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The Fed Acts Like Scrooge: eXp Commercial’s KC Conway Advises How to Weather 2023

As 2022 chugs to close, eXp Commercial is poised to navigate choppy financial waters and shifting markets in 2023, thanks to economist and futurist KC Conway

In December, Conway expertly predicted the Federal Reserve Board’s move to raise rates again on Dec. 14, 2022. 

Unlike other economists trying to sell a “soft landing” in 2023, Conway stuck to his guns and made the right call. He said the Fed “is going to be Scrooge this year.” He was right. 

While the Feds’ half a percentage point rate hike slowed the pace, it still put rates of between 4.25% and 4.5% at their highest in 15 years. More rate hikes were promised for 2023 as the Fed aimed to curb inflation.

“I think I’d like to trade in my crystal ball, because it’s not looking good. I think those that are still thinking soft landing, or that the Fed is not going to keep raising rates, are in denial. The damage will be done. I think it's a very tough year. I think the Fed will raise rates through each meeting in the first six months next,’’ Conway said.

“Until the Feds see what they want to see on jobs, on unemployment, they’re going to raise rates. And the problem is going to be they’re not going to see that data on jobs until mid-spring or summer of 2023, because unemployment benefits or other severance payments will delay the actual number of unemployed,’’ Conway said.

Here are more key excerpts from a dynamic Q&A between eXp Commercial President Jim Huang and KC Conway: 

The Pause Button for Residential Real Estate 

With interest rates over 7%, multi-family rentals will stay strong. Prospective buyers and new households are forced into a rental situation. Older homeowners and empty nesters who were thinking about retiring or selling won’t be willing to buy a “replacement” home at a 7% or 8%  mortgage rate. Inventory from existing homes won’t be there. 

Americans Will Look for Ways to ‘Outrun’ Inflation 

Conway said if inflation occurs in the 7-9% range, people will want to be in places that have growth, and that 10-12% growth is primarily in the South.

“I think in early January we're going to get new move reports from U-Haul and United Landlines,  which are going to continue to show the population, the workforce and the household formation moving South, whether it's Texas or Florida or the Carolinas or Tennessee or even to the Midwest. In fact, the Upper Midwest has the highest personal income growth rates of like 9 to 10% in the whole country, even better than the South.”

There’s a Market Disconnect Between Commercial Buyers & Sellers

Two big issues that we're facing right now:

    1.  Buyers and sellers cannot agree on pricing. Sellers cannot believe what buyers are coming back to them on transactions. Buyers are saying: ‘With the interest rate rise and the slowing of the economy, I've reset my price and it's 20 to 30% lower than what they thought they had. Meanwhile, sellers are still stuck in prices from six months to a year ago. Buyers are not there. 

    1. Property returns are primed for reset. We've already seen expenses out running rent growth by about a 3-to-1, affecting net operating income. So just the NOI is less, same cap rate, that means a lower value. The net result of this discrepancy is that with 7.5% or higher interest rates, a lot of deals are falling out. 

Banks Aren’t Lending

“When I talk to a lot of the clients that I advise, merchant developers, big brokerage companies, they're all telling me something along the following lines: Banks are just pulling back on their commitments and deals are falling out of escrow.

“We have to remember what the Fed is telling the banks is that lending is inflationary, so quit lending. No matter how they want to parse it, that's what they're telling the banks to do. And then the banks are rewriting deals. They're going lower on loan-to-value, higher on debt service coverage ratio. 

“And banks don't want to do a lot of stuff. They don't want to do offices, or retail and anything with any risk. Even if a deal's solid, the fundamentals are good, all the underwriting is solid. They are just pulling the commitments. They are not funding deals.”

Advice of the Year: Rethink Your Capital Structure 

“Banks you thought had relationships that would stay with you are gone. You're going to have more success trying to put a deal back together with a community bank or a smaller bank. Your big national banks are not going to be there. The Wells Fargo's, the Bank of Americas, they're all pulling their horns back in. But a good community bank, like The Bank of Tampa in central Florida, is still doing deals, still underwriting local.”

An REO Market Will Not Emerge for Commercial or Residential 

With potential for resets and readjustments in leases, it would seem as if commercial office space would be vulnerable to an REO market. There will be value destruction of offices, just like what ecommerce did to big box retail. But we’re not going to see the banks reconstitute REO departments. It’s expensive, and banks don’t want to put those kinds of departments together.

An REO market will not emerge for residential, either. Many folks are in really good, low rates for their fixed mortgages in the low 4’s. So if they’ve got a fixed low mortgage and a job, they’re going to continue to pay. People also have a lot of equity in these homes, in many cases upwards of 50% increase in value of single-family homes. 

Homeowners will stay put until rates come back low and they can move in and get a new mortgage if they buy a new place. For the new household, for millennials, they're going back to apartments until they can afford the payment and rates come back down.

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