Archives for April 2024

Over the past four years, the office and industrial real estate markets have undergone seismic shifts.

Since the onset of the pandemic, the office sector has struggled to keep up with evolving workplace demands and expectations. The abrupt shift to remote and hybrid work has led the sector to experience record-high national vacancy at 19.8%. Despite an uncertain outlook, not all is doom and gloom. Office tenants now favor newer, centrally located trophy and Class-A assets that offer modern amenities. Tenants are in a “flight to quality,” with the overall vacancy in these types of buildings decreasing by 5% in the past five years. Meanwhile, industrial real estate has witnessed record demand since 2020, with rent values growing and new construction happening across the country.

It isn’t possible to be certain of the exact trajectory of these markets. Commercial real estate is often volatile due to its ever-changing nature. Economic uncertainty throughout the past year and a half has shaken up assets across all sectors, and technology, including high-tech software solutions and artificial intelligence, continues to evolve rapidly. That is why remaining at the forefront of trends, aligning with those who are similarly forward-thinking and adapting to change are the best ways to stay agile in the market.

The Society of Industrial and Office Realtors, or SIOR, a leading global commercial real estate association, understands this and equips its members with the leading tools, knowledge and resources necessary to thrive in a rapidly evolving real estate landscape.

“If there is a silver lining in any changing market, it’s that people and companies begin looking at things in new and highly creative ways,” SIOR CEO Robert Thornburgh said. “While economic factors are undoubtedly influencing all sectors, change is also driving opportunity. Any significant transformation happening in commercial real estate creates avenues of growth for those paying close attention.”

The continued effects of political and economic uncertainty on industrial and office properties remain noteworthy as each sector adjusts, Thornburgh said. As interest rates rose in the past year to combat record inflation, property prices and market fundamentals have been negatively impacted, slowing down construction starts. The office market is experiencing similar economic setbacks but was also greatly impacted by work-from-home policies implemented during the pandemic.

The real estate industry is also confronted with a variety of technological advancements, including artificial intelligence and smart building technologies aimed at reducing costs and enhancing operational efficiency, that are reshaping the way properties are acquired, sold and overseen.

In a survey conducted by SIOR to explore the influence of technology on commercial real estate, 84% of respondents said they believe commercial real estate technology, particularly proptech, is essential for success. Nearly 100% reported that drones will be among the most valuable technology for the future of the industry, and 82% said big data will be among the most valuable.

“Companies that choose to take advantage of these technologies will play a pivotal role in the industry’s future,” Thornburgh said. “CRE has traditionally been slow to integrate new technology, but this is changing. Those that accelerate smart, relevant adoption will ultimately be better informed and conduct more precise decision-making.”

These trends illustrate why staying prepared for uncertainty will give companies an advantage, he said. To thrive in today’s dynamic environment, change becomes a prerequisite for success.

“Building a culture that isn’t afraid to explore new ideas and related thinking is paramount for success,” Thornburgh said. “SIOR has helped its brokers succeed during numerous cycles over the years. Thankfully, we are constantly pushing the envelope to drive innovation and business development, and we are proactively evolving to ensure both our organization and its members are prepared to meet tomorrow’s demands.”

The past two years have been “revolutionary” for SIOR, Thornburgh said. Adopting a new five-year strategic plan, the organization has set its sights on a more global, nimble and forward-thinking association.

“A revitalized brand, thoughtfully implemented new initiatives, platforms for exchanging best practices and ideas, and the exploration of technology-based advancements will all bring a heightened energy and culture to the organization,” he said. “It will ensure our members are well prepared to meet any challenges that lie ahead. These new changes are already driving greater interest in SIOR today.”

In 2023, SIOR saw the most new members join the organization since its inception in 1941. It saw a 21% increase in female members, a nearly 25% increase in members under 35 and a 13% increase in international members. The society has more than 3,900 members across 49 countries. These numbers are particularly notable as the organization raised its qualifications in a variety of ways, making it more difficult to earn the designation.

