Navigating through the ‘seiche’ of early 2023 to calmer waters

Daniel Walsh
Founder and CEO
Citymark Capital

Crain’s Cleveland Business, January 2023 – As I look out the window of Citymark’s downtown Cleveland offices at the sparkling, spectacular Lake Erie, I’m reminded of the Lake’s awesome power recently displayed by the late December severe winter weather, causing a rare “seiche.” Seiches are typically caused when strong winds and rapid changes in atmospheric pressure push a large, sustained wave of water from one end of a body of water to the other. Think tidal wave. Think tsunami. It can cause significant damage and sadly did in the Lake’s eastern basin.

Our global economy is currently weathering its own “seiche.” Driven by rising interest rates, what started in 2022 continues to worsen in 2023, likely dampening the economy through mid-year. Floating and fixed interest rates are up over 450 basis points since early 2022, and are continuing to rise. It’s easy to see the seiche visual related to interest rates as levels rose rapidly, imperiling the economy and leading to a likely recession.

The good news is that a seiche appears rapidly, is relatively short-lived, and those who are well prepared can weather its effects. I believe there will be plenty of opportunities in 2023, but it appears the year will be a tale of two halves, where the macroeconomic environment in the first half of 2023 will be very difficult, and the second half will start to see some calming waters.

Inflation has remained stubborn and fighting it continues to be job #1 for the Federal Reserve in 2023. Despite the Fed’s best efforts, various predictive models, including Citymark’s, show that inflation will remain elevated, likely above 4% for the remainder of 2023—washing out any growth with continually rising levels of interest rates.

The forward yield curve that predicts future interest rates shows the 10-year Treasury bond and Secured Overnight Funding Rate (SOFR) index, upon which floating rate debt is priced, will peak in the summer of 2023. We expect these increasing rates in the first half of the year to slow the economy and will likely lead to increasing unemployment.

The higher interest rate environment will put pressure on borrowers with floating rate debt and lead to a higher probability of borrower defaults. These loan defaults and opportunities for well-capitalized investors to provide “rescue finance” (i.e., mezzanine debt, preferred equity) to help corporate borrowers and real estate investors to restructure their balance sheets—a life preserver, if you will.

Banks remain very cautious as loan defaults are on the rise, exacerbating a “liquidity crunch” that is likely to remain in the first half of 2023. However, it is important to note that unlike 2008, banks are well capitalized which means a “liquidity crunch” is likely to be short lived. The “rescue finance” option could be very effective in helping owners preserve their equity values until the economy begins to grow again in a post-inflation future as interest rates recede.

For real estate investors, the cost of debt capital is an important driver of property values. Higher borrowing rates typically cause downward pressure on real estate values and overall investment returns. This same dynamic is true in the private equity markets as the cost of debt capital increases. We think that the first part of 2023 will present some compelling distressed investing opportunities for those who can help restructure deals that have unhedged floating rate debt exposure.

As we start 2023 in very choppy waters, assuming Congress doesn’t fumble the handling of the debt ceiling (a very real and increasing risk), we expect the second half of the year to see early signs of recovery with a cautiously strengthening economy. Looking at the forward interest rate curve again, the 10-year Treasury and SOFR are reflecting receding levels of interest rates. Assuming the forward rate curve accurately reflects the future market, one would expect borrowing costs to begin to decrease in the second half of 2023, which could lead to increased transaction volume characterized by a strengthening stock market, private company acquisitions and new real estate investments.

The new year always brings new ideas, hope and optimism. We believe that while 2023 will have its challenges like every year does, there will be opportunities for those who are well prepared and positioned to ride the wave.

 

Crain’s Cleveland Business – January 30, 2023

The information contained in this communication should not be regarded as an offer to sell or a solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be in violation of any local laws. The general information discussed is not a guarantee, prediction, or projection of real estate investments. There are risks associated with investing in real estate assets, such as inflation, interest rates, real estate tax rates, changes in the general economic climate, local conditions such as population trends and neighborhood values, and supply and demand for similar property types. This communication may contain forward-looking statements identified by the use of words such as “outlook,” “indicator,” “believes,” “expects,” “potential,” “continues,” “may,” “will,” “should,” “seeks,” “approximately,” “predicts,” “intends,” “plans,” “estimates,” “anticipates” or the negative version of these words or other comparable words. Such forward-looking statements are subject to various risks and uncertainties. Accordingly, there are or will be important factors that could cause actual outcomes or results to differ materially from those indicated in these statements. These factors should not be construed as exhaustive.