Archives for December 2023

The great post-pandemic return to office (RTO) is a polarizing issue in the U.S. labor market.

While many companies want their workers to return to the office for at least a few days a week — seeking better communication, increased productivity and a return on investment (ROE) for their expensive office real estate — the reality is that Americans like working from home (WFH) and the flexibility it provides.

Employers seem to be coming to terms with that fact. After a big push in 2020 to 2022 to bring employees back to in-person work — when the number of days US employees worked from home dropped from 61.5% to more like 30% — the RTO trend stalled in 2023, according to data from Stanford economics professor Nick Bloom and his team.

“WFH levels have become ‘flat as a pancake.’” he recently posted on X. “Return to the Office is dead.”

Here’s why this employment trend is having an eerie impact on commercial real estate across the country.

The impact of office vacancies

The data shows that in November of 2023, the percentage of U.S. employees who are working remotely or have a hybrid working arrangement is sitting at just under 42% and has been sitting at roughly that level since 2021.

Many bustling hubs are now starting to look like ghost towns as office occupancy in the 10 largest U.S. metro areas has been hovering at around 50% this year, according to Kastle data.

“We are three and a half years in, and we’re totally stuck. It would take something as extreme as the pandemic to unstick it,” Bloom recently told CNBC.

Office vacancies on a national level hit a 30-year high of 18.2% in the second quarter of 2023, according to CBRE data — with empty offices or “ghost towers” cropping up from coast-to-coast.

This is a major driver in the overall dive in office property values — an important metric for real estate investors. Shifting office demand could result in a 35% plunge in office values by the end of 2025, according to a recent report from Capital Economics. It also projects that those values are unlikely to recover before 2040.

CBRE’s forward-looking analysis is slightly less grim. It expects the overall office vacancy rate to peak and the average rent to bottom out in late 2024.

“Continued uncertainty about long-term hybrid working arrangements and concerns about the economic outlook are causing many tenants to delay leasing decisions,” the firm explained in its “2023 U.S. Real Estate Market Outlook Midyear Review”.

“Although vacancy rates likely will remain structurally higher in many markets, active tenants in the market suggest that leasing activity will eventually rebound and support the start of an office recovery once economic conditions stabilize.”

Prospects for real estate investors

Not only have office vacancies reduced foot traffic in the “office adjacent” economy — impacting local businesses like restaurants, retailers, convenience stores and hair salons — but it has also dulled investor confidence in the sector.

According to CBRE, commercial real estate investment volumes fell by 64% year-over-year in the same period.

But all is not lost for commercial real estate investors.

With the support of the Biden administration, Lawmakers in cities like San Francisco, New York and Washington D.C. are taking actions to convert vacant offices, hotels and other non-office commercial spaces to multi-family residential properties.

This, they hope, would revitalize their downtowns and address the long-standing supply shortage and affordability crisis in the U.S. housing market.

But commercial-to-residential conversions are not always straightforward, as a top aide to New York Mayor Eric Adams told Yahoo News: “Those are really hard projects” — noting that there’s a lot of red tape around zoning laws and design challenges.

It is important to understand the scale of these projects too. CBRE noted: “While 2023 is shaping up to be a banner year for office building conversions to other uses like residential, they account for less than 2% of total U.S. office inventory.”

Still, if these conversion projects prove successful, this could be a major boon for residential real estate investors — with opportunities through avenues like residential real estate investment trusts (REITs), exchange-traded funds, and crowdfunding platforms.

Source: “‘Return to the office is dead’: Stanford economist says the US is ‘stuck’ with remote work as more offices sit empty — is the bell tolling for commercial real estate?“

After unprecedented, accelerated growth in 2021 and 2022, industrial and logistics operators have taken their foot off the gas when it comes to new development and has even hit the brakes – at least this year – according to a new report from Colliers.

New supply tallies have set all-time highs of 450 million square feet through the first three quarters of 2023, up 33% year-over-year, it said,

Colliers also noted that demand for industrial product during the past 36 months “may never be repeated in our lifetimes.”

However, headwinds such as rising interest rates, vacancy concerns, and normalizing demand led to a big drop off in starts this year, which Colliers said is a good thing.

The top 25 markets Colliers tracks have witnessed an increase of 125 basis points over the past year. Vacancies have risen 176 basis points in the other 52 markets it follows.