With more members joining SIOR each year, attracting the next generation of office and industrial leaders is critically important, Thornburgh said.

“It is of paramount importance for SIOR to be composed of the industry’s finest,” he said. “In all categories of membership, the primary drivers for us are integrity, competence and skill. We’re working to elevate expectations in the office and industrial space with the best brokers in the game.”

Looking forward, key initiatives for the organization include increasing value to its dedicated members and industry partners, prioritizing its member associate program, an area that focuses on those starting out in their careers, becoming an international resource for members across the globe, and setting a new precedent for excellence in the industrial and office sectors.

“The driving question for us? How can we continue to accomplish extraordinary outcomes for those that are a part of the global SIOR community and this industry we care so much about?” Thornburgh said.

Source: “How SIOR Is Embracing Change To Move The Office And Industrial Sectors Forward“

Office landlords and the tenants they lease space to are both shifting into a new leasing paradigm more than four years after the onset of the Covid-19 pandemic.

While it’s been well established the pandemic permanently changed norms around in-office versus remote work, it’s taken years for landlords and occupiers alike to figure out how to navigate office-space decisions because of those shifts. And while the office market’s challenges will be felt for years to come, there’s become greater clarity from both owners and lessees of real estate around how to traverse the complicated office market.

A majority of landlords — 82% — in VTS Inc.’s fifth annual landlord survey said they are seeing the length of renewals increasing or holding steady. Additionally, 57% of landlords said retaining and renewing tenants was their No. 1 priority, compared to 41% that picked leasing vacant space.

Ryan Masiello, co-founder and chief strategy officer at VTS, said this year’s survey, when compared to previous iterations, indicates there’s more certainty among landlords about the path forward in the aftermath of the pandemic.

For many landlords, that means investments in tenant and common spaces at their buildings, with 47% of landlords surveyed saying property improvements were a key priority for them this year.

That includes technology investments, with 33% of landlords saying they were investing in tenant-experience technologies at their buildings. That percentage ranked ahead of 31% who said they were investing in outdoor communal areas, 30% who said property operations, 27% who said food-and-beverage options and 27% who said fitness centers.

“Over the past couple of years, landlords were inching toward navigating the market and making investments in certain things from a digital perspective. … It comes out quite clearly that a lot of dollars are being poured into modernizing the way landlords are managing their process to attracting tenants, and the experience they have once they get to a building,” Masiello said.

It’s also become more important for landlords to retain companies currently on their tenant roll — even more important, according to the survey, than leasing vacant space. There’s been a significant increase in the office vacancy rate since the start of the Covid-19 pandemic, hitting a record 19.8% in the first quarter of this year, and a staggering amount of sublease inventory has been listed, much of which is being converted to direct vacancy as those leases expire.

Many tenants in the market right now are looking for a deal, Masiello said, and landlords are still offering lofty concessions like tenant-improvement allowances and a period of free rent to lure a more shallow pool of companies in the market today. Some landlords are getting creative with concession offerings by negotiating a way for tenants to use credits to access on-site amenities like conference or fitness centers.

“[Landlords are] trying to tie the amenities in the building to the lease, if you will, and make those as an additional concession,” Masiello said.

Tenants start to find their footing

A separate survey of small-business owners, executives and leaders by The Business Journals examined how occupiers are thinking about their space needs.

It found 42.3% of survey respondents leased their office space, 32.1% owned it and 14.9% had a mix of owned and leased space. About 11% said they didn’t have office space.

Echoing the findings of the VTS survey, 41.8% of the executives who responded to The Business Journals’ survey said they plan to renew their lease in their current office space, while another 14.9% said they were unsure about their future plans for their leased office space, 13.6% said they didn’t have an office and didn’t plan to get one, and 11.2% said they planned to expand to a larger space.

Slightly more than half of the respondents said their companies’ employees were in the office at least three days a week, with 30.3% indicating they were in the office five days a week and 21.5% saying they were in the office three to four days a week. Only 8.7% said most of their employees are fully remote.

