Archives for February 2024

There’s a widely accepted narrative about the office market:

• Covid-19 came and companies, often under government demand, closed their offices and had people work from home.
• When things returned more or less to normal, employees didn’t want to return, despite executive insistence.
• Because of tight labor markets, employees had more leverage, so office buildings faced significant drops in occupancy.
• Over time, companies realized they had less need for office real estate and started to pare back, leaving many office owners facing big trouble.

An easy four-step journey. And if Brookfield is correct, one that has embraced some big misconceptions. They argue that too much office inventory isn’t the issue. Rather, it’s too little inventory of the right sort. “There is an excess of dated, functionally obsolete office buildings and an undersupply of offices that satisfy tenants’ changing needs,” they wrote. Instead of companies not needing office space, “tenant preferences have shifted to buildings with modern amenities and functionality, and the recent rise in interest rates has exposed older office buildings as uneconomical.”

That will lead to a “distribution of outcomes for owners, lenders, and local communities,” because the uneconomical buildings don’t have the financial strength to continue existing as they do.

Brookfield goes on to offer a startling number, that 90% of all office vacancies are in the bottom 30% of buildings, “largely characterized by older offices with limited amenities and reduced functionality.” The top 25% of buildings, in comparison, see stable vacancy rates and record-high rents. “We believe this growing divide will only widen as legacy leases expire and tenants look for new space that reflects evolving business culture to engage employees and meet sustainability goals,” they write.

This fits with the “flight to quality” trend that GlobeSt.com sources have noted. This is particularly true, according to many, as companies decide to reduce their footprint and use the opportunity to find better space.

There is a limit to the improve-and-move theory, however. Cushman & Wakefield recently asked whether there is enough appropriate office space to meet flight-to-quality demand. The answer is yes, for the immediate time, but not for too long. Other reports have also raised doubts about whether this trend is, in fact, real.

The most attractive and desirable office space is only between 10% and 15% of total inventory, Cushman said. Demand for the buildings is high. Top-tier space in gateway markets enjoys vacancy rates that are 700 basis points lower than the remaining market. “Direct vacancy in the best buildings is sub-11%,” an impressive number in relative comparison.

There’s an inherent development that led to office bifurcation, as Brookfield says. As office supply developed between 1990 and 2022, businesses heavily digitized how they operated.

“There is no agreed upon universal metric for measuring the amount of office space needed in any given market,” Brookfield writes. “But with the adoption of modern technology, it is generally accepted that fewer square feet of office space are needed by today’s corporations than in the past. The level of excess office inventory in the U.S. relative to the rest of the world is particularly pronounced when measured on a per capita basis.”

The firm’s view of the future was a bit grim. “To resolve the vacancy issues plaguing office real estate, we believe a large portion of these older office buildings will need to be repositioned, repurposed or demolished,” they wrote.

Source: “What Many Get Wrong About the US Office Market“

According to new data from CBRE, commercial real estate lending in the U.S. demonstrated signs of stabilization at the end of 2023, with borrowing costs appearing to have peaked, even as transaction activity remains subdued.

The CBRE Lending Momentum Index, which tracks the pace of CBRE-originated commercial loan closings in the U.S., increased by 1.0% from Q3 2023–marking the first quarterly increase since Q1 2022. The index still saw a decline of 38.1% compared to the strong loan volume of Q4 2022. The index closed Q4 2023 at a value of 189.

“While the capital markets continue to present challenges, we are seeing more constructive lending conditions for specific asset classes,” stated James Millon, U.S. President of Debt & Structured Finance for CBRE. “We are experiencing a material decline in credit spreads in the liquid markets, lower trading band for benchmarks and a reset of cap rates at higher levels. Additionally, as the Federal Reserve has indicated interest rate cuts on the horizon, these factors combined have created a more favorable transactional environment in the first quarter.”

Banks maintained their position as the largest contributors to CBRE’s non-agency loan closings for the seventh consecutive quarter, accounting for 39.5% of the total in Q3 2023–an increase from 38.4% in the previous quarter. Floating rate loans contributed about one-third of the loan volume in Q4 2023, with 38% allocated to refinancings and the remainder supporting property acquisitions.

