From Volatility to Opportunity

Market Update

The convergence of rapid interest rate hikes, elevated inflation and recent bank-related pressures have fueled continuing market volatility and heightened risks — notably a widespread expectation of recession and continued price discovery across asset classes.

With volatility and risk come opportunities, though, and given the long-term nature of investments in certain diversifying real assets, interest in the space remains strong for the year. At this point in the cycle, whether it’s capitalizing  on the non-correlated diversification benefits and income characteristics, or helping to address environmental, societal and governance (ESG) considerations, as pricing comes into focus there may be attractive opportunities to add — and maintain — strategic positions of quality real assets in portfolios, particularly for long-term investors with the mindset of looking through cycles.

Farmland

With uncertainty at home due to an elevated commodity price environment, the continued Russia/Ukraine conflict bringing instability for Ukrainian agricultural output and disruption to regional supply chains, near-term farmland value remains unclear. As we approach the 2023 agricultural growing season, many are looking for a “breather.” With farmland remaining somewhat more insulated from volatility compared to other assets, there is potential for commodity prices— partnered with supply and demand — to help propel land markets higher in the second half of 2023, leading to relatively stable land values.

Timberland

For investors looking for a low-to-moderate risk profile and non-correlated alternatives to stocks and bonds, timberland investments have remained a strong option for the first half of 2023. While supply and demand are projected to soften throughout the year with interest rates adding downward pressure, overall, performance drivers have gained momentum over the past two years with total returns for Southern Private Timberlands reaching 12.9% in 2022.1 Looking towards the rest of 2023 and on, timberland’s biological growth — a key driver of returns over time — should benefit from longer investment holding periods, which would help mitigate the risks of short-term market cycles and volatility.

Energy

2023 has revealed several key demand and supply factors putting upward pressure on oil, such as increased demand coming from China and increased export volumes from Russia. This will likely help mitigate a spike in crude prices in 2023, resulting in oil price expectations remaining in the $75-$80/bbl range for the year. While the price should tighten, overall, oil inventories are expected to grow throughout 1H 2023.

Commercial Real Estate

The commercial real estate (CRE) market, facing strong cross currents in the occupier and capital markets, is shaping up to be much different in 2023 than it was a year ago. Cash flows and cap rates are higher today, valuations are facing downward pressures, and the development pipeline is slowing. But even with financial pressure on the horizon, some subsectors and geographies remain well-positioned to ride out economic complications and make sense over the long term, especially given diversification benefits and income features.

Farmland

As we look ahead to the 2023 agricultural growing season, we remain in an elevated commodity price environment, albeit declining from year ago levels. Land values may continue to receive some support in 2023 from this elevated commodity price environment; however, it is becoming increasingly clear that the cycle of aggressive appreciation experienced over the last two years is slowing and farmland markets are taking a “breather,” with many expecting land values to plateau in 2023.

There is the potential for commodity prices to gain momentum to the upside, and for interest rate relief to propel land markets higher in the second half of 2023; however, the more likely scenario is that land values continue to level out or even decline slightly as interest rates persist at elevated levels, and commodity markets maintain current levels as experts wait for clarity on the supply picture.

Higher interest rates are putting some upward pressure on cap rates and farmland return expectations for investors. Due to higher rates and higher input costs, farmers have begun to shift their focus from expansion of land holdings to maintenance of existing farms and farm equipment. This, coupled with the fact that 75% of all farms transacted in 2022 did so at public auction² — a practice that favors local farmers in the bidding process — should create opportunities for investors to acquire farms with less competition from farmers, potentially resulting in pricing that becomes increasingly attractive as we move deeper in the year and into 2024.

THE RUSSIA/UKRAINE CONFLICT

The conflict continues to be a source of uncertainty for agricultural markets. There is the potential for the impact to Ukrainian agriculture output to be more significant in 2023 than in 2022 as the disruption from a year of conflict continues to take its toll on agricultural infrastructure and supply chains in the region.

Regional agricultural exports remain a wildcard in the outlook for the wheat and corn markets globally. Ukrainian agricultural exports were down about 30% for the 2022/2023³ marketing year, and smaller harvests and logistical challenges are likely to continue for the 2023/2024 marketing year. The markets have adjusted to these uncertainties and this risk premium is reflected in the current commodity markets. A resolution to the conflict in 2023, although not anticipated currently, could provide some headwinds for commodity prices, especially wheat, and corn to a lesser extent.