“The pullback on speculative development will help ease vacancy concerns and return the market to a supply-demand equilibrium,” according to the report.

It’s the first time the pipeline has contracted since mid-2020 with industrial space under construction down by 26% on average year-over-year in the 25 largest markets.

And while circumstances have pushed vacancy rates higher in nearly all markets, Colliers said the outlook for industrial remains favorable as e-commerce and reshoring continue to grow.

Colliers expects balance to return to most markets by the end of 2024, resulting in stabilizing vacancy rates and steady demand.

Source: “Industrial’s Supply-Demand Should Balance by End of 2024“

Industrial and multifamily continued in their corrections mode last month, while retail performed best with four months straight of pricing gains, according to data from Crexi that is based on properties in its database.

Office occupancy went unchanged in November and industrial rents were stagnant.

For-sale properties on Crexi experienced a seventh month of pricing growth alongside a gradual compression of cap rates.

Shanti Ryle, CREXi Senior Content Marketing Manager, reported that occupancy has also been trending up overall in new listings with the past four months experiencing growth and with new listings posting an 80.33% average occupancy.

Industrial and multifamily’s struggles can be attributed to over-deliveries, Ryle said, and “too-high” rents pricing out renters in some major metros, “but it will ultimately be okay in the long term.” And the high-priced single-family home market continues to make renting more attractive.

“Would-be homeowners are still prioritizing renting due to rising mortgages, with equilibrium a long way off. While this is bad news for homebuyers, it’s good for apartment owners,” according to Ryle.

Industrial deliveries are glutting the “accelerated growth” from previous months, Ryle said. “However, a healthy demand exists, especially as companies continue onshoring their manufacturing and retailers prioritize last-mile logistics facilities.”

Offices showed life, posting a third consecutive month of pricing gains. However, nationwide office occupancy didn’t change. It’s at a 64.5% average.

Crexi found a fourth straight month of pricing gains and average occupancy rates in November for retail as it hit its highest levels since October 2022 at 85.96%.

Retail remains a desirable asset and one of the fastest growing on Crexi, Ryle said.

The sector is expected to hit $400 per square foot after the holidays after inching so close to that milestone in November.

Retail’s rent growth rose for a second consecutive, touching a three-month high and a 9.64% rent rate increase compared to November 2022.

Restaurants’ average asking rents experienced a third consecutive month of contraction in November, even though there is similar average square footage available for lease.

Source: “Data Show Industrial, Multifamily Still in Correction“

Commercial real estate transactions slowed considerably in 2023, amid high interest rates, declining values and pricing uncertainty.

Investment volume declined by 42% in 2023 from the prior year, according to CBRE Group Inc. (NYSE: CBRE). The Dallas-based commercial real estate firm is expecting deal volume to be down again in 2024, but by a more modest 5% year over year.

Richard Barkham, global chief economist and global head of research at CBRE, said there’s been “enormous excitement” since the 10-year Treasury yield recently dropped, to about 4%. Combined with the Federal Reserve’s signaling of some interest-rate cuts next year, that should propel more commercial real estate transactions in 2024.

“There are still some issues we will need to contend with,” Barkham said, adding the Fed still wants to see a lower rate of inflation, and economies in the rest of the world are also slowing. “We’ve found it very difficult to forecast and be accurate on inflation. It’s not impossible we’ll get another inflation upside surprise,” he added.

CBRE is forecasting an average 10-year Treasury yield of 3.3% between 2025 and 2028. That will likely result in more deal volume in the medium term rather than in 2024, though transactions are likely to start picking up in the second half of 2024, Barkham said.

CBRE isn’t predicting a recession in 2024 but expects the economy to slow, with a projected unemployment rate of 4.5% — up modestly from the rate of 3.7% last month — and the inflation rate to cool to about 2.7% by the end of 2024.

Next year will also have a closely watched U.S. presidential election. Barkham said he wasn’t sure what impact that will have on commercial real estate activity but, he added, during very contested elections, the market tends to slow about three months before Election Day.

Interest rate impact on commercial real estate

Rebecca Rockey, deputy chief economist and global head of forecasting at Cushman & Wakefield plc (NYSE: CWK), in an email said last week’s Fed announcement was largely expected and doesn’t meaningfully shift the Chicago-based commercial real estate firm’s perspective for 2024. There’s also still uncertainty about inflation and no guaranteed path for the federal funds rate, she added.

