Archives for October 2022

NAIOP echos what many are seeing ahead for commercial real estate: tougher times ahead.

Its NAIOP CRE Sentiment Index reveals that overall sentiment is down from the spring as respondents expect unfavorable conditions during the coming 12 months due to higher interest rates, higher cap rates, and a decrease in the supply of equity and debt.

Respondents “predict a sharper increase in cap rates and greater contraction in the supply of equity and debt than in any previous survey.

“And their outlook for occupancy rates, face rents and effective rents is also less optimistic, though they still expect rents to grow.”

Construction and labor cost inflation is anticipated to improve, they said, and developers will maintain recent deal volume over the coming year, completing about the same dollar volume of new projects and transactions as in the past 12.

Development Pipelines for 2023 Already Set

Andrew Fallon, executive managing director, SRS Real Estate Partners National Net Lease Group, tells GlobeSt.com that there’s “no question that we face a lot of headwinds going into 2023.

“Project costs and rising rates will put more pressure on developers and tenants as they determine the feasibility of new facilities, but the fact of the matter is that the pipelines for the first half of 2023 are already set with construction projects and deliveries in motion.

“The expectation is that new project starts will decline throughout 2023, and transaction volume will be down due to a shallow buyer pool, while the market absorbs the new interest rate environment. Deal structures may need to be adjusted as rents and exit cap rates change, but demand for space and durable real estate investments will prevail.”

Debt Costs Have Doubled

Drew Dolan, Principal and Fund Manager, DXD Capital, tells GlobeSt.com that his firm will continue to invest in the self-storage sector despite headwinds he is seeing in the current marketplace.

“Debt costs have doubled in the past nine months, and transactions have slowed significantly in the last quarter leading DXD to believe that many projects will be ‘shelved’ or may never happen,” Dolan said.

Institutional self-storage investors are on the sidelines for the time being, this immediately following a two-year period of unsatiable appetite for self-storage investment from the same investors, he said.

“Rental rate increases are expected to continue, but at a slower pace than in the previous two years,” which saw historic rate growth and historic inflation levels, according to Dolan.

“Construction costs, which have been one of the major headwinds for real estate development are beginning to show signs of dampening.

“While most reports are anecdotal to date, subcontractors proactively seeking work indicates excess labor supply in the coming months.

“DXD Capital remains bullish on the self-storage sector and its pipeline remains oriented to markets of high growth and significant barriers to new development.

Bid-Ask Spread Widening

Charles Byerly, CEO, Westport Properties, tells GlobeSt.com, that transaction volume has slowed in all three of its verticals (self-storage, industrial and multifamily).

“There are still opportunities, but the bid-ask spread is widening which may take at least six months to reconcile.

“Obviously, the Fed will have a big say in how this plays out depending on how far they go with rate increases and if/when the increases flatten.

“Debt appears to still be available in the product types we play in, but terms are very conservative and lender spreads have not come in to help offset the increases.”

A Slowing in Top-Line Growth

Byerly said that operationally, he is seeing a slow-down in topline growth in storage assets, “but that is after a very strong couple of years, so it was bound to happen regardless.

“Industrial rents appear to be hanging in there as well, but not seeing the large lease-to-lease increases we previously were seeing over the past couple of years in the markets we’re active in.

“We have several multifamily assets in the Southern California market and those assets continue to perform well.

Source: “NAIOP Survey Says Sharp Increase in Cap Rates Among Many Headwinds“

In the annals of wishful thoughts of what could have been, the National Multifamily Housing Council brought up a bill filed in the House and Senate last year, which is likely out of time.

Known as S.2511 in the Senate and H.4759 in the House, the Revitalizing Downtowns Act was introduced by Sen. Debbie Stabenow (D-MI) and Rep. Jimmy Gomez (D-CA) at the end of July 2021.

The act, had it passed, would have provided a tax credit to convert older office buildings into new uses. Developers would have been able to deduct 20% of qualified conversions expenditures for qualified office conversions.

The building would have had to be in service for a minimum of 25 years before the conversion. A developer or owner could turn a space into “residential, retail, or other commercial use.” In the case of a residential conversion, there were several conditions. For example, 20% or more of the building’s units had to be rent restricted and available only to people whose income is 80% or less of the area median. A building could also have been written into a state or local government agreement.