SUPPLY AND DEMAND FUNDAMENTALS

Commodity prices have driven strong growth in farm income over the last several years, including in 2022 when net farm income reached a record high of $162 billion.³ Will corn and soybean futures prices continue to cool down in 2023 to more stable (historical average) levels? Current USDA projections indicate easing pressures with improving domestic stocks-to- use ratios for key agricultural commodities for the upcoming 2023-2024 marketing year. This comes after multiple years of tightening supplies driven by multiple factors, such as increasing demand for commodities to curb food scarcity resulting from the COVID-19 pandemic and the war in Ukraine. Corn and soybean markets maintained high price levels for much of the past two calendar years, and so far this year, price levels remain high historically. However, a bearish wave has hit the corn market recently with prices dropping about 60 cents per bushel³ on poor export demand. Conversely, soybeans have been supported by strong demand and ending stock estimates continue to remain historically tight for the soybean market. Global grain supplies remain near decade lows. These estimates for increasing stockpiles this fall rely on strong production estimates for the upcoming U.S. crop that is yet to be planted. Therefore, any weather risks during the growing season could provide additional support to key commodities. Also, there are concerns on the demand side in the event of a global slowdown that could lead to moderate increases in ending stocks, which may alleviate some of the pressures of another year of tight global supplies.

Old-crop and new-crop U.S. balance sheets for corn, soybeans and wheat

Timberland

As 2023 unfolds, timberland investments remain an attractive asset class for long-term investors with a low-to-moderate risk profile who are looking for non-correlated alternatives to traditional financial investments such as stocks and bonds. Biological growth is the primary driver of timberland investment returns and is independent of the market and economic cycles, providing powerful optionality — a key factor underpinning timberland’s investment characteristics. Wood product price changes and fluctuations in underlying land values also contribute to total investment performance.

Fundamentals

The traditional performance drivers for timberland investments have gained momentum over the past two years, further supporting the core investment thesis for timber. Much of the gains are attributable to strong demand for logs as manufacturers pushed to keep up with high lumber demand. Total returns for Southern Private Timberlands reached 12.9% in 2022 and were driven by solid appreciation and income returns (9.58% and 3.32%, respectively),⁶ a level previously obtained in the mid-2000s leading up to the housing recession. Despite the strong returns, log prices have mostly stayed the same due to ample available logs. Relatively flat log price appreciation was more than offset by the strong land price appreciation as numerous investors competed on a limited number of quality offerings in the marketplace.

On the demand side of the market, U.S. housing is expected to soften throughout 2023, off relatively strong production experienced over the last several years. Driven by higher interest rates, new housing starts are expected to be reduced by 18% year over year before recovering towards long-term averages of 1.5M7, resulting in less demand for solid wood products which will likely dampen the log price recovery — and potentially timberland investments — in the short-term.

On the supply side, excess available logs — particularly in the Southeast where the dominant commercial wood species is pine — will continue to place downward pressure on log prices. Due to the unique transportation costs associated with the sector, the impacts of regional oversupply vary by locale. Focusing on high-quality timberland assets in competitive markets helps mitigate some areas’ challenges. The industry has faced difficulties with logger and truck driver shortages. The operating and insurance costs lead to small margins that can be difficult to sustain. Workforce development in forestry is a priority for many local governments. The shortages affect every aspect of the industry, and key stakeholders are taking proactive steps to help.

LONG DURATION

Long-duration assets such as timberland are susceptible to increases in interest rates, resulting in increased discount rates and downward pressure on values. Over the coming year, timberland valuations will likely face this downward pressure as interest rates and discount rates increase; however, a near-term softening in timberland values potentially creates an attractive entry point for patient investors looking to add long-term timberland investments to their holdings.

Uniquely characteristic of timberland investments is the value of its embedded optionality combined with its inflation hedging utility, which can help offset an increased interest rate structure that comes with a corresponding increase in discount rates. Inflation is often reflected in the nominal prices for logs and wood products — subject to localized supply conditions — while the embedded optionality allows investors to adjust to changing market conditions, potentially optimizing the relationship of the organic growth of trees to the market pricing of logs.

