know, certainly foreign travelers coming into the United States from that prism, you know, what property types, what regions should I think people be most, do you think people should be most nervous about? Do you have a higher level of concern of some areas and some property types as a result of all that?
Slightly, yes. I mean, I think if we were to... I mean, I remember that trade is only 15% of GDP and goods are only 36% of consumer spending. So, you know, let's not entirely view the US economy through the lens of trade because it's a big kind of standalone economy. However, let's...
The property types, the four major property types, office, industrial, retail and residential. I mean, I think the two property types that are most exposed to the trade tensions would be the industrial sector and also the retail sector. And I think the industrial sector, and I'm not talking about...
manufacturing here. I'm talking about industrial logistics. The majority of what we call industrial is kind of logistics and warehousing and that kind of housing, you know, big hub, um, warehousing or kind of last mile warehousing. Um,
That had been slowing up, I think, even before trade tensions emerged. We've still got a fairly decent level of gross leasing, but a fairly weak level of net absorption, if I can make that distinction. Is that because people are giving back space? Yeah, that's right. I mean, I think...
You know, you've got really if people are leasing more space than they're giving up on aggregate, then you've got positive net absorption and generally speaking, coming down. Yes, I think people were, you know, we had a sense, I think, and I was hearing it from around the world that the industrial users maybe had overexpanded during the COVID era and that, you know, trade was kind of normalizing into a kind of post pandemic phase and
And, you know, whilst industrial users or logistics operators were leasing new space, they were giving up old space. And I think so there had been a little bit of a slowdown in industrial leasing. And I think industrial leasing is probably...
the sector of one of the, one of the sectors of the market where occupiers have become a bit more cautious. So, you know, I suppose particularly around ports, right. I would guess around LA long beach. Well, not, not necessarily. I mean, you know, there was a pull of inventory in to try and escape the,
tariffs. So, you know, actually the ports have probably experienced some reasonably buoyant conditions due to sort of inventory coming in. But yes, you would think that... Dead ahead. Yeah, dead ahead. I'm hearing that kind of Southern California industrial is pretty much ground to a halt now in terms of new leasing. So I think the industrial sector, you know, was...
It was doing okay, but it contracted a little bit on 2024. And that's obviously exposed. And of course, the retail sector. Now, the retail sector, oddly enough, given all of the negative headlines about retail since e-commerce really started booming in 2015, 2016, retail has actually been very solid in terms of fundamentals. The retail sector at the moment has got the lowest vacancy rate.
with vacancy at about 4.5%. You know, so we haven't built much retail space for about the last 15 years. And grade A space is in extremely short supply for retailers. But I'm beginning to think that, you know, retailers, well, I'm beginning to hear that retailers are becoming very cautious on new leasing.
And we may see an uptick in retail vacancy from a pretty strong position of about four. I don't know what it will go to. We haven't quite put our forecast in. 4.5% is extremely low vacancy there.
Industrials closer to 7%, just for comparison. But I think the momentum of leasing activity in those two sectors is slowing up quite quickly and would be expected to stay slow during this period of trade tension. You didn't mention hotels and kind of leisure hospitality. I would think that would also be quite vulnerable here, no? No.
I mean, I think potentially, yes. But, you know, for the last several years, I think Americans really have been going overseas. So, you know, the kind of there hasn't been a huge insurge, you know, because the dollar has been so high on U.S. hotels. Yeah.
And, you know, I don't know that they're going to particularly suffer. I mean, we are hearing that kind of Canadians are staying at home and not coming to the States. But I think, you know, the sector...
I don't think has been pumped up by kind of, you know, it's got used to dealing with that foreign tourists going, going back to COVID when the Chinese stopped coming into the West coast. Um, you know, I think, uh,
I think that the hotel sector is reasonably okay, actually. It doesn't have a big supply, you know, because of the expansion of, you know, short lease market, Airbnb, so on and so forth. There hasn't been a lot of new hotel construction. Well, I have to say you sound just to my ear kind of sanguine. I mean, yes, there's risks. Yeah. You know, there's going to be some pressure coming from all the, you know,
the, all the trade war and everything else, but generally saying, what would it take? Did I get that right? And so what would it take for you to seek in the property markets to make you feel, change your mind that, oh, maybe this is going to be darker than I thought?
