Archives for April 2024

Key takeaways

• An economic rebound may not be on the immediate horizon, but multifamily investors can still make preparations for the future.
• Multifamily investors should look at economic indicators, such as housing markets, interest rates, and political and geopolitical dynamics—including the upcoming U.S. election—to get a clearer picture of the economy.
• Performing market research, proactively reaching out to building owners and optimizing liquidity can help multifamily investors position themselves for success when the economy rebounds.

The economy performed better than expected in 2023. But interest rates, inflation and other economic indicators remain in flux, leaving the future—and the timeline for an economic recovery—uncertain.

“The market right now is like the offseason,” said Al Brooks, Head of Commercial Real Estate at JPMorgan Chase. “In the offseason you’ve got to be eating better. You’ve got to be working out harder. You’ve got to be ready to compete when the season begins.”

Brooks, along with Ginger Chambless, Head of Research for Commercial Banking at JPMorgan Chase, and Tom LaSalvia, Head of Commercial Real Estate Economics at Moody’s Analytics CRE, weighed in on the current economic environment and how commercial real estate investors can prepare now for an economic recovery.

What to consider in the current economy

From labor markets to inflation, there’s no shortage of economic indicators for investors to keep an eye on. But a few factors stand out, including:

• Political and geopolitical dynamics: “Globally, the variety of conflicts elevate the probability of supply-side shocks—to oil, freight and intermediate goods—enough to warrant consistent monitoring,” LaSalvia said. Domestically, U.S. political parties’ lack of cooperation, which nearly led to a debt default last year, could delay critical spending on infrastructure and research and development and potentially damage the economy. Plus, 2024 is an election year, which could fuel market volatility.
• Housing markets: “The lock-in effect within single-family housing could affect supply for years to come,” LaSalvia said. Combined with high construction costs, single-family home prices will likely remain high, helping drive demand for multifamily properties among would-be homebuyers.
• Interest rates: “A higher-for-longer rate environment seems likely,” Chambless said. “The pace of disinflation has slowed in recent months, labor markets remain strong and the economy appears to be performing well. While the Fed has opened the door to lowering policy rates in 2024, it doesn’t appear to be in a rush to do so.”

“It’s tough to envision an economic boom in the near term given where we are in the economic cycle; equity markets are near all-time highs and GDP growth is above trend,” Chambless said.

LaSalvia agreed. “I believe the economy has peaked in terms of growth rate, and we’re heading for a softer environment,” he said. “This in no way means a recession is likely, but instead points to a somewhat weaker labor market and below-average GDP growth. Our expectation is for one to two years of slightly below-average growth before the economy picks up.”

What investors can do now to prepare for an economic rebound

In the meantime, commercial real estate investors can prepare for an economic recovery in several ways, including:

• Performing market research: Smart investors are familiar with their local markets, including rent prices, regulations and cap rates. Likewise, they’re familiar with cost, cash flow and sales comparison value approaches.
• Proactively reaching out to building owners: In performing due diligence and market research, investors may come across properties to help optimize their portfolios. However, these properties may not always be for sale. “Smart buyers approach building owners all the time,” Brooks said. “They know every deal in the market, and they know who owns it. Investors proactively reach out to let the owners know that—should the occasion arise—they’re interested buyers.” This is especially true for buildings in prime locations, such as on a waterfront.
• Increasing liquidity and cash on hand: Real estate’s cyclical nature allows investors with cash on hand to buy properties at discounted prices in a down market. Raising equity is an option for investors looking to make acquisitions, as is treasury management. With the latter, commercial real estate businesses can save time and money by implementing cash management tools and rent payment solutions.
• Doing the math, factor in the sweat equity: In a down market, commercial real estate investors can benefit from discounted prices on existing properties, which can help save on costs and increase their bottom line. For example, a new-construction 10-unit building may cost $500,000 per unit. If investors acquire an older 10-unit building at $300,000 a unit, they can gain a big rent advantage—especially in sought-after neighborhoods. And if investors put sweat equity into the property they can profit even more. For example, installing stainless steel appliances, laminate wood flooring, unique amenities and proptech may require limited upfront expenses and can command higher rents.