CHANGING MARKET

Adding pressure to the traditional timberland investment thesis, motivated investors focus on alternative values alongside wood product production. Historically, institutional owners sought timberland assets due to the favorable tax treatment, attractive risk profile and inflation hedging attributes. New investors are utilizing timber to support their company operations in cases where they can benefit from the timber investment thesis and use the asset to help meet their environmental, societal and governance (ESG) priorities.Timberland investments can help meet these objectives through carbon emission offset programs, conservation easements and other renewable energy projects. Timber production and sustainability are not mutually exclusive, and specific investor objectives can vary widely. Investors that utilized the asset class for alternative purposes in addition to core timberland attributes will continue to put upward pricing pressure on institutional-sized timberland opportunities.

Energy

As we move through 2023, we are seeing oil prices relax to around $80/bbl8 from the peak of over $100/bbl during summer 2022. There are several key demand and supply-side factors that are putting upward pressure on the price of oil for 2023, including increased demand coming from China driven by the reopening, improving economies elsewhere across the globe, the 4Q22 and 1Q23 OPEC+ output cuts and limited U.S. shale oil growth. Despite these factors, increased Russian export volumes and increased oil stocks will create a downward push on oil prices. These competing supply/demand factors should keep the oil balance tight and help reduce the risk of a big spike in crude prices in 2023, resulting in oil price expectations to remain in the $75-$80/bbl range for the year.

KEEPING UP WITH NATURAL GAS DEMAND

Natural gas prices have fallen back down to the $2-$3/Mcf range, resulting from significant increases in production coupled with reduced consumption and limitations on exports. Typically, natural gas prices increase in the winter as temperatures decrease and demand increases. This warmer than normal winter has contributed to the lower demand and lower prices. In addition, an outage at the Freeport LNG export facility that began in June 2022 has resulted in approximately 2.0 Bcf/d of export capacity. This relatively higher production, combined with these two reductions in natural gas consumption, has resulted in a large increase to the natural gas storage levels back to above the five-year average. Expectations for natural gas prices for 2023 are around $2.73/Mcf.

ENERGY POLICY, ELECTRIC VEHICLES AND DEMAND FOR OIL

U.S. energy policy is an important driver of the energymarkets. Required changes, including the move toward electric vehicles (EV), is expected to have an increasing impact on markets going forward. By 2027, EV sales may make a visible dent in oil demand. Expectations that transportation fuel demand would peak when EVs as a share of total vehicles sold reached 20%, and we estimate current EV sales penetration is now at 14%. Interestingly, gasoline demand in the U.S. is already starting to decouple from miles driven, according to the latest data, even as EVs only make up 7% of total cars sold in North America. Rising EV sales should eventually level off gasoline and total transportation fuel demand over the medium term.

Yet, the path is unlikely to be linear. While electric vehicle sales will keep biting into future oil demand for years to come, the speed of the transition will depend on the availability of scarce raw materials such as lithium, cobalt or copper. The spike in lithium prices this past year boosted the costs of car manufacturers and squeezed profitability, factors that could eventually slow down the transition to a gasoline-free future.⁹

DOMESTIC ENERGY

Many companies, both large and small, are limiting their drilling programs to preserve inventory. Business plans are now focusing on slower growth with better investment returns to shareholders. U.S. companies now flush with cash are choosing to opt out of new CapEx investments and instead pay down debts and get balance sheets out of the red. Supply chain and staffing issues are also limiting expansion. The U.S. land rig count is currently around 730 rigs, compared to just over 680 a year ago (80% oil, 20% gas).¹⁰ This current rig count is still less than the pre-pandemic rig count. Leasing activity in the U.S. has increased since the recovery of commodity prices, with shale plays remaining the focus. Dollar/acre bonus amounts continue to recover from pandemic lows but are still not back to pre-pandemic levels. These initial low offers result in longer negotiation periods as lessees remain cautious.

Commercial Real Estate

The commercial real estate (CRE) investment market in 2023 looks quite a bit different than it did a year ago. Opposing and strong conditions exist simultaneously, which complicates the backdrop, making it tricky to untangle the forces making an impact. Cap rates are influenced by benchmark interest rates, which are significantly higher across the curve versus a year ago, and are pushing cap rates and discount rates up — a headwind to values, as is the refinance risk on a wall of CRE debt maturing into a higher rate world. Cash flows driven by property market fundamentals and inflation are up strongly over recent years for many subsectors, so depending on the subsector and depth of an upcoming economic slowdown or recession, existing fundamentals can be a tailwind and stabilizing factor.

