The only thing certain in this market is the continued uncertainty. It seems conflicting economic signals have become a weekly occurrence. Last week investors got to digest a much better than expected June ADP Jobs Report which was quickly followed by the June BLS report on Friday.
The BLS easily missed the consensus as it showed the lowest monthly number of jobs created since the lock downs started to end in spring of 2020. I don't expect much clarity in the months going forward as the Federal Reserve continues to hike up interest rates.
The one thing that is clear to me, however, is that both the residential and commercial real estate market are going to get significantly worse, with associated downstream impacts before they get better. Average mortgage rates are up back to their recent highs of November, nearing the 7% threshold. Housing prices have held up well so far given their huge gains off the pandemic. However, that is largely due to the lack of inventory as few want to give up their 3% mortgages.
That will change if job growth reverses, which I see it doing in the next few quarters. Housing starts also surged in May, meaning more supply is on the horizon. I am seeing the first significant price cuts here in Delray Beach in many years. Housing prices have significantly further to fall in my view and I expect average sales prices to drop at least 20% from their peak before we hit a trough here.
This is still less than half the local market's post pandemic gains. I will be putting some new short positions - via bear put spreads - on some homebuilding stocks in the weeks ahead. The SPDR® S&P Homebuilders ETF (XHB) has gained over 25% so far in 2023 despite challenging housing conditions and reversion to the mean seems overdue.
Unfortunately, the residential housing market is in much better shape than its commercial brethren. This is where my main concerns are focused as I feel this is a substantial potential land mine for the markets and the economy. Prices for office buildings are plummeting as vacancy rates have hit record highs in many major cities such as Los Angeles and San Francisco. In Manhattan, there is some 70 million square feet of space available. That is more than 25 Empire State Buildings for those keeping score at home.
The commercial mortgage back securities loans on these buildings have seen delinquency rates almost triple so far in 2023 to 4.5%. I expect that to hit double digits in the not too far off future. Some $500 billion in loans on these facilities are coming due over the next three years. Rates to refinance this debt have soared since the Fed began their monetary tightening early in 2022 even as values for these properties have plunged. Many owners will simply hand in the keys rather than roll over loans on assets they no longer have positive equity in. This will force down values further.
The $64,000 question for investors is how big of an impact will this have on the markets and the economy. The beleaguered regional banking system has some 70% of these loans which make up a substantial portion of its overall loan portfolio. At the very least, rising defaults will lead to more write-offs and tightening credit conditions for many sectors of the economy such as small business. In a more dire scenario, we will see more regional bank failures along the lines of Silicon Valley Bank.
The market managed to ignore the accelerating pain in the real estate markets in the first half of the year. Will it continue to do so in the back half of 2023? My bet is that it won't and at some point during the year, this realization will cause a significant hiccup in equities.
