Economic Outlook by Blake Hastings

Outlook for US, Texas and Austin Economies for SWBC Mortgage & Heritage Title

August 29, 2023

by Blake Hastings, SVP of Corporate Strategy and Chief Economist SWBC

Presentation Outline

Current Economic Conditions

U.S. Economic Outlook

Outlook for Texas

Outlook for Austin Economy and Real Estate

Current Economic Conditions

Progress on Core Inflation Slow But Steady

4.7%

3.3%

4.1%

Key Sticky Inflation Components Peaking As Expected

Labor Market Strong, But Mixed Signals

Labor Market Far From Equilibrium

Source: Bureau of Labor Statistics

Wages Finally Keeping Up with Inflation

Home Equity Borrowing: Maxed Out, Declining

Credit Card Usage Also Propping Up Consumer: Peaking?

Consumer Balance Sheets Weakening: Especially Middle Class

Source: Commerce Dept. and Wells Fargo

Real Retail Sales Continue Slow Decline

Economic Outlook 2023

Yield Curve

Signaling Recession in Next 6 Months

U.S. Financial Institutions Tightening Credit Standards; As Expected

Source: Federal Reserve 1st Quarter 2023 Senior Loan Officers Survey

Outlook for U.S. Economy in 2023: Recession Ahead

The U.S. economy continues to slow

o 4th quarter of 2023 or 1st quarter of 2024 recession likely begins

o Likely to be a shallow recession and will last as long as it takes to tame inflation (2-3 quarters)

 Could be a “jobfull” recession – unemployment will likely only go up to 5.0% (rather than typical 710% seen in most recessions)

• Employers will hold until labor longer due to difficulty attracting and retaining (survey data already supporting this thesis)

• Once recession has ended labor markets will move back to full employment quickly (longer term demographic challenges will return to the forefront)

Outlook for Rates

Fed Policy

• Likely the terminal rate 5.5-5.75%, currently 5.25-5.5% (1 more hike possible)

• Won’t lower rates until late 2024/early 2025, earliest

• However, may start to signal market in mid 2024 especially if we’re in a recession

Market Rates

• Market rates for mortgages, commercial and corporate bonds will likely peak once Fed starts its “pause” this quarter.

• Market rates may start to “drift” downward (sustainably) towards the end of 2023 in anticipation of Fed reaching terminal rate. Again in mid 2024 as Fed signals future cuts likely.

• It may take years (if ever) for some market rates to return to pre-pandemic levels.

• Pandemic levels were anomalous and not likely to occur again unless significant economic stress occurs.

Texas Economy

Texas Ranks 5th in Job Growth Since Pandemic

Job Growth Slowing in Most Metros, But Still Robust

Home Prices Continue Bottomed?

Back Up

Multifamily Rents Bottoming

Middle Skilled

Lower Skilled

Higher Skilled

Outlook for Texas

Texas Will Likely Enter Recession Later and Exit Earlier or Avoid it All Together

o Texas economy already showing mixed signals/slowing

 Manufacturing and Retail indicators all negative

 Home prices picking back up

 Services Revenue remains strong

 Rents stabilizing

o A combination of stronger labor markets, net migration (people and firms), and overall stronger growth than rest of nation

o Exposure to energy sector much more limited than in past, but will have some impact (energy is a very cyclical industry)

o Recession may cause more businesses and people to relocate to reduce costs, taxes, etc.

o Once recession has ended, labor markets will tighten again quickly in Texas

o Likely to continue to see job growth weaken but remain positive throughout 2024

Austin Economy

Austin Job Growth Slowing, But Remains Strong

(U.S.)

Austin Unemployment Ticking Down

Most Austin Sectors Gained Jobs in June, Accelerated

Home Prices Rebounded, Now Leveling Off

• Prices rebounded, but leveling off as inventories pick up

• Inventories are higher, but still well below equilibrium (6 months)

• Build up of inventory in higher price points not surprising given slowing in higher skilled workers

Source: Texas A&M Real Estate Research Center (Data through July, 2023)

Housing Affordability Improved Q1, Down Q2

Source: Wells Fargo

Austin New Housing Permits Recovering

Back of the Tray

Outlook for Financial Sector

Asset Ratios Improving as Investments Regain Value

U.S. Banks Equity Asset Ratio

Source: Board of Governors of Federal Reserve System

Borrowing from Fed BTFP Stabilized

Source: FDIC

Net Interest Margins Now Under Pressure

Deposit Outflows Continue, Restricting Lending Activity

Source: FDIC

Non-current Loans Ticking Up; Far From Troubled Territory

Non-current Loans: Community Banks

All U.S. Banks

Source: FDIC

Banks Are Well Braced for an Economic Slowdown

Source: FDIC

Troubled Banks/Assets Still Very Low

Source: FDIC

Number of Banks with Texas Ratio Above 100 Declining

$1.5 in CRE Loan Resets, A Problem?

• Multifamily, Retail, Industrial, Lodging and Health appear to be holding up well

• Will be some regional challenges with retail (ex. downtown areas of major cities with high office vacancies)

• Office will be a challenge in most metros, especially NY, SF, LA, Chicago, etc.

• Banks hold 45% of all CRE mortgages

• Community and regional banks have highest exposure to CRE at 20% of all assets (big banks 4%)

• Total office CRE resets around $255 billion

• Regional and small only average of 3% of total loans in office CRE

• Top 25 banks have less than 1% of total assets in office loans

• May be some bank failures, likely to be isolated not a financial crisis

Outlook for CRE

Valuations Should Stabilize

Higher Interest Rates Are Slowing New Inventory Build –

• Will create floor on prices

• Multifamily and Industrial will continue to be favored by investors

• Retail will be very location specific

• Office space will be challenged

As Interest Rates Peak, Investment Activity Should Bottom

• Likely Fourth/First Quarter

• Should see uptick in activity and may represent “best opportunity” for buyers (except office)

Multifamily Outlook Still Strong

• High single-family prices and interest rates making most markets renters markets.