An overwhelming majority of respondents — 65.1% — said they had not changed their office space square footage since March 2020, while 16.8% indicated they had reduced their office space by some amount. Meanwhile, 18.1% said they had expanded by some amount since the pandemic.

As for pricing, 24.1% of the executives who responded to The Business Journals’ survey said they were neutral about a potential price increase for their next lease, while 18.6% said they were “very concerned” and 18.1% said they were “slightly concerned.”

Asking office rates have been holding fairly steady since the pandemic, but effective rents declined 0.04% in the first quarter, according to Moody’s Analytics Inc.

Speaking about the VTS landlord survey and more broadly about the market, Masiello said the office sector is beginning to shift into a reset, where landlords and tenants feel more confident about their space decisions.

“You’re starting to see the stabilization and consistency of people know what they need to operate in the new world, and it’s much more distinct in this survey than we’ve seen in the past,” he said. “I think that’s a good sign for the office market — there’s a confidence in what needs to happen to navigate [the market].”

Source: “Surveys of landlords, occupiers suggest increased confidence in office-space decisions“

Trading in florescent office lights for the comfort of home, by 2025, one in five Americans are expected to work remotely, according to the Census Bureau–a trend that terrifies the commercial real estate market and the banks that finance increasingly empty office buildings.

Plummeting office property values and high interest rates spell trouble: Economists at the National Bureau of Economic Research said 44% of office loans are for properties now worth less than their outstanding debt.

According to researchers at the International Monetary Fund, small and regional banks are almost five times more exposed to the sector than large firms. They pointed to the Mortgage Bankers Association’s estimate that more than $1 trillion in commercial real estate debt in the U.S. will come due in the next two years.

“Financial supervisors must continue to be vigilant. Rising delinquencies and defaults in the sector could restrict lending and trigger a vicious cycle of tighter funding conditions, falling commercial property prices, and losses for financial intermediaries with adverse spillovers to the rest of the economy,” the researchers wrote.

In a February interview with CNBC, JPMorgan Chase chairman and CEO Jamie Dimon was skeptical of fears the issue will spark a broader market downturn.

“If you have a recession, yes it will get worse. If we don’t have a recession, I think most people will be able to muddle through this, you know, refinance, put more equity in. And of course when you talk about defaults being higher, part of that’s just a normalization process,” Dimon said.

Large firms like JPMorgan Chase and Bank of America, whose chair and CEO Brian Moynihan called commercial real estate “a slow burn,” are much better positioned to weather negative outcomes than smaller firms like New York Community Bancorp.

Top ratings firm Moody’s downgraded the bank to junk status earlier this year. One vulnerability it cited was “(a)round 54% of its office loans are in Manhattan where office vacancy is around 15%.”

During a hearing last month before the House Financial Services Committee on the Federal Reserve’s Semi Annual Monetary Policy Report, Fed Chair Jerome Powell said this is a problem that will linger over the financial system for years.

Source: “Declines in office space value present years-long threat to financial system“

While 2023 was challenging for US commercial real estate (CRE) investors, we believe that it’s “off the floor in 2024,” with real estate poised to start its price recovery sometime in the second half of the year.

Think of it as a chain reaction, which starts with fed fund rate reductions. That should help to lower real estate debt costs, which should, in turn, reduce upward pressure on cap rates. An eventual lift in cap rates should drive higher real estate prices.

Lower interest rates start a chain reaction

The December 2023 Federal Open Market Committee (FOMC) meeting sent the message that real estate investors have been waiting for. Confidence in lower inflation is solidifying, and monetary tightening is nearing an end.

The fed funds rate is expected to be cut three times in 2024 and several more times into 2027. While inflation and economic growth have surprised to the upside since then, at the March 20 meeting, the FOMC reinforced that they expect to start reducing the fed funds rate sometime this year with additional cuts to follow.