CRE fundamentals are in particularly good shape for certain subsectors, with the notable exceptions of office and lesser quality retail malls. The office subsector is experiencing growing and visible stress as the economy slows and workplace flexibility trends fuel uncertainty about future demand for space, and the mall sector is bifurcated by quality with lesser malls continuing a secular struggle. In the face of softening demand, reducing prices, elevated interest rates, scheduled near-term loan maturities likely magnify this stress.

For certain subsectors, new supply over the last decade has been relatively modest, resulting in low vacancies and significant growth in rents. The consumer is supporting resiliency in necessity and convenience retail, multi-family tenant demand remains intact (albeit softening) and benefits from the current jobs picture (3.5% unemployment as of Q1 202312) and pressure on affordability of home ownership, and the industrial sector remains near historic low vacancies with continuing demand for space.

HIGHER INTEREST RATES MEET HEALTHY FUNDAMENTALS

While not all subsectors are created equal, CRE fundamentals in general have been able to ride out an initial phase of rising interest rates — the main influencer of property values right now — and are well-positioned for a year that likely turns turbulent as the economy battles inflation, reduced lending volume,a looming recession and significant near term loan maturities.

Transition to a higher rate environment has been a game-changer, reflexively driving up discount rates and cap rates, making future cash flows less valuable and credit more expensive for leveraged investors. The strong investment returns posted during the accommodative low-rate environment have moderated since the second half of 2022 and deal volume has sharply declined. Total returns for both the NCREIF Property Index (NPI) and Fund Index (NFI-ODCE) were positive for 2022 but decelerated in the second half, reflecting negative appreciation in 4Q.¹³

On the demand side, tenants’ appetite for space is expected to slow this year and vacancies rates move higher, but for many subsectors and markets, an increase in vacancy would be from a low level historically.

On the supply side, the development pipeline has hit the brakes for projects not yet started due to higher rates and concerns about a recession. A reduced forward pipeline of rentable space combined with relatively low vacancies should help support fundamentals. Overall, moderating growth in rent should be expected as the economy slows and vacancy rates tick up.

WEAKER CAPITAL MARKETS PRESSURE DEAL VOLUME AND PROPERTY VALUES

Higher rates across the curve are impacting CRE near-term with downward pressure on values. In the debt market, higher loan interest rates make it difficult for leveraged buyers to acquire accretive assets. This dynamic of negative leverage presses leveraged investors into accepting lower returns, writing larger equity tickets, or both. As a result, investors have migrated to the sidelines, deal flows are falling and relative values are being recalibrated through renewed price discovery. So far, the regional banking situation has had minimal effect on CRE markets. During Q1 2023, total CRE sales were about $85 billion, down roughly 55% from a year earlier.¹⁴

The squeeze

CRE borrowers with near-term maturities or exposed floating rate debt may find it difficult to refinance at higher coupons and tighter lending standards, suggesting that some borrowers may be caught in a squeeze and forced to contribute more equity (or partner with capital providers who can), sell assets to retire debt — potentially at an inopportune time — negotiate workouts or undergo foreclosure.

Across the CRE lending universe, there’s about $447 billion in mortgage maturities expected in 202315; however, CRE most likely exposed to a squeeze would include assets or entities subject to maturing loans in challenged sectors where demand has shifted lower or incurable obsolescence exists, such as lesser quality office and regional malls in tertiary markets. Recent short-term floating rate loans closed in the low-rate environment where inadequate time has elapsed to capture value appreciation— encompassing a range of property sectors— are also likely to be exposed as borrowers look to refinance debt in an environment of higher interest rates, lower advance rates with tighter underwriting, slowing economy and softening values.

Distress

Stress in CRE markets could take a while to play out and certainly bears watching; but it is also worth noting that previous recessions stemming from the tech wreck of 2001, the global financial crisis (GFC) of 2008 and the pandemic of 2020 did not result in immediate liquidations of CRE assets as many expected.