“So, as the Fed stated, it is too soon to declare victory,” Rockey continued. “I think there is a temptation to place too much emphasis on the Fed pause and pivot. Certainly, it will add much needed clarity, but the fact remains that we are in the midst of a broader adjustment process to higher costs of capital, and that will persist well after the Fed’s pivot and throughout their cutting cycle.”

Still, she said, Cushman is predicting commercial real estate transaction momentum to gain steam through next year and into 2025 as the economy and interest-rate picture becomes clearer. That’ll allow for greater conviction in underwriting income and exit assumptions, Rockey said.

Tim Bodner, real estate deals leader at PricewaterhouseCoopers LLP, said there’s new optimism among real estate investors since the Fed’s announcement last week. The economy is also holding up fairly well, with inflation coming down and the consumer and labor market overall resilient, he added.

“All of these things provide a really nice backdrop for … the commercial real estate market,” Bodner said.

But it’s inevitable a looming wave of debt maturities will need to be addressed, and most who track the commercial real estate industry closely expect an uptick in distress and foreclosures in 2024. Moody’s Analytics Inc. estimates there will be $182 billion in commercial real estate debt maturing next year.

Are more office foreclosures on the horizon?

The office market will continue to be closely watched next year, in particular as debt matures on troubled properties.

Bodner said challenges observed in the office market right now are similar to what’s been seen in the mall sector in recent decades. There are also a number of properties that don’t have the right capital structure, Bodner added, which will trigger distress — and it won’t be immune to just office.

So far, loans facing issues at maturity in commercial real estate have largely been dealt with through loan extensions and modifications. Barkham said it’s likely banks are going to be a little more firm next year in how they handle financially strained properties after mostly soft pedaling in 2023.

“The banks always go easy in the periods of real uncertainty but, oddly enough, as (there is) greater certainty about the trajectory about the economy and about a soft landing, I think they’re going to want to deal with some of those loans that are very underwater,” Barkham said, adding a marked uptick in office building foreclosures is likely next year.

Rockey said office is likely to struggle because underwriting absorption or rents is very difficult for that sector in today’s market, and pricing is still disconnected from the higher rate environment.

“However, opportunistic capital is eager to see distressed or discounted sales even in this sector,” she added. “It just needs to be the right price.”

While more deals in the distressed space is expected among commercial real estate economists, there’s not likely to be an avalanche of transactions in that world, Bodner said.

Financial institutions still largely don’t want to own or manage a lot of real estate, and that might prompt lenders to continue to extend loans, even on troubled assets, he added.

Investors ‘look selectively’ at CRE deals

Some major commercial real estate players are sharpening their pencils to figure out which deals will make sense in 2024.

Alfonso Munk, Americas chief investment officer at Houston-based Hines, said during the recent economic and real estate turmoil, his firm has selectively continued to invest, particularly in property types like retail, medical office and student housing.

But Hines has historically been a major traditional office player, with Munk estimating the firm manages close to $30 billion in office assets. The firm has pulled back significantly on its investment in office, having only bought one office property in the U.S. in 2023, an 11-story building in downtown Washington, D.C., for nearly $60 million in April.

“I think you’ll see a re-shift, like we saw in retail, where the demand is going to be there, but it’s going to be focusing on the best office (buildings) and locations,” Munk said.

And despite the buzz last week around the Fed’s intention of cutting interest rates next year, Munk said Hines isn’t yet counting on rates going down in its underwriting assumptions, which means a lot of deals still won’t pencil.

He said he’s also closely tracking the labor market in 2024, as well as which markets are starting to get crowded and could be at risk of being oversupplied — places like south Florida; Austin, Texas; and Denver, according to Munk.

But metros like Tampa, St. Petersburg and Orlando in Florida; Charlotte, Raleigh and Durham in North Carolina; and Dallas are interesting because of their employment growth and infrastructure investments, such as the Brightline train that connects Miami and Orlando, Munk said.

“We look selectively at markets,” he continued. “You have to go where the barriers to supply are, (where there’s) not as much hype and you can still find value.”

Source: “Commercial real estate volume may pick up in 2024 as Federal Reserve signals interest-rate cuts“