Alternative lenders, such as debt funds and mortgage REITs, represented 30% of the Q4 2023 loan volume, up from 27.4% in Q3 2023, with multifamily assets remaining the preferred property type. Collateralized loan obligations (CLO) totaled $672 billion in Q4 2023, resulting in a significant decrease from the $30.3 billion recorded in 2022, with the 2023 annual total reaching just $6.67 billion.

Life insurance companies accounted for 27.4% of origination volume in Q4 2023, down from 33% in the previous quarter, predominantly in fixed-rate acquisition and refinancing loans for industrial and retail assets.

CMBS conduits accounted for less than 3% of non-agency loan volume in Q4 2023. Industrywide CMBS origination in Q4 2023 reached $12.86 billion, showing improvement compared to the previous quarter. Overall, CMBS volume for 2023 totaled $39.33 billion, representing a 44% decline from 2022.

Underwriting criteria changed slightly in Q4 2023. The average underwritten cap rate increased by 16 basis points (bps) to 5.68%, while the average loan-to-value (LTV) ratio rose to 61.4% from 58.3% in Q3 2023. Higher interest rates translated to loan constants averaging 6.72% in Q4 2023, representing a 79-bps increase year-over-year.

Government agency lending on multifamily assets slowed to $27.1 billion in Q4 2023, down from $29.8 billion in Q3 2023. CBRE’s Agency Pricing Index, reflecting average fixed agency mortgage rates on 7-10-year permanent loans, rose 40 bps in Q4 2023 and 83 bps year-over-year to 6.04%.

Source: “Commercial Mortgage Lending in U.S. Shows Signs of Stabilization in Late 2023“

The Federal Reserve Bank of Kansas City’s commercial real estate index continued to drop in the last quarter of 2023, with falling absorption rates and lower loan demand being the primary culprits.

The Kansas City branch monitors economic trends in the Federal Reserve’s Tenth District, which includes Albuquerque, Santa Fe and much of the northern half of the state. Much of the southern half of New Mexico falls into the Reserve’s Eleventh District under the Federal Reserve Bank of Dallas.

The index value — a measure of standard deviations from historical norms — showed commercial real estate contraction in Q4 of 2024, falling from -0.8 to -1.3. The report illustrated a continuing trend of declining real estate activity. That decline has been credited to the Federal Reserve’s continued efforts to curb inflation, the most notable being increased interest rates.

Not all contributing market metrics declined. Notable but small bright spots included construction materials sales, developer access to credit and credit standards for commercial real estate loans.

Regardless, most metrics were in the red. Property sales, for example, contributed -0.088 to the index value and absorption, or the rate in which commercial space is sold or leased, contributed -0.093.

However, the numbers don’t tell the entire story. Nichols Sly, vice president at the KC Fed, told New Mexicans business leaders at a recent Economic Forum of Albuquerque event that the outlook varies by commercial real estate sector and city population size.

“What’s happening on the coasts, or what’s happening in some middle markets is not the same as what’s happening in Albuquerque or Santa Fe,” Sly said.

According to Sly, one of the most talked about concerns in real estate, vacancy rates, differ depending on the size of the metropolitan area. In metros with a population of between 3 million and 500,000 residents, vacancy rates “haven’t moved that much,” he said.

The Kansas City branch is primarily made up of this category, with Omaha, Albuquerque and Oklahoma City all sitting below 1.5 million residents. The district’s biggest metros, Kansas City and Denver, have less than 3 million each.

Sly anoted the outlook for central business districts, industrial areas and suburban office spaces vary. 

There is also disagreement in the algorithms being used to portray real estate trends, with Sly labeling it as “measurably high.”

“Within commercial real estate, but frankly more broadly, … the disagreement about the algorithm has never been larger,” Sly said. “That has to change the way you think about some of the headlines.”

Local and national picture

In Albuquerque, between Q2 2023 and Q3 2023, office market square footage increased by 34.3% and vacant square footage increased by 1.9%, according to Colliers’ 2023 Albuquerque Office Market Report.

A recent look at central business districts by The National Observer found that some of the issues surrounding them have been tied to branding and shifting focuses in a post-pandemic world, with a push for more diverse offerings in downtown areas.