In both houses, the bell went to committee. NMHC said that, with a coalition of industry partners, sent a letter to Congress in support and to suggest some changes, like allowing REITs to take part, expanding the incentive beyond office buildings, and enabling states to use tax-exempt Private Activity Bonds to cut financing costs even further. It might also be wise to prohibit such a credit from being extended to the conversion of older apartment buildings into some other sort of commercial property.

The basic idea is terrific. Many parts of the US are terribly short of housing, in particular. Conversion costs are high. Old buildings that started as office or some other sort of construction aren’t quick transformation into housing, or probably any other type of property. Finances, especially at times of high rates, might make a conversion unprofitable if significant blocks of units would be low-income housing, as seems only reasonable. Tax credits might make the difference and encourage more creation of housing that is desperately needed.

But, as NMHC admits, there’s little chance of this happening. Midterm elections are in a few weeks, officials are wary of taking stances at this point that might throw off a re-election bid. Plus, as Politico noted, there are at least a big spending bill to prevent a partial federal government shutdown and the National Defense Authorization Act.

That leaves a heck of a lot of things that never got done and won’t. Something that didn’t receive enough attention to get a hearing is unlikely to catch a blaze of attention now.

That said, CRE professionals might prod their representatives into considering this next year. Some proposals come back year after year. Of those, there is a portion that do eventually get passed.

Source: “Congress Had a Great Idea That It Absolutely Won’t Pass This Session“

As U.S., like the rest of the world, continues to grapple with stubborn inflation (at 8.2 percent in September), there are worries that consumer spending is going to falter and impact industrial owners’ ability to raise rents. Industry insiders, however, say such fears are over-stated.

At the moment, industrial real estate fundamentals remain strong and rental rates continue to rise, especially in key coastal markets, according to San Francisco-based Al Pontius, senior vice president, national director for office, industrial and healthcare, at real estate services firm Marcus & Millichap.

Pontius does cite nuances in the marketplace that might point to slowing demand for warehouse space. Such indicators include the depth of prospective tenants and change in landlords’ approach to lease up of new build-to-suit properties. For instance, in January and February of 2022, rental rates were rising so fast that landlords held off on making final deals with tenants until the date of occupancy. “Now landlords are locking in rates right away.”

Industrial tenants also are slower than they were before to make decisions, Pontius adds. As a result, absorption in secondary markets and absorption of older industrial product has slowed down.

In the third quarter, the national industrial vacancy rate rose by 10 basis points, to 4.0 percent from an all-time low of 3.9 percent, according to research from real estate services firm Savills. That change was distributed unevenly, however, with vacancy in Houston and the Pennsylvania I-81/78 Corridor falling by more than 350 basis points and vacancy in Detroit going up by 30 basis points. Year-over-year national rent growth reached 12.5 percent, which is considered a modest increase compared to rent growth of 40 percent in some markets in recent times. Industrial leasing activity fell below 200 million sq. ft. for the first time in eight quarters, Savills researchers report.

Leasing activity has decelerated over the past several quarters, in part due to constricted supply, agrees Matthew Dolly, leader of national industrial research with real estate services firm Transwestern. As a result, U.S. overall net absorption is at its lowest level in two years, and the national vacancy rate has ticked up slightly in the third quarter, to 3.9 percent, according to Transwestern research. Meanwhile, some warehouse owners are intensifying property marketing efforts, which could be another indication of a slowdown in demand, as Dolly notes that this has seldom occurred for the better part of the past 10 years.

New deliveries are expected to move average vacancies further up, despite continued strong demand. According to Dolly, more than 130 million sq. ft. of industrial real estate product was delivered nationally during the third quarter, which is consistent with the previous several quarters. And additional 970 million sq. ft. is currently under construction—a record high. Slightly more than one-third of that product is pre-leased, according to Dolly. That corresponds with Savills’ estimates, which put the share of under-construction space pre-leased nationally at 36 percent, though the figure also varies greatly by market. In Baltimore, more than half of under-construction space is pre-leased. In Houston, that figure is 17 percent.