Source: “How real estate investors can prepare for an economic rebound“

While the hybrid world has dealt a harsh blow to many downtowns across the nation, the lingering impact has been far from uniform.

That’s according to the latest Downtown Vitality Index from The Business Journals, which analyzed a variety of metrics affecting downtown activity across more than 40 major metros to determine which central business districts are best positioned for success.

Miami topped this year’s Downtown Vitality Index, thanks to its strong momentum for office real estate, a thriving tourist economy and work-from-home rates that remain only slightly above the national average of 9%. Last year, another Florida city — Tampa — topped the list.

Wichita, Kansas; Nashville, Tennessee; Cincinnati and Orlando also finished near the top in the Downtown Vitality Index, which is based on a weighted formula that looked at these factors:

The formula is weighted, with office space trends, work-from-home percentage and downtown cellphone activity among the heaviest-weighted factors. With the exception of downtown cellphone activity, the category scores are compiled using percentiles that show how downtowns around the nation compare. A score of 0 is worst and a score of 100 is best.

Those obviously aren’t the only factors that contribute to downtown vitality, but this project aims to put downtown recoveries in context and spotlight standout performers in these metrics in conjunction with our recent Future of Cities event.

The recovery gap between cities at the top of the Downtown Vitality Index and coastal metros like New York and San Francisco is top of mind for business leaders everywhere.

Economist, historian and futurist Richard Florida foresees a reckoning in the post-pandemic world as empty office spaces continue to dot downtown skylines and a commercial real estate price reset looms.

“We still haven’t felt it because lease terms haven’t come up,” he said. But in the coming years, “we’re going to see prices adjust to the point where (buildings) will either be converted, reused or torn down.”

And yet, he’s optimistic, because Florida believes such a reset sets the table for a revolution that could reshape America’s cities.

While hard data shows distinct patterns of recovery, Florida understands the value of a case study and cites Nashville, Tennessee; and Orlando as urban areas getting it right.

“This entertainment factor, this buzz … has become so important,” he said. [Nashville is] still an affordable place to live. It’s a really nice place to work and is a fun place for people.”

As for Orlando, Florida attributes its success to, “conventions, tourism and Disney (as) part of the economic development making the downtown stronger and a better place to live and work.”

Here’s a breakdown of each metric in our Downtown Vitality Index, including the top performers in the category and key takeaways:

Downtown office commercial real estate

What we looked at: We analyzed central business district vacancy and absorption rates for office space from CoStar Group, Jones Lang LaSalle and Cushman and Wakefield.

The takeaway: Several tech-centric metros that have struggled to backfill vacant spaces posted low scores in this metric, as have some cities that saw tremendous new construction of office space in the years leading up to the pandemic. Several fast-growing Sun Belt markets were among the standouts in the category.

Urban hotel occupancy

What we looked at: Using data from CoStar or local tourism associations, we tracked occupancy rates for hotels in central business districts or urban areas, and how those rates have rebounded since the onset of the Covid-19 pandemic.

The takeaway: While recovery was very strong in centers of commerce and tourism such as New York, Boston and Washington, D.C. — which all showed rates of at least 89% — some smaller regions such as Birmingham, Alabama, bounced back even stronger at 100% or more of their pre-pandemic level.

Downtown activity

What we looked at: The latest data from the University of Toronto School of Cities and the Institute of Governmental Studies at UC Berkeley, which have been working jointly to track cellphone data of more than 18 million North American smartphones to show how activity in downtowns compares to pre-pandemic levels.

The takeaway: The latest data from the study, covering the spring of 2023, shows the average downtown is now at 74% of its pre-pandemic activity. Las Vegas, which is a unique case because of its focus on tourism, leads the nation at 103%. Among more traditional metro economies, top performers included San Jose, California; Miami; and Phoenix. At the other end of the spectrum, St. Louis, Minneapolis and Louisville, Kentucky, are all at 56% or less of their pre-pandemic activity level.

