A Questionable State of the Industry

Delta Variant Brings a Cloud to Brightening Skies

Is that a light at the end of the tunnel that CRE practitioners see, or is it the Delta variant “train” heading towards them? The truth is it may be too soon to tell, but for the first time in over a year, markets have been recovering from the impact of the pandemic.

“The overall office market conditions continue to heat up in my market (Raleigh/Durham, N.C.), with life sciences being the most active thanks to Research Triangle Park,” says Street Jones, SIOR, principal, vice president, RCR | Rich Commercial Realty. He adds that 95% of his clients are back in the office, and the remaining that are not have established a timeline to return, “though the news about the rising Delta variant and speculation for the fall has extended some of those timelines.”

“For us, it was the quarter of opening back up,” says Grant Pruitt, SIOR, president and managing director, Whitebox Real Estate, Dallas, while cautioning that “So much with COVID is geographical and regional.” For example, he notes, a mask mandate was implemented in Dallas County at 11:59 PM on Wednesday, August 11. “By Sunday evening, the Texas Supreme Court struck it down; the masks and temperature checks were implemented for two business days and then went away Monday or Tuesday of this week,” he reports.

Pruitt, whose company experiences real estate both as a tenant and a representative, sees clear improvement from both perspectives. “The second quarter, as far as being a tenant, has been transitional,” he says. “We saw temperature check stations go away, gathering restrictions go away, the mask mandate went away – we really began to experience a return to normal in every sense of the word.”

As a tenant with a client base, he continues, COVID made it very difficult to service clients. “Now, it’s different,” he asserts. “We’ve hit 12-month lows in deaths and cases, which gives the assurance to businesses they’ll be able to plan for moving forward. We went from really being locked down to being really open.”

“Things have continued to improve over last year,” notes Graig Griffin, SIOR, managing partner, Windermere Commercial Real Estate, Salt Lake City. On the industrial side, he says, demand “never really waned,” except for a two-month period in the middle of the “void.”

While there was more uncertainty in the office market, he says that has also begun to change. “There’s a great divergence from last quarter to this quarter as it relates to demand,” he says. While there are still a number of variables, “now, there are a lot of answers,” says Griffin. “There’s more surety as to what the workplace can look like and should look like; the vaccine has made an enormous difference.”

“From the perspective of industrial, we’re still going forward at an incredible clip; leases are up, sales are up,” adds David Liebman, SIOR, designated managing broker, Merit Partners, LLC, Northbrook, Ill. “The pandemic has even helped the industrial sector—probably more than any others, with the possible exception of multi-family. The Amazons in the world and the companies that service them were and are going to need warehouse space. Unfortunately, product is getting lower, and that’s the biggest challenge.”

The end result, he says, is “a fair amount of equilibrium” in the industrial market. “Developers are not doing the stupid things they did in 2007-8 when they overbuilt,” says Liebman. “The end result was that literally for three years after that, for the first time in my career I had not seen one square foot of spec warehouse space happen anywhere in metro Chicago.”

Today, he says, “In certain submarkets we have more demand than product, and in a very few, it’s vice-versa.”

TAKING A CLOSER LOOK

While the overall theme is positive, a closer look at property types and submarkets shows that things can vary significantly. For example, in Raleigh/Durham, Jones says that conversations around flexible work from home models are “ongoing,” and that the long-term impacts to the office market are yet to be known. “The downtown Raleigh submarket seems to be the submarket that continues to be the most negatively impacted in the area,” he says. “Prior to the pandemic, rising rental rates coupled with high parking costs had a lot of users considering suburban environments who had never considered moving out of downtown before. Between the pandemic and the civil unrest last year, many tenants have indicated that they would be moving out of downtown at lease expiration. On the flip side, downtown Durham is thriving as it did not have the same level of civil unrest as the Capital City, and also landed Google amidst the pandemic.”

The biggest news in Dallas, says Pruitt, seems to have been office sublease vacancies in the past 12 months. “They peaked since the start of the pandemic somewhere around 9 million square feet in this market (we are roughly 400 million square feet as a market),” he shares. “There is currently roughly 8.5 million square feet of office sublease space on the market—1.1 million is in Fort Worth, Texas,  (oil and gas collapse), 500,000 was Class C or mis-classified product (really retail or industrial, etc.), and 900,000 had less than 12 months of term left.”

That leaves 6 million square feet, he notes. Of that, two-thirds of the spaces are less than 15,000 square feet. The other one-third is comprised of 10 blocks of space. “When you break it down, the sublease market is not what the news has hyped it up to be,” says Pruitt.

“According to Kastle Systems, the occupancy is finally starting to rise,” he continues. “It plummeted to the low of about 20% in April of last year.” It was pretty flat between 30%-40% occupancy at the start of April of this year (aside from a massive drop in March of this year), he adds, but over the last quarter there started to be an uptick:

• April 2020 – Roughly 20% occupancy
• April 2021 – 30-40% occupancy
• June 2020 – 30-40% occupancy
• June 2021 – 40-50% occupancy

“We’ve seen a steady increase in rents over the last couple years through COVID; we sort of expected them to level off, but they really didn’t,” says Griffin. Inventory is low, he adds. There’s a lot of money, and more than 50% of all transactions are in cash—which, he says, is unusual for this segment.

“The cost of land has continued to rise without exception, and with the cost of construction commodities, it makes sense to raise prices,” Griffin adds. This started, he says, based on the supply chain, but it has worked its way through business. “I’ve seen people take extra profit because they can—even if their costs are not up,” he shares.

ADJUSTMENTS, ANTICIPATION

SIORS, like everyone else, have had to make adjustments during COVID. Some of these may continue for a while, but others, due to the recent improvement and anticipated brighter future, may see a “return to normal.”

“We went from virtual standstill to getting off high center,” says Pruitt. “We’re beginning to implement plans for people to feel safer, so they can go back to the office and be comfortable in those environments.”

Although technology has certainly enabled business communications to continue during the pandemic, he says “it still makes it difficult to engage in business efficiently and effectively.” In short, he says, “we’re going back to what we were.”

“Industrial looks fine; we have no reason to believe things will slow down,” says Liebman. “We’re working on a couple of investment sales deals that really could go for numbers much above what I estimated they would be.”

However, he adds, there are some yield issues coming up with respect to investors. “Construction pricing really knocked industