This Week’s Economic Update, December 5, 2022

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Hopefully all of you had a wonderful and safe Thanksgiving and are looking forward to an enjoyable Christmas Season.

The commercial real estate market is currently showing increasing stress.  Bankers should be aware of the storm clouds that are on the horizon.  Larger, urban core office buildings are experiencing increased vacancies, upward of 25% or more.  Recently, in downtown Minneapolis, two towers have been deeded back to the lenders by the owners. One of the owners, the Illinois Teachers Pension Fund essentially walked away from a long-term holding, experiencing a huge loss.  The IDS Tower in Minneapolis now has a 27% vacancy level as existing tenants either scale back floor space or relinquish their space completely. 

Minneapolis is not the only core that is experiencing stress.  Salt Lake City, Kansas City, Chicago, as well as others are seeing increased vacancies and declining property values.  The issues are bleeding into the suburban areas as well.  Many long-term leases signed prior to the Pandemic are now maturing.  Between recent construction as well as a change in many business models where less office space is needed, a perfect storm of declining rental payments and higher vacancies appears to be building.

The latest numbers out of the St. Louis Fed indicate that banks are tightening credit standards on real estate loans.  However, one area that appears to be a blind spot, one that the regulators are targeting, is the integrity of the appraisals.  Appraisers are used as the market experts, often their assessments are unquestioned.  Please understand, Appraisers do a great job, but are constrained in their information to events that are in the past, not anticipating the future.  In market periods where variables are changing rapidly, the information received by the bank is outdated. 

We are seeing cap rates that are lower than the current environment supports.  Cap rates are being based on interest rates that are lower than what are expected in the near future.  Appraisals are also looking at vacancy rates that are lower than the market is currently showing as well as rents that are higher than renegotiated terms that are existing today. 

All of this is very concerning based on the concentration of commercial real estate on banker balance sheets.  2023 as well as 2024 are likely to be a very difficult time in banking based on the decline in the real estate markets.  Next week I will walk through the multi-family market, which is likely in worse condition.

Our economy appears to be firmly in the Twilight Zone in terms of numbers.  There is no clear direction that exists right now.  The Federal Reserve Indexes have been soft, but nothing that is consistent.  They are up one month, down the next, only to rise the third month. 

The ISM Manufacturing report came in at 49, a drop of 1.2 from October which was 50.2.  This is the first time since March of 2020 where the index fell into a contraction range.  Manufacturing is expected to be weak as the supply chain clears up, back logs are cleared and demand is soft as consumers increasingly struggle with inflation.  As inventories are drawn down, we might see improvement the first quarter of next year.

The Durable Goods numbers released on November 23 covering the October time period, were above expectations.  Overall, the durable goods orders were at 1%.  If you take out defense, it was still a good .8%.  The strength in durable goods related to transportation purchases.  This was primarily companies that have experienced improved supply chain conditions which have allowed them to catch up.  Appliances, equipment and electrical equipment provided nice gains for the October numbers. 

The Job market continues to be very strong.  Non-Farm hiring is building.  November hourly earnings rose nicely, up .6% month over month.  Manufacturing as well as government hiring remains strong.  The Tech industry is currently in free fall in terms of labor.  Most of the job cuts in the past month came in this area.  Continuing jobless claims bumped up a bit, but nothing concerning.

Employers in the US are struggling with hiring people.  Open positions available by business at the end of October were 10.3 million.  While this is off the peak of over 11 million, it is way too high.  Employers struggle to get qualified, willing candidates to hire.  With a labor participation rate at 62.1% there is plenty of bench strength, as long as the bench sitters are qualified, want to work and can be enticed by higher wages.  This of course only compounds the FED’s issue on inflation.  There is a real concern that our supply inflation issue will be exchanged for wage push inflation.

Have a great week.



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