Lower fed funds rate projected ahead

FOMC median projections of the fed funds rate at year-end

First reaction: Lower real estate debt costs

Lower policy rates are a necessary catalyst for reducing interest rates more broadly, including CRE debt costs. The historical relationship between policy rates and debt costs has been well established.

Real estate debt costs are priced at a spread above certain base interest rates, including the fed funds rate. The spread varies over time. When policy rates are escalated, the spread to real estate debt costs narrows, which eventually causes real estate debt costs to rise in order to maintain a premium over base policy rates.

By contrast, when policy rates are reduced, so is pressure on debt costs, eventually leaving room for them to fall, which ultimately affects real estate cap rates.

Next reaction: Lower cap rates

Reductions in real estate debt costs have historically led to lower cap rates and price growth. Because commercial real estate investing often includes financing, real estate debt costs historically have been closely related to real estate cap rates (the relationship between a property’s net operating income divided by the property’s purchase price).

Since the start of 2000, the correlation between market cap rates² and fixed debt costs³ has been a very strong 0.85.⁴ A decline in debt costs is highly likely to result in a decline in cap rates, which typically reflects rising prices.

Next reaction: Rising prices

The historical relationship between year-over-year changes in cap rates and CRE prices has been very strong. A reduction in cap rates and a rise in prices typically go hand-in-hand, and vice versa, for a structural reason.

Real estate price is part of the cap rate equation (i.e., net operating income divided by price). From the start of 2000 to the end of 2023, the correlation between the annual movement of cap rates versus prices has been -0.81, indicating a very strong inverse relationship.⁶

So historically, falling policy rates led to falling debt costs, which led to falling cap rates, which led to rising prices. We expect this chain reaction to unfold over the next several months.

Plus, plunge in new starts

Slower leasing velocity through much of 2023 largely reflected tenants’ caution in a higher interest rate environment. While office buildings and malls continue to face long-term structural demand pressures, the leasing pace in other property types is expected to accelerate as interest rates ease and confidence in sustained economic growth recovers.

Ideally, the recovery of leasing demand will coincide with the expected decline of new supply deliveries later this year and into early 2025.

New construction financing has stalled for more than a year due to higher interest rates, leading to a rapid reduction of new construction starts from the end of 2022 to the present.⁵

Since new projects typically require one to two years to complete, a dearth of new starts in 2023 means that new deliveries will shrink in 2024 and into 2025.

Once leasing demand eventually picks up, a lack of new supply should provide room for rents to grow. And growing rents would provide confirmation to investors that a new growth cycle had indeed commenced, which would attract capital and drive real estate prices higher.

Some risks

Just as the shift in Fed policy could be the primary catalyst for real estate price recovery, factors that could redirect that policy shift are a risk. Inflation could unexpectedly escalate and cause the Fed to delay the loosening of monetary policy.

The US government’s upward revision of 2023 job growth released in January invites questions about the potential for wage expansion to fuel inflation.

Keeping interest rates higher for longer would delay the reduction of real estate debt costs and, in turn, the easing of cap rates and growth of CRE prices.

It could even cause cap rates to rise further and prices to fall further. Additionally, sustained higher interest rates would likely cause tenants to remain cautious and delay leasing decisions.

Our expectation of real estate prices finding a trough in the second half of 2024 is contingent on the Fed’s confidence that inflation is on a path toward normalization.

Assuming it does start to reduce policy rates this year as expected, the time required to ultimately affect cap rates could potentially stretch into 2025.

Conclusion: Rise in prices in second half of 2024

The Fed sent a clear message about inflation and monetary policy in December and reinforced it in March. The shift in Fed policy, in our view, will start a chain reaction that will lead to lower real estate debt costs and cap rates and, in turn, a rise in CRE prices sometime in the second half of 2024. And while there are risks to this outlook, we believe that real estate investors are poised to act on a growing conviction of rate reduction.

Source: “Why We Expect A Price Recovery In Commercial Real Estate“