But, overall, demand is strong enough that it’s still a landlord’s market, Dolly notes, especially in key locations. In Dallas, for example, demand for new industrial construction has rebounded in the third quarter to tie with the previously all-time high set in 2021, adds Andrew Matheny, Dallas-based research manger with Transwestern. That is pushing up forecasts for the industrial vacancy rate in Dallas-Fort Worth over the next 12 to 18 months to 8.5 to 9.0 percent (that rate today is 6.2 percent, according to Savills research). But while new projects could experience longer lease-up periods than they have over the past few years, the long-term outlook remains positive, says Matheny.

In fact, several of the most populated metropolitan areas in the U.S. are still underserved when it comes to the amount of industrial space they need, particularly those experiencing substantial population growth, says Dolly. The vacancy rates in the Inland Empire and in Los Angeles markets are currently under 2.0 percent, according to Savills. In Northern New Jersey, South Florida and the Pennsylvania P 81/78 Corridor they are under 4.0 percent.

In addition, rising demand for manufacturing space could tighten industrial vacancy, Dolly notes. Over the past few months, the number of manufacturing companies leasing space in the U.S. has increased, a good indicator of how much on-shoring is taking place. Plus, transportation and retail companies also continue to actively look for industrial space. “Large tenants continue to dominate leasing activity, but smaller tenants may get an opportunity if some of the larger users are able to unload some of their inventories during the holiday season,” Dolly says.

Meanwhile, Matheny notes that current trends may make the industrial property sector more resilient to economic downturns. He points to the continued growth in e-commerce shopping, which remains 25 percent above pre-pandemic levels, and the fact that prevalence of remote work has geographically shifted centers of consumer demand, creating the need for last-mile industrial facilities in suburban and periphery locations.

“Higher market share and geographic dispersion may increase inefficiencies and costs that discourage consolidation, partially insulating industrial vacancy in a downturn,” Matheny notes.

Source: “Demand for Industrial Space Is Slowing Down. But It’s Still a Landlord’s Market.“

The increasing severity and frequency of climate-related extreme weather events is one of several factors pushing commercial real estate owners and operators to step up efforts to analyze climate risk within portfolios. Institutional investors in particular are feeling growing pressure from investors and ESG mandates, as well as the need to prepare for a proposed SEC rule that will make climate-related financial disclosures mandatory for those companies that report to the SEC.

Hurricane Ian was the latest in a growing number of climate-related disasters that have topped the $1 billion mark. Last year, the U.S. recorded 18 separate billion-dollar disasters and an additional 15 have occurred year-to-date, according to the U.S. National Oceanic and Atmospheric Administration (NOAA).

However, stakeholders in the commercial real estate industry are at very different stages of developing processes and identifying tools to assist in asset-level and portfolio climate risk analysis. One of the biggest challenges is that approaches in assessing climate risk vary widely and there is no consensus on standardization. Some providers are thinking about value at risk in terms of insured value, others look at change in asset value or replacement cost, notes Elena Alschuler, our Head of Americas Sustainability at LaSalle Investment Management. “Those are three very different metrics,” she says.

LaSalle Investment Management conducted a climate risk assessment across its entire global portfolio in 2022. “We do view it as something that is relevant to the financial performance, value and risk mitigation of our assets. So, we are trying to proactively address it,” says Alschuler. The firm conducted an in-depth review of different service providers and recently released the report How to Choose, Use, and Better Understand Climate-Risk Analytics in conjunction with ULI that aims to bring to light some of the issues and inconsistencies that exist around different climate risk analyses and provider approaches.

One of the key takeaways from the report is that there can be huge differences in physical risk scores for the same asset depending on the methodology and provider. For example, when addressing hurricane risk, many models only look at wind and coastal flooding and don’t include pluvial flooding—flooding caused by extreme rainfall, says Alschuler.

Another inconsistency among providers is whether or not they are considering baseline risk or the existing risk today. In its research of providers, LaSalle Investment Management found that some firms were not flagging assets in Florida for hurricane risk and were only flagging assets further up the East Coast in markets such as Baltimore, Boston and New York. The reasoning was that models were only accounting for forward-looking change in risk.