Well, Sanguine, yes. I mean, when I talk to my team on the ground, you know, I still get the impression that real estate fundamentals are in pretty good shape. I mean, the press has covered offices everywhere.
you know, quite extensively over the last four or five years. And there we have actually had a vacancy rise from 12% to 19%. So that has been a big hit to office fundamentals. Although I'll have to say that, you know, office demand has come back quite nicely over the last year.
But if you think that office is 25% of overall retail and, you know, vacancy rates are at about their long run average, you know, the majority of real estate is quite healthily producing income. You know, 95% of real estate is income.
We've seen with the rise in interest rates that happened in 2022, values have fallen 25%. But the majority of US real estate
is generating positive net operating income and is in, I would say, robust good health. So, you know, if I sound sanguine, it's because, you know, that's the reality. Whatever you read in the press, that's the reality. US real estate is in actually good shape. But of course, you know, real estate, you know, is a derived demand. It feeds...
With lags, it's going to be dependent on the macro economy. And there's a pretty close relationship between real estate vacancy and unemployment rate. So if we see unemployment rising as a result of corporates kind of beginning... Corporates have been quite quiet, I think, over the last 24 months. They haven't been hiring, but they haven't been firing either.
You know, if they have to take action to preserve their earnings, then, you know, we could see unemployment rising. And I think that would begin to choke off, you know, apartment demand, probably begin to choke off unemployment.
you know, some office demand as well, albeit there is a pent-up demand. I mean, people didn't do much for four or five years in offices, and there's a lot of pent-up demand there. So kind of my narrative for the CRE market is that if you go back a couple, three years ago, it was all hair on fire, CRE doom loop, you know, kind of discussion. That abated...
over the last year or so as the economy performed well, we got a lot of jobs. We got, as you pointed out, consumers doing really well. Travel had picked up.
And it looked like interest rates were coming in. The Fed had started to ease interest rates, and there had been strong expectations that they would continue to ease, and then even potentially long-term rates would come in. And as a result, if there were some CRE properties that were having trouble making payments on their mortgages, that the banking, the banks, and other sources of capital that
provided that credit, were willing to work with the owners of these properties, kind of manage through these issues because they knew that with a better economy and lower rates that it would all work out.
But here we are now, and everyone must be asking themselves if that kind of narrative still holds. The economy is going to weaken, I think. It's just a debate to what degree. As you say, 50-50 recession. Even if we don't go into recession, that's a much weaker economy, less consumer spending, fewer jobs, less –
less movement of goods, all the things that drive demand for commercial real estate. And now you've got the Fed saying, I'm not cutting interest rates, at least for a while until there's some clarity around what's going to go on here with the trade war and
Does that mean inflation? Does it mean slower growth? Long-term rates have backed up. They haven't risen a lot, but there's a lot of concern that they could given what's going on with regard to the trade war and Fed independence or anything else. So long-winded way of saying, will banks and other creditors continue to show the kind of forbearance and willingness to work
with owners to make sure that there aren't defaults, will that change? And will we see
you know, a more substantive pickup significant, there's already been a pickup in delinquency and default, you can see it in the commercial mortgage backed securities market data, CMBS data, but will we see a bigger pickup in delinquency and default, even if you're, you're, you're right in, you know, we're 5050, we don't go into recession? Are you? Is that something we should be worried about? Or is that still you're relatively sanguine about that kind of scenario playing out?
Well, I talked to some of our, you know, we have a debt business. You know, the banks are still lending to real estate. And I wouldn't say aggressively, but I think the appetite on the banks from the bank to lend to real estate is still pretty high. And, you know, since the trade war erupted,
You know, I'd expected risk spreads to move out and they have to a certain extent, but the spreads on real estate lending and maybe moved at 10 basis points, 15 basis points.