Remote work

What we looked at: The U.S. Census Bureau’s latest American Community Survey, which showed the percentage of workers in each metro who are working from home. For the purposes of the Downtown Vitality Index, a higher percentage of individuals working from home translates to a lower score in this metric, because high work-from-home percentages are a factor many communities say are limiting activity in their downtowns.

The takeaway: Many transit systems have struggled since the pandemic, with the average system still down 29.6% compared to 2019. Metros with average levels of remote work and strong hotel occupancy rebounds also generally fared well in our public transit metric, as well as systems that have recently upgraded their systems.

Population growth

What we looked at: We analyzed the latest population growth estimates from the U.S. Census Bureau, taking into account growth since the pandemic and one-year growth between 2022 and 2023. While these are metro-level numbers and not limited to downtowns, they show which regions have the strongest momentum for population growth, which is a factor that adds vibrancy to downtowns.

The takeaway: The Sun Belt remains the star, dominating population metrics once again this year. Texas cities Austin, Dallas, Houston and San Antonio all showed three-year growth rates of at least 4.76%, with Orlando and Jacksonville in Florida hovering near 5% and 6.5%, respectively. A closer look at county-level data also shows some Midwest regions picking up the pace.

Expensive coastal metros like Los Angeles, New York and San Francisco continued to lag for population growth.

Source: “Downtown Vitality Index: The cities are best-positioned for success in the hybrid era“

There will be losses stemming from commercial real estate, or CRE, portfolios for US banks, but they will be manageable for our coverage.

We think New York Community Bancorp NYCB was uniquely risky and would have been highlighted as such by our risk screens.

Rather than a real estate apocalypse, we see a small to medium drag on earnings for several of the banks we cover, and potentially a larger drag for Zions ZION in particular. However, we think every one of our banks will emerge from this pressure intact.

As certain market participants remain worried about CRE risks, understanding how to sort and size these risks is paramount. We think any increased pessimism that is at least partially based on CRE loss content could present opportunities for patient investors.

How Large Will Losses Be in Commercial Real Estate?

The four primary sectors within commercial real estate include industrial (which primarily represents warehouses and manufacturing facilities), multifamily (which represents housing units that accommodate more than one family, primarily apartment complexes), retail, and offices.

Our analysis shows:

• Industrial’s fundamentals are great, with strong demand and low vacancy rates, and we do not anticipate any major stress.
• Retail, while not as strong as industrial, should remain relatively stable due to less of a dramatic demand drop and supply that has been adjusting for over a decade.
• We would keep an eye on multifamily, particularly in the Southeast, as we think overbuilding combined with higher interest rates (that is, higher funding costs/lower property values) will put stress on some properties. However, the lack of a dramatic demand shock makes us predict the pain here will be limited.

Office is where the real pain is, and we think it will get worse before it gets better. There has been a structural demand shock that will take years to work its way through the system, as we are in year four of what will likely be a six- to seven-year process.

The pandemic massively accelerated the remote work trend and created a real structural drop in demand for office property. A significant proportion of the US workforce has now worked remotely for over three years, and we do not think it is ever going back to the way it was before the pandemic. Hybrid work has become a norm in corporate America, and most employers in the US now offer some form of it.

The impact of the hybrid-work-related disruption can be seen in office real estate fundamentals like vacancy rates, net absorption, and rental rates. All have deteriorated, and we expect additional deterioration as more companies in the US shrink their overall office footprint. We estimate that average quarterly office leasing volume has declined over 30% to around 39 million square feet compared with 59 million square feet prepandemic.

Office leasing volume recovered steadily until the second quarter of 2022, after falling sharply in the early stages of the pandemic, but the recovery reversed over the past year as more companies started to rethink their long-term office requirements.