The problem that creates is a huge variance in climate risk assessment even among similar assets, says Alschuler. If an LP is getting reports from various investment managers or REITs on climate risk and one provider includes the baseline risk in their climate risk assessment and another doesn’t, it will create different results that makes one portfolio look much more high risk than the other. In addition, a lot of assessments don’t account for any risk mitigation measures or improvements that have been made to a property, or risk mitigation measures taken by the government, she adds. So, it becomes important for investors to dig in and understand the methodologies being used, she says.

Best practices continue to emerge

Although real estate owners are still in the early stages of developing climate-risk assessment strategies, many are looking to learn from what others are doing. For example, CBRE Investment Management uses a number of third-party tools including Moody’s ESG Solutions to get an initial indication on potential physical climate risk. Moody’s assesses exposure to critical physical risks including floods, heat stress, hurricanes/typhoons, water stress and sea level rise. CBRE Investment Management uses the results are used to analyze the physical climate risks associated with both new acquisitions and existing portfolio assets.

“If an asset or area is identified as high risk, we begin more in-depth analysis to determine mitigating factors that might have already been implemented or could be implemented to de-risk the investment,” says Helen Gurfel, head of sustainability and innovation at CBRE Investment Management.

PGIM Real Estate also uses Moody’s physical climate risk score for individual risk reports for new acquisitions and new developments, as well as the Physical Climate Risk Exposure (PCRX) module in Measurabl, an ESG data management software platform, for standing assets. Those tools help the firm to holistically evaluate climate risks, and existing standing assets are reviewed quarterly as part of portfolio reviews.

Additionally, PGIM Real Estate investigates an asset’s likelihood to be impacted by adverse weather conditions, such as wind or flooding, for assets flagged as high-risk and/or flagged for flooding and sea level rise risk factors. The company’s ESG team uses the information to make budget recommendations and determine a cost-effective manner to protect assets. “Our emphasis on resilience along with ESG ensures that we stay ahead of the curve with regard to the changes in our environment,” says Christy Hill, head of Americas Asset Management and global head of ESG at PGIM Real Estate.

An increasing number of institutions also are utilizing the voluntary Resilience Module included in the GRESB Real Estate Assessment, which aims to increases information for investors on how companies are assessing and managing risks associated with climate-related shocks and stressors.

LaSalle Investment Management created a global climate risk task force two years ago that initiated pilot projects with different providers before selecting one provider and rolling climate risk analysis out to its entire global portfolio. In some cases, the company also supplements information with additional sources. “You really have to treat it like it’s more of a flagging exercise,” says Alschuler. “We don’t see any of this as establishing value to the fourth decimal point. It’s much more about flagging assets that need to be looked at more closely so that you can dig in and bring critical thinking.”

Climate risks influence strategy

Ultimately, companies are hoping to better understand climate risk exposure as a means to enhance financial performance. Extreme weather events have the potential to impact asset-level and portfolio performance whether it is property damage from an event, capex needed to mitigate potential effects from storm damage or rising insurance premiums.

The exposure to climate risk for the CRE industry is significant. For example, there was an estimated $1.5 trillion in commercial and multifamily real estate assets that were in the five-day path of Hurricane Ian, according to MSCI Real Assets, which tracks assets valued greater than $2.5 million. Potential losses from even a single event are enormous. Rising insurance costs in high-risk areas are another concern. According to Swiss Reinsurance Company Ltd, climate risks globally are expected to add an estimated $200 billion to annual property insurance premiums by 2040.

Real estate owners and managers are using climate risk analysis to drive strategy and investment decisions. For example, LaSalle Investment Management has incorporated physical climate risk assessment into acquisition underwriting to identify any potential issues. That assessment takes into account mitigation measures and capex that might be needed at the asset level, as well as issues such as portfolio diversification. “The same reason why you don’t want high concentration of your assets in one real estate market, physical climate risk becomes another reason why you want to pay attention to physical market concentration in a portfolio,” says Alschuler.

A growing number of CRE owners and managers, including both institutions and non-institutions, are taking proactive steps to assess the potential impact of climate change over time as part of an ongoing risk-informed decision-making process. “In addition to considering climate risk, we focus on building resilience and environmental stewardship to both protect the environment and strengthen our global businesses,” says Hill. “That focus enables us to improve the potential for higher investment returns and benefit our clients, employees and shareholders as well for future generations.”

Source: “How Institutions Are Managing Climate Risk Within Real Estate Investment Portfolios“