So, you know, the spreads on real estate lending are about 150 basis points. The all in cost of debt for prime grade real estate is still below 6%. And, you know, when, you know, buildings need to be refinanced,
it's very competitive. Banks are lending. So, you know, that's just an immediate market snapshot. It's not answering your question completely, but, you know, the broader situation, you know, that we've seen
kind of referred to for the last four or five years, you know, the wall of maturities. Yeah. You know, a lot of kind of real estate lending that, you know, was extended at the peak of the last cycle, 2019, falling due. And it's been, you know, what we've seen from the banks is just a willingness to, even if values have dropped, even if values may be actually below the level of the loans, you
As long as the properties can service those loans, the banks have been quite willing to extend the loans. So borrowers have maybe in certain cases had to put more cash in. Maybe the banks have got creative and put some sort of preference equity in.
But I think the general feeling I'm getting is that that will continue, that this wall of maturities will never actually kind of tumble over, that we will continue to work our way through, you know, the refinancing of US commercial real estate. And I think it goes back...
To the point that I made earlier, there's a problem in the office sector, which is that rise in vacancy from 12% to 19%, and the functional obsolescence of a portion of US office stock.
but you've got to remember that the office is only 25% of commercial real estate. Multifamily or apartment is a much bigger sector now, and that is in robust good health. So I think the fact that the majority of US commercial real estate can continue to service those loans,
you know, augurs well, I think. And I suspect behind the scenes, um, the Fed has also been watching this very closely and the regulators and I've told the banks, not that I generally don't think the banks have been through this before in the great financial crisis. They don't want a ton of office back to them. They don't want to manage it. They don't want to dispose of it. You know, they just don't want to deal with it because they've, you know, they've been through that before and it's a waste of their time. Um,
So, and I think even owners where kind of high vacancy offices, they don't want to abandon that because they'll be in hock for kind of waste management fees and taxes. So there are all sorts of incentives to try and work through this in a way that I think
means that we, you know, we call it extend and pretend, but I do, I don't think, right. You know, on even a, even a mild recession scenario, um, that we're going to see, uh, problems in the, in the real estate sector feeding through into the banking system and creating a credit crunch. So no doom loop, no doom loop. No. Well, you know, just everything, nothing's impossible. Yeah. Yeah. I mean, you've probably noticed the, the, the,
The top 50 banks, I think, over the last 24 months have provisioned about $150 billion against losses on securities. So they're ready if it happens. They're ready. I suspect if there was a severe recession and unemployment went up, we might have further problems in the community and regional banks because, albeit that they've been cleaning up their balance sheets as well. So they've been selling loans. They haven't been idle yet.
But I don't know that they've got the capital reserves. So I think if we started to get unemployment moving, you know, if unemployment goes up from four to mid fives, then I think we get through this with more extend and pretend. If unemployment moves up to six point five percent and we get, you know, some quite serious move upwards in retail and, you know, apartment vacancy.
then I think that begins to become a problem for the regional banks. But I wouldn't
I'd be putting that at a relatively low probability, 10 to 15%. Got it. The bulk of the probability is just on continue to muddle through. To muddle through. Hey, Chris, I know you watch the credit statistics carefully. Have you noticed any kind of change there or is it still, as Richard called it, extend and pretend and kind of manage through?
Yeah, I'd say to a large degree that that's the case. You can see the maturities just keep getting extended out. I did have a question though. Okay, yeah, far away. Regarding the functionally obsolescent component of the office market, as you put it, how do you see that sector being worked out? There's a lot of talk, of course, of conversions. Are these teardowns? What's your sense of how this is resolved? Yes, I mean, it's a rough and ready estimate.
But I think, you know, what we I think probably 10 to 15 percent of the US office sector won't, you know, will have to be repurposed or torn down. That's that's a lot of real estate that won't happen overnight. We're seeing conversions surge.
But even now, there hasn't been, I think, enough drop in value to make, you know, a whole scale conversions pencil out. And I think with rising, you know, one of the areas that I think that we haven't touched on, you know, with tariffs and trade war is just going to push construction costs up. So, you know, that's going to put a brake on any sort of new development. So I think that would that would slow the conversion process down.
But I think this is going to take two cycles. This might take the best part of 20 years to work out alternative uses for that functionally obsolete office stock. And it is happening. The conversions are ramping up quite quickly, but even so,
You know, I think, you know, at 1% of the stock per annum, that still gives you a 15 year. And that, as I say, it's a two cycle, two cycles to get that resolved.
