Economic uncertainty – how did we get here?

High interest rates, heightened regulatory pressure on big banks, an inverted yield curve, stubborn inflation. How did we get here?

Mortgage Professional America reached out to Michael Acton (pictured), head of research and strategy of Boston-based AEW Capital Management, for a snapshot of what’s occurring today in the commercial market – what with the Fed tinkering with rates as it continues to fight inflation. Along the way he showcased strategies on how his firm protects its portfolio amid volatility.

“There are a lot of stresses on commercial property right now,” Acton said during a telephone interview. “The primary one is a pretty significant change in the interest rate environment over the last 18 months, but really since the Fed started bringing up overnight lending rates. That was a really big move, and it happened really quickly. It created stresses outside of properties – it created stresses in the banking system, and we saw that in March and in the spring when many banks came under pressure.”

Big banks slow down before the big bang

And then, the fireworks started in earnest. “When we first saw it was the middle of last year,” Acton said. “The transaction market in the United States had been very strong in 2021 following the COVID shutdown. Things came back pretty quickly – very high levels of transactions occurred that continued into 2022. The week before the Fourth of July is when the large lenders we work with, the big money center banks, started reaching out to us saying ‘look, we’re really going to slow things down; we’re going to pull back; we’re not going to be advancing as much credit to properties. Certainly, we will honor all existing obligations and all that kind of stuff. We’ve been very busy the last 12, 18 months, we’ve grown our book enough. We’re getting pressure from regulators to slow down.’”

They weren’t kidding either: “By the middle of the year, the big banks really pulled back,” Acton said. “The smaller lenders, the regional, more local banks, kept lending.”

Those relying on the big banks for credit felt the impact of the slowdown. One of the world’s largest real estate investment managers, with some $90.7 billion in assets under management, AEW Capital Management was among those feeling the change among big banks.

“The commercial property sector really depends on available credit,” he explained. “Assets are big and lumpy and have cash flow characteristics. They’re very supportive of using financial gearings, financial leverage. When all that is pulled back or constrained, activity slows down and it slows down quickly. As trading activity slows down, uncertainty rises. Things become much less clear. And things just sort of come to a standstill.”

Here’s an interesting bit of perspective: “The total trading volume in the US through August is pretty much exactly the same as it was through August of the COVID year of 2020,” Acton said. “So in some sense, the contraction on credit, the pullback on credit, has had as much of a slowdown effect on the market as COVID did. For very, very different reasons, but comparable.”

Going with the flow in changed economic waters

So where does all this leave AEW Capital Management? Despite its behemoth status, the firm – like any other investment firm – needs to manage its portfolio accordingly amid the changing economic waters. Acton described some of the strategic moves he’s taken in an ever-changing landscape.

“That’s a process that’s sort of a continuous process,” Acton said. “We’re always evaluating all the possible places capital can go in commercial property, trying to figure out growth prospects for the income, the certainty of that, risks along with that, and so on.”

Then there are other pathways to investment in the sub-category world, he suggested. “There really are very large and growing groups of what people refer to as alternative, or niche, or sub categories of properties,” Acton said. “Most of them when you peel them back are subcategories of a bigger category. I mentioned the cold storage/refrigeration that’s a subcomponent of the broader industrial market. People talk about student housing or senior housing. Affordable housing. Those are all sub-categories of residential.”

Take the office market, for example. “There are subcomponents,” he said. “Medical office properties have a really compelling demographic and economic story. The demographic story is we have a really large and aging Baby Boomer population that needs a lot of medical services,” he said.

Despite the economic downturn, there are still plenty of places in which to invest. “There’s a million of these little stories… and they’re all interesting. As any investment manager, you just have to take stock in all of them and make your assessment. You gotta pick the ones where you think the opportunity is perhaps the greatest. We’re looking at those places where there really could be both a good long-story but also our ability to execute on it.”

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