Nolan Marshall, executive director of the South Park Business Improvement District in Los Angeles, told The National Observer that office towers, such as Albuquerque Plaza in Downtown Albuquerque, could benefit from incorporating more social-focused amenities.

“We’re recognizing that these neighborhoods that were devoted to commercial towers now have to serve different purposes, whether that be conversions to residential or conversions to hotel and hospitality focuses,” Marshall said. “In the downtown management world, we would traditionally refer to coffee shops or small pocket parks as third places, where people could gather, socialize, do some work. Office towers now have to become third places as well.”

Meanwhile, the Albuquerque industrial market fared worse in the same period from Q2 2023 to Q3 2023. Available square footage increased by 90.4% and vacant square footage increased by 17.27%. However, the industrial market has about half the available and vacant square footage compared to office space in the city.

The trends can be partially explained by a national decline in development starts after a surge following the end of the Covid-19 pandemic, according to Stephanie Rodriguez, national director of U.S. industrial services at Colliers International Inc. The slowdown can be correlated to creeping interest rates, she told The National Observer, as well increased difficulty for developers to obtain financing.

There’s good news for industrial spaces on the horizon, though. Recent federal policies, including the CHIPS and Science Act and the Inflation Reduction Act, have incentivized bringing manufacturing space back to the United States after years of offshoring.

This can be most clearly seen in New Mexico with Singapore-based Maxeon (NASDAQ: MAXN), who announced in August they would be building a new facility in Mesa del Sol. Another hot spot for such onshoring projects include the Borderplex in Santa Teresa, where companies like Taiwan-based automotive parts manufacturer Hota Industrial Manufacturing are erecting new facilities.

Source: “KC Fed commercial real estate index continues to fall, but numbers don’t tell full story“

The year 2022 was a tough one for renters. The rent-to-income, or RTI, ratio peaked, driven by high multifamily rent increases that were chasing growing property prices and falling cap rates.

Last year was an improvement, at least in theory, according to Moody’s Analytics CRE. A combination of decelerating rent increases — negative growth, even — and increasing real incomes have meant that RTI have been declining.

But it hasn’t done much to change the fortunes of most households. “Still, metros previously identified as ‘rent burdened’ remained the same for this edition of the report, even as 85% of all metros experienced RTI decline relative to one year prior,” Moody’s wrote.

Moody’s had done the analysis for median households. There’s always a danger — which they recognized — with a view of median or mean results. Distributions are necessary to see how all people are being affected, and the differences here may seem surprising at first.

The Wall Street Journal had an interesting take in early February. The wealthiest renters saw falling rents. Quoting data from Yardi, they wrote, “Asking rents at properties populated by the highest-earning renters fell by 1% in December,” and that the figure didn’t include additional concessions, like periods of free rent, included in about a third of all rental listings according to Zillow. But others didn’t.

As GlobeSt.com reported at the time, construction costs had raced upward, ultimately adding more than 40% of final delivered costs over pre-pandemic times. Property valuations jumped. To make new deals pencil, units in an apartment building had to promise significant future rent growth. Many developers focused on up-scale units as a result.

Moody’s noted that the share of B/C multifamily units of the entire market dropped from two-thirds in the early 2000s to less than half by last year.

That meant more growth in luxury units than moderate- to lower-income apartments in much of the heavy construction trends that led to the record inventory delivery levels of 2023 and 2024. The overabundance of higher-end units would lead to a concentration of supply for a limited part of the market, so prices would fall more there. But, as Moody’s pointed out, mortgage rates and house prices have increased significantly, meaning that home ownership remains out of reach, even for many households with higher incomes.

Also, Moody’s noted, “Moderate- and low-income households enjoyed an above-average boost to incomes, particularly in 2022. However, their rent burden improved little. Marginal dollars earned does not appear to be enough to offset increases in rents, even in the more affordable segment of the multifamily market.”

The problem goes back to the Global Financial Crisis, which set off a housing shortage that grew over a decade. Many developers got out of the business and liquidity was hard to come by. Construction never caught up, leaving a major deficit.

Source: “The Rent Burden Has Eased But Not for Everyone“