With the exception of investors caught in a squeeze and lesser quality office and malls as mentioned, a significant amount of distress resulting in wholesale liquidations is unlikely to surface near term. Late-cycle market conditions with higher rates and heightened regulatory pressures on banks — especially given circumstances in the (regional) banking sector — will likely keep lending and deal volumes low for the year and at the same time elevate the visibility of any problem loans as they surface. Emerging credit risk — across industries — embedded in banks’ balance sheets will be an important indicator to watch, especially if interest rates remain elevated for an extended period or if there’s a deep recession. If sustained, these same forces could also pressure balance sheets of speculative grade corporates and smaller businesses, which can be CRE tenants.

Despite assets re-pricing lower and growth in rents decelerating, there are certain property segments that have seen considerable growth in rents and values over the last five or more years and are unlikely to experience much distress this time around. Also, substantial dry powder pointed at U.S. CRE looking for a suitable entry point — debt and equity — should spark the return of new deal flow and help buoy valuations.

AROUND THE HORN

Overall, property values are reducing as investors — especially those relying on leverage — will be sidelined for the year. Unforced sellers also will be waiting for a more stable environment in which to transact, resulting in a significant reduction in CRE deals combined with upward pressure on cap rates and discount rates, thus putting downward pressure on values. The wall of CRE loan maturities will ripple through the capital markets; but there is significant capital from healthy lenders looking for an attractive entry point, such as life companies, private credit and federal agencies for apartment properties. There are mixed outlooks among sectors with potential winners to include those able to generate growing cash flow, maintain good fundamentals and benefit from secular tailwinds driving demand.

INDUSTRIAL is a pro-cyclical sector with fundamentals in good shape, exhibiting continued rent growth and demand supported by e-commerce and changes in supply chain. Softening can be expected in connection with economic slowdown or recession, but it will come at a time when vacancy rates are near record lows. Largely due to high occupancy rates and inflation pressure, in-place leases may be below market when they expire, suggesting a market-to-market opportunity in many cases to increase future rents.

STORAGE has been resilient and increasingly attracts interest from institutional investors. Short-term leases allow landlords to capture from inflationary pressure. A potential all-weather asset, storage can be a priority for households in need of space during periods of both economic weakness and strength. Some of the top issues plaguing demand for office space — flex work and work from home — benefit the storage sector. Interest rate-induced delay in new development should help fundamentals by helping to keep supply in check.

APARTMENTS benefit from continuing low unemployment, a chronic housing shortage and an expanding pool of potential renters resulting from elevated home prices and higher mortgage rates, making it situationally cheaper to rent than to own. At the same time, in combination with a slowing economy and rising operating expenses due to inflation, the segment will be challenged by higher vacancies— which have been slowly increasing — and lower rent growth due to significant increased supply (716,000 units for 2023-24¹⁶) arriving on the market. As a result, near-term vacancy rates should increase, but higher debt rates are already pinching the feasibility of new developments not yet started, suggesting the high-water mark for new construction will probably happen this year. Unlike other subsectors, the apartment market has considerable debt available to it from federal agencies (Fannie Mae, Freddie Mac).

RETAIL comes in a variety of flavors with necessity and convenience retail suggesting stable results with consistent tenant demand, while regional malls are bifurcated by quality with lesser malls continuing a long-term struggle.Omni-channel retailers find value in physical stores, both as a quasi-last mile delivery hub and to service pick-ups made by customers who buy online. Store closures and tenant failures have also declined, while consumers have returned to shopping in physical stores for goods and services. This may change with a recession, as consumers and tenants alike may come under pressure. The general lack of new supply since the GFC, along with higher interest rates on construction debt, should help support occupancy rates.

OFFICE is complicated as the market is simultaneously being hit by softening demand, functional obsolescence, reducing values and significant refinance exposure. Bifurcated along quality lines, the subsector is adversely impacted by a slower return to office (especially in gateway urban center markets), leading to reduced leasing and rent, along with persistent questions about future demand: How much space is really needed? What type of space and where should it be located? Tenant demand for office is decreasing while simultaneously exhibiting a move to quality, leaving lesser assets in a tough spot competing for a shrinking pool of occupants. Overall, utilization rates are below pre-pandemic levels and vacancy rates are fast approaching levels last seen during the Savings & Loan crisis. Office conversions to multi-family, incentivized by programs such as the Revitalizing Downtowns Act which expands the investment tax credit to include a qualified office conversion credit, but is expected to have only a marginal near-term impact on the market.