• National median vacancy rate at 6.9% in Q2

• Rental rate increases moderating, but still elevated by historic standards

 Q2 rental growth was 1.1%, down from 2.8% in Q1

 However, still strong in sunbelt regions

• High growth markets in mountain west and south may face under build situations over next couple of years.

• Cap Rates at 5.4%

Industrial Outlook is Moderating

• Near record low vacancy rates should keep rental rates growing modestly

• Need to keep additional inventory dissipating as pandemic winds down

• Expect vacancy rates to pick up modestly

• Leasing off by 10% in 2022 from 2021 indicating demand normalizing

• Vacancies picked up to 4.2% in Q2.

• Record completions in 2023, but starts plummeting (higher rates)

• E-Commerce market share moderating, brick-and-mortar resurgence

• Rental growth rates and vacancies still better than pre-pandemic, 8.9% in Q2

• Dallas, Chicago, Houston, Phoenix, Indianapolis, Kansas City, Atlanta have highest absorption rates

• LA, NY and Boston have seen most negative absorption.

• Cap Rates at 6.7%

Retail Outlook is Stable

• Downtown retail in cities with high office vacancies under pressure, likely to continue (San Francisco, Chicago, New York, Atlanta, Dallas, etc.)

• Suburban markets fairing much better, especially in growth states

• Continue to see resurgence in brick-and-mortar retail, dining, etc.

• Vacancy rate unchanged last three quarters at 4.2% (lowest subsector)

• Rent growth of 3.6% in Q2

• Cap Rates at 6.1%

• Strongest absorption rates in Chicago, Phoenix, Houston, Dallas, Atlanta, San Atnonio, Austin, Charlotte, Tampa

Office Outlook Very Challenged

• Nearly 102 million square feet of space became available in Q2

• Vacancy rate at all time high of 13.1%

• Interestingly, Class A has seen most deterioration in 2023

• San Francisco, Dallas, Houston, Austin, Washington, D.C., Phoenix, Chicago, Denver, L.A., and Atlanta have largest vacancies

• Space will be likely challenged for next 2-3 years if not longer

• Markets will clear in terms of valuations in next 12-18 months

• Cap Rates at 7.9%

Gap between

U-1 and U-6 at Low Levels

Auto Lending Continues Cooling Off

Used Auto Prices Still Have More To Come Down

SWBC Collections Activity Continues to Increase

SWBC Skip Tracing Assignments Also Up

Credit Card Delinquencies Picking Up Rapidly; Below Pre-Pandemic Levels

Actions to Consider

• Risk Management

o Rapidly rising rate environment

 Interest rate risk and mismatch monitoring/hedging

 Be prepared for more deposit outflows as consumers and businesses dip into savings

 Stress test all assets for a 5% downturn (will be regional differences)

o With anticipated continued deterioration in delinquencies:

 Actively monitor including insurance (consumer credit, mortgages and autos)

 Robust collections (including foreclosure and repossession)

 Increase loan loss reserves (i.e. JP Morgan Chase)

 Watch CRE (Office especially)

o Other

 Prepare for decreasing asset prices, watch LTV ratios

 Consider tightening underwriting (if haven’t already)

 Prepare to see some uptick in auto collision and warranty claims (higher costs)

• Non-Interest Income

 Softening loan demand and tight interest margins will create greater need for non-interest income

• Drive Efficiency and Productivity

 Process improvements and use data analytics to make workforce more productive

 Partner with vendors to manage operational costs

 Look for ways to outsource most human capital-intensive activities

Both CPI and Core CPI Higher in Texas

Labor a Little Looser in Texas

Immigrants and their US born children drive US labor force growth

Foreclosures Picking Back Up

Not Surprisingly Negative Equity Climbing

Commercial Real Estate Outlook

Cap Rates Likely to Increase More, But not dramatically

• Cap Rates 100 bps higher = 10-15% decrease in valuations

• Expect another 25-50 bps increase = 5-7% decrease in valuations

• Will likely peak in fourth quarter and decline gradually over 2024 as interest rate environment becomes more constructive

Valuations Should Stabilize

Higher Interest Rates Will Slow New Inventory Build –

• Will create floor on prices

• Multifamily and Industrial will continue to be favored by investors

• Retail will be very location specific

• Office space will be challenged: Class A will hold up, but B & C already seeing distress

As Interest Rates Peak, Investment Activity Should Bottom

• Likely Third Quarter

• Fourth Quarter should see uptick in activity and may represent “best opportunity” for buyers

Office will Continue to be Strained

Retail Should Be Steady: Some Weakness From Recession

Despite headwinds from recession, negative real wages and declining retail sales, retail real estate should hold up due to lack of new supply

Industrial Outlook is Moderating

Supply and Demand in Balance

• Near record low vacancy rates should keep rental rates growing modestly

• Need to keep additional inventory dissipating as pandemic winds down

• Expect vacancy rates to pick up modestly

• Leasing off by 10% in 2022 from 2021 indicating demand normalizing

• Record completions in 2023, but starts plummeting (higher rates)

• E-Commerce expected to continue gaining market share, especially in high growth areas

Multifamily Should Be Stable Despite Higher Vacancies

Rent growth stabilizing; vacancies edging up