Let's end the conversation around another concern, potential concern related to recent events, and that's inflows of foreign investment. So obviously foreign investors are a key part of the commercial real estate market. And there's been a lot of hand-wringing about
investor demand for US assets in the context of recent events. This whole concern about the US safe haven status, money comes flowing here when times are tough, and that doesn't appear to have happened. It doesn't feel like capital's fleeing, but it doesn't feel like capital's been coming in. You can see that in treasury yields, certainly the value of the dollar is down, which would not be consistent with capital coming in. Have you noticed anything in terms of
foreign investor interest or demand in the current environment? Has that waxed or is that still as strong as it's ever been? Have you noticed anything? I think in general, around the uncertainty, all investors are on the sidelines for the moment. I think we started the year with pretty positive investor demand, and that included from overseas.
But I think investors don't like the uncertainty, so it's difficult to distinguish with all investors on the sidelines whether you've got some overseas aversion. I suspect there will be, for instance, and I'm just hypothesizing here, I don't know anything that...
there might be some Canadian Canadians are probably the biggest buyers of US commercial real estate you know they may well be on the sidelines for a while but on the other hand you know with the weaker dollar you know this this is going to present some buying groups in Asia possibly Europe you know with a generational opportunity to acquire US real estate so it could go one way or the other but at the moment I think
you know, there is a pause in the kind of investment market, uh, for, for us real estate. Some, I think it, it offers an opportunity for, you know, private domestic capital, which has been, um, you know, uh, quite active over 2024. I do expect. And, and it's one of the things that you kind of continuously surprises me about working in the United States, just how much private capital there is out there. Uh,
You know, just how wealthy the society is at certain levels. And, you know, I think it's an opportunity probably, you know, for private capital to, if we do see that kind of easing back from kind of the big institutional investors.
Yeah, I guess consistent with that, the point of view you're expressing is so-called cap rates remain pretty stable, haven't they, at least so far in all of this? They moved out. When interest rates went up in 2022, they moved up maybe 150 basis points in all sectors. And that is, you know, it's like bond rates. You know, bond rates go up, bond rates fall. And so we've seen 25% drop in real estate values.
But I think for the last 12 months, perhaps the last six months, real estate values have been stable and cap rates have been stable. And to the extent that the 10-year Treasury trends back down to 4%,
then I think cap rates will remain stable. To the extent that the 10-year Treasury goes up above 4.5%, then I think possibly there'll be further value diminution and outmove of cap rates. But at the moment, we're at 4.3%, and I just don't know that there's
That's probably talking about kind of market stagnation, really, with values not neither moving up or moving down, perhaps gently drifting down. Yeah, I've noticed the spread between the cap rate and the 10-year yields, that has been relatively stable in the last, it feels like in the last several months, despite everything. And one argument I've heard is that
hard assets and commercial real estate is a so-called hard asset actually do well in this kind of environment. People want that, you know, that steady stream of income that you were talking about, and that's helped to support demand or investor demand. And thus the cap rates have held pretty steady here. Does that resonate? I think the, uh,
I think the cap rates are holding steady just because I think cap rates are just a kind of a lagged variable. Okay. So we haven't seen it. It's too early to tell. It's too early to tell. But I think the general idea that if you look at previous periods of stagflation, and we'll go back to the 1970s for that,
Now, we're nowhere near that sort of situation, albeit there is a bit of 70s-like policy kind of entering in. Real estate did very well. You know, I don't know that it's, you know, real estate tends to do quite well where you get high and persistent inflation.
And, you know, people like its inflation. It's not a not a technical inflation hedge. It doesn't hedge you against unexpected inflation, but it's quite a good long term capital preserver. It preserves the real value of capital. And, you know, I think in turbulent times with a bit of a whiff of higher inflation for longer, then, yes, I think that potentially will motivate investors. I can't say that we've seen it yet, but I think it will.
Well, I want to thank you, Richard, for joining us. That was a very informative conversation. And, you know, hang on to that James Bond accent. That serves you well. So thank you for coming on. Really appreciate it. Yeah, we'll remain shaken but not stirred. Great line. I think you've said that before. I just have a sense that you've said that before. But anyway...
No? Okay, that was a good line. Very good line. And with that, dear listener, we're going to call this a podcast. Talk to you next week. Take care now.