While we think muted supply-side additions will eventually help the office sector reach a more stable equilibrium in the distant future, for now, the demand-side shock is the key factor. There is simply no way to adjust on the supply side for such a drastic decline in demand. Property values will remain under pressure in upcoming years.

What This Means for the Banking Industry

All that said, what can we expect for the banking sector—the largest holder of CRE-related debt?

• Banks have already built up sizable reserves, particularly for their most risky portfolios (often 8% or more for office loans). Generalists often miss that this already accounts for material stress in the sector (default rates of over 20% and property value declines of over 50%).
• Not all banks are exposed equally to CRE. NYCB is a case in point. It had close to double the relative CRE exposure of the most exposed bank under our coverage (Zions) and more than 10 times the exposure of the least exposed banks under our coverage. Much of this exposure was to rent-controlled multifamily in New York City, one of the worst multifamily markets since regulations changed in 2019. None of the banks we cover are comparable. Investors must know how to sort through these risks.
• CRE exposure is heavily concentrated in smaller banks with less than $10 billion in assets. We would not be surprised if there are some bank failures here. However, even under a bear case (CRE losses greater than the 2008 financial crisis, particularly for office properties), we don’t anticipate any of the banks under our coverage to face serious capital risks.

We find that generalists are not digging into these details.

The whole sector tends to sell off when CRE risks are front of mind, such as immediately after news of NYCB’s struggles hit. We think times of heightened risk sentiment related to CRE can offer opportunities for cheaper valuations.

As the market better digests potential CRE risks, we think some of the risk premium that banks are experiencing will fade. Therefore, current holders should not panic, and watchers of M&T Bank MTB and Zions should be ready: These banks can go through periods of higher CRE risk discounts, offering opportunities.

The table below shows how, even in a bear case, these banks’ anticipated CET1 ratios (which measures a bank’s capital against its assets) still exceed the regulatory minimums.

Source: “How Large Will Losses Be in Commercial Real Estate?“

Average sale prices for industrial assets saw a considerable increase — up by 9.6% from the previous quarter and by 2% year-over-year, which is notable, considering the challenges posed by rising interest rates, tighter capital markets, and normalizing demand.

Properties were trading at an average of $132 per square foot, the latest U.S. industrial market report from CommercialEdge shows. Nationwide, industrial sales totaled $5.7 billion in the first two months of 2024.

Investor interest in Los Angeles properties remains elevated as it led the nation in sales volume, with transactions here totaling $435 million.

Price appreciation has leveled off following a period of rapid growth, CommercialEdge reported. Between 2019 and 2021, the average sale price in Los Angeles climbed 44.7% from $190 to $294 per foot. The average sale price rose only 8.9% in the years since, resting at $320 per foot in 2024.

The West maintained its status as the priciest in the US. The national average is $7.68 per square foot. Orange County ($15.29 per square foot), Los Angeles ($14.14), and Seattle ($10.94) posted double-digit rental pricing. Only in the Central Valley, with $6.15 per square foot, did a Western market show listing rates below the national average.

In-place rent growth increased by 12.7% year-over-year in the Inland Empire, the highest in the country.

“The market has been at the top of the rent growth metric since we began reporting rents at the start of 2021,” according to the report. “Notably, in-place rents in the Inland Empire swelled more than 60% during that time.”

Los Angeles and Orange County, both at 11.4% as of February, were the only other markets to post double-digit in-place rent growth, according to the report.

A rise in demand for data centers, particularly in the Washington DC market, “has witnessed a significant surge in growth during the past year,” CommercialEdge reported.

In the 120 markets covered by CommercialEdge, there are currently 27.4 million square feet of data center space under construction, and an additional 33.5 million square feet are in the planning stages.

“While recognized as a niche subset of the market, it is a notable opportunity in certain markets as general warehouse/distribution project starts continue to slow.” Peter Kolaczynski, Director, CommercialEdge, said in prepared remarks.

Source: “Industrial Sale Prices Up 9.6% Over Previous Quarter“