Archives for September 2023

While the massive interest rate hikes have hammered the commercial real estate market, the recent Federal Reserve decision to hold rates unchanged will give the market a break. After 11 collective rate hikes in the last 18 months, commercial real estate credit has gotten even tighter as lenders have been more cautious after the recent collapse of the two regional banks in March of 2023. According to the Federal Reserve survey, small and mid-sized banks — holding most commercial real estate loans — reported tighter lending standards in the year’s second quarter. In the meantime, delinquency rates for commercial real estate loans have increased, albeit remaining historically low. Although the Federal Reserve is signaling more rate hikes to follow by the end of the year, this pause will give some time to assess the impact of higher rates on the economy.

As low-interest loans mature at higher rates, all commercial real estate sectors face challenges. Higher vacancy rates and slower rent growth remain the dominant trends of the current market. Negative net absorption and new supply have pushed the office vacancy rate to another all-time high at 13.3% in August 2023. Even though multifamily rent growth decelerated even further, demand for apartment buildings has increased as many people are priced out of the market due to higher mortgage rates. Retail availability remains tight as this sector holds the lowest vacancy rate of any other sector at 4.2%. Finally, the industrial real estate sector remains strong, with the fastest rent growth among other sectors, but demand seems to be sliding closer to the pre-pandemic level.

Commercial Real Estate Sector Performance in August of 2023

The unprecedented surge in delivered units has amplified the available space within the multifamily sector. Over the last 12 months leading up to August, there has been a notable 32% upswing in units delivered to the market compared to the previous year. Consequently, vacancy rates registered a 1.2% uptick in contrast to last year’s corresponding period. Nonetheless, absorption rates have sustained their upward trajectory into August, demonstrating a substantial 23% surge compared to a year prior. The multifamily sector is expected to remain strong compared to the other CRE sectors, owing to favorable demographics, a strong job market, and low housing affordability due to higher mortgage rates.

Despite the pandemic coming to an end, employees are lacking enthusiasm for returning to physical office spaces. Meanwhile, the amount of office space delivered to the market remains high. These dynamics, coupled with the progression in remote technology and the rise of flexible work environments, have led to a massive surplus of 59.4 million square feet of unoccupied office space compared to occupied space in the 12 months ending in August. Consequently, the office vacancy rate has reached one of the highest in the past 10 years at 13.3%. With a growing number of office construction projects in progress and ongoing technological advancements, the office sector is poised to face considerable challenges in adapting to evolving work arrangements and demands.

Although the industrial sector of commercial real estate has tapered off from its peak last year, it has now reverted to pre-pandemic levels. Net absorption has fallen by 47% compared to the previous year. A record-high 525 million square feet of additional industrial spaces entered the market, coupled with decreased demand, have elevated the industrial vacancy rate to 5.4% and moderated rent growth to 7.5%. Nonetheless, rental expenses for industrial spaces have persisted in rising faster than in the pre-pandemic period.

The rise of e-commerce has posed challenges for the conventional retail sector over the past decade, and the pandemic has further exacerbated this decline in activity. However, the retail sector remains robust, with 12-month rent growth ending in August decreasing by 1.2% compared to the previous year’s record-breaking 4.4%, now at 3.2% but still higher than pre-pandemic levels. The vacancy rate has plateaued for the last five quarters at 4.2%, the lowest among all CRE sectors. As inflation continues to recede and interest rates are projected to stabilize later this year, the outlook for retail space demand remains strong.

Hotel demand has remained on the rise, leading to increased occupancy rates and higher room rates. The hospitality industry has made a noteworthy recovery, with hotel revenue receiving an additional boost after being impacted by COVID-19 restrictions and quarantine measures. The revenue per available room (RevPAR) is now more than 13% higher, and the average daily rate (ADR) is about 18% higher than their pre-pandemic levels. With business and leisure travel gaining momentum, the demand for hospitality establishments will continue its upward trend throughout 2023.

Source: “September 2023 Commercial Real Estate Market Insights“

Predicting the future of the U.S. commercial property market is never easy. Fortunately, research conducted by industry thought leaders provides key insights that should help lenders better position themselves for the murky future ahead.

The last Commercial Buildings Energy Consumption Survey conducted in 2018 by the U.S. Energy Information Administration found that 97 billion square feet of commercial real estate space existed in the U.S., approximately 16% of which is commercial office.

According to a recent article by J.P. Morgan Chase, $1.5 trillion of commercial real estate debt will mature before the end of 2025. In the CMBS market alone there is approximately $185 billion in commercial office debt, 20% of which is predicted to default.

It is hard to predict where the biggest trouble will lie, but since the pandemic, suburban office space has recovered at a faster pace than urban markets. In the third quarter of 2022, vacancy in suburban offices was 11% compared to 18% for Central Business District offices. In addition, Class A properties, which are often newer and may include energy efficiency enhancements, access to outdoor space, fitness facilities and state of the art technology are doing better compared to their Class B (or C) counterparts. According to the same J.P. Morgan Chase article, nationwide, Class A vacancy was 18% and Class B vacancy was 20.2% at the beginning of 2023.

Overall, the U.S. commercial office market is experiencing a 20% vacancy rate. Detroit is faring slightly better (19.3%) than cities like Chicago (23.5%), Indianapolis (22.4%) and Columbus (21.7%), but it’s likely vacancy rates will continue to increase due to several factors, including sublease expirations and “shadow space.” According to Michigan commercial brokers, available subleases have experienced a dramatic rise with available sublease square footage in 2023, which is anticipated to double the available square footage of 2022.

