Let’s face it, the story of 2022 will be the Federal Reserve’s policy to combat inflation.
Inflation soared in 2022 as a result of a strong labor market, stressed supply chains, an abundance of low-cost capital and pandemic-related stimulus programs, all of which mixed to fuel furious growth. Rising rates, which we have not seen since before the Great Recession, along with an inverted yield curve, can signal headwinds – none more amplified than a possible recession in the coming year.
After seven Federal Reserve interest rate hikes in a relatively short timetable, we find ourselves assessing and measuring not simply whether there will be more rate increases, but more importantly, what this means for the economic conditions and for commercial lenders and borrowers in 2023 and beyond.
Higher borrowing costs historically hit the housing market first, as potential buyers have less borrowing capacity, which can put downward pressure on housing prices and values. However, this can still be offset by a strong labor market, along with low supply of housing, specifically in affordable housing. With potential demand high, sellers may be reluctant to reduce prices, while landlords can maintain or even increase rents.
As developers see higher borrowing costs and municipal permitting processes limit new development or impose stricter conditions – such as affordability or green initiatives – volume and scale of new projects may slow. This will keep rental and housing unit inventories from rising too rapidly. While rising rates are impacting existing projects, many of which were started prior to or at the onset of the rate increases, the true impact will be on future development and financing of projects currently in the planning stage.
How Will Asset Classes Respond?
One of the biggest areas to watch will be the impact of rising rates on stronger asset classes, like multifamily housing. Multifamily housing has been a leader among all commercial asset classes and still has robust activity, due to the availability and diverse sources of equity capital that can partner with higher-cost debt.
According to most sources, rents remain stable or are expected to increase in 2023, with vacancy rates continuing at low levels. Rents are reliant on a strong labor market, and although inflation and rates are on the rise, one of the primary causes is the low unemployment, which is a leading indicator for rents. Landlords may also see an increase in the pool of renters waiting out home prices, which some expect to decline in 2023.
The capital markets will be watching employment numbers closely in 2023. Overall, the multifamily sector continues to show strength and drive activity.
Less can be said about other asset classes such as office or retail, already reeling from the pandemic. Office markets may see more stress in a slowing economy brought on by rising rates, and banks will be watching the sublease and rollover activity very closely. Negative trends in the office markets could further drive repurposing of office into lab or residential products.
Surprisingly, retail has shown resilience, especially in grocery-anchored retail plazas, and as a result of lower inventory. With inflationary pressure on consumers, lenders will be watching credit quality of the retail tenants into 2023.
Commercial and industrial borrowers entered this inflationary period buoyed by stimulus programs, such as the Paycheck Protection Program, providing liquidity and seeing robust economic growth post-pandemic. Many took advantage of stimulus funds to avoid layoffs, reduce debt and firm up balance sheets.
Choppy Waters Ahead
Looking ahead, banks will be paying close attention to income statements and looking for margin compression. Increased interest expense, specifically for working capital, is a leading cause, as the prime rate has more than doubled since the beginning of 2022.
While companies report some relief in their supply chains of late, materials, upward pressures on labor expenses and healthcare costs will require more adaptation of cost controls and innovation with technology to keep bottom-line profits from decreasing. Although borrowing at higher interest rates, companies looking to expand still find a healthy lending environment and continue to have accessible capital from lenders.
While rising rates themselves aren’t very popular, savings rates are being cheered by depositors, who are seeing returns on savings accounts held at banks, the likes not seen in over a decade.
Many forecasts predict that the Fed could deliver a soft landing, even cut rates late 2023 or early 2024. Until then, lenders and borrowers will have to work closely to navigate the choppy waters ahead.
In spite of these headwinds, there are reports of healthy backlogs and decreases in material costs, such as lumber, offsetting the higher borrowing costs in the short term. The year 2022 ended with many companies reporting strong profits, development soaring and an economy weathering record inflation and turbulent global conditions, which was a subplot to the Fed’s fight with inflation. Now 2023 starts out having us look back at 2022 and wonder, was that the “worst” best year we all had?
Stephen DiPrete is chief commercial banking officer at Weymouth-based South Shore Bank.