A statistic that hasn’t received much attention previously, but is important now, involves “shadow space,” space that is currently under lease, but not available for sublease, and is not being utilized by the tenant. According to research conducted by global real estate services provider Cushman & Wakefield, shadow space makes up approximately 20% of commercial office space. With a 20% vacancy rate, shadow space of 20% and fast-growing sublease availability, the commercial office market is at a significant turning point.

With higher capital costs, declining occupancy and a tight or nearly non-existence lending market for commercial office, many owners are reluctant to put more money into their properties.

Lenders are cautious to take assets back, preferring to work with borrowers and return the loans to performing status. But few borrowers have sufficient capital to contribute to obtain lender approval for an extension, loan modification or forbearance arrangement. While some lenders may return to the “extend and pretend” strategy from 2008, others are focused on declining office space values. These lenders, for example, may be willing to take a property back now and incur a $5 million loss rather than give the borrower a two-year extension and take the property back at a $15 million loss.

There’s also increased interest from investors considering loan or REO property purchases from lenders, but pricing expectations are not always aligned with investors seeking larger discounts than lenders are willing to offer.  A recent study by Columbia University and New York University projected office values could decline over 40% of the pre-pandemic value by 2029.

What happens next is not going to be pretty for many property owners or lenders, but conditions might present an opportunity for those willing to invest at a discount or repurpose or improve their property.

Source: “Commercial Office – What Happens Next?“

Industrial investors are wondering how long this asset class can sustain its top ranking.

Al Pontius, National Director, Office & Industrial Division, Marcus & Millichap, said during a company news video that interest rates have clearly caused some pullback in the marketplace.

But that may be short-lived.

“We’re already seeing the gap in expectation between buyer and seller close. So given the popularity of industrial as an asset class, we’re going to see a continued escalation of transactions as more and more equity, earmarks, industrial for either portfolio balancing or simply to participate in the industry in the expectations going forward.”

Also, Pontius said although there is some oversupply right now, particularly in major markets in the short term, the anticipation is that the construction supply pipeline is going to slow.

In 2023, another 550 million square feet of industrial will be delivered, and that will outpace absorption for the year, raising vacancy rates modestly, according to Marcus & Millichap.

However, looking at 2024 and beyond – basically over the next five years – this will fall off to an average of 200 million feet per year.

No question, interest rates have had an impact, Pontius said.

“It’s very difficult to broad-brush the entire market because you have considerations such as sub-market, vintage, configuration, existing rents relative to market rents,” he said. “But the short story would be that cap rates have moved between 75 and 150 basis points on the averages.

“So, if average cap rates have moved 75 to 150 basis points, that would mean some deals are trading with negative leverage.”

Assets are trading with negative leverage today for several factors, he said, including where are the rents in that asset relative to the market and how fast can I get those rents to market.

Another consideration going to the other end of the spectrum is new property, he said.

“There’s a broadly held belief that construction costs will only continue to increase,” Pontius said. “So, if I buy a new asset today, I am automatically locking in a low basis relative to where newer properties will be years down the road.

“And correlated to that will be upward pressure on interest rates to come, one more time, especially in an environment where the supply spigot is going to turn off considerably.

“Again, that would be very contingent on location, configuration, and existing rents for starters.”

He said the reason industrial assets would trade with negative leverage is the anticipation of moving those rents in the relatively near term or going to the other end of the spectrum in a brand-new property.

“[Investors are] locking in a basis today that is already going to be lower than the basis will be in the future for new construction,” he said.

Newly constructed product is also a consideration.

“There’s a broadly held belief that construction costs will only continue to increase,” he said. “So, if I buy a new asset today, I am automatically locking in a low basis relative to where newer properties will be years down the road.”

Correlated to that will be upward pressure on interest rates to come, one more time, “especially in an environment where the supply spigot is going to turn off considerably,” according to Pontius.

Source: “Expert Says Strong Industrial Wave Nowhere Near Over“

For the past three years the multifamily sector has experienced a construction boom not seen since the 1970s, which has helped lead to the current moderation of rents.

However that may be about to change.

According to a new report by Greg Willett of Institutional Property Advisors, rents could resume an upward path by spring 2024, with “robust” increases in 2025.

A slowdown in early stage multifamily building showed up in 2Q 2023, with starts in key markets falling slightly. This was largely attributable to less access to development capital, Willett reported. The largest banks were holding back on real estate lending, while smaller banks shied away after the failure of regional lenders earlier in the year. In addition to the low rate of rent growth, capital sources were worried by rising operational expenses, especially insurance costs, that “soared above past norms.”

While more than one million apartment units are currently under construction in the U.S., they may not make a significant dent in the nation’s housing needs. About half the total construction pipeline is in 15 markets only, with 30,800 units being built. “That start volume is off 52% from the quarterly norm of 64,200 that was sustained for nine quarters from early 2021 through early 2023,” Willett noted. “Absolute peak quarterly starts totaled 81,500 units from April through June 2022.”

He anticipated that rent growth would begin to show up by spring 2024, “when the normal seasonal upturn in leasing velocity should coincide with obvious signs that today’s new supply excess is temporary” to push rents higher during 2025.

The most obvious signs that apartment construction is slowing appear in Texas. Starts fell 79% in Houston, 74% in Austin and 64% in Dallas-Fort Worth compared to the prior two years – even though these metros continue to be leaders in job growth and apartment demand. They are therefore likely to see boosted rents.

Other likely candidates are Philadelphia, Denver and Washington, DC – all of which have seen sharply lower multifamily construction starts. More moderate declines are underway in Nashville, Phoenix, Miami, Orlando, and Charlotte. Even with the slowdowns in construction, Phoenix still ranked with Raleigh-Durham, Charlotte, and Dallas-Fort Worth at the top of the list for multifamily starts in the second quarter, each with 3,200 to 3,500 units being built.

Source: “Multifamily Rents Poised For Robust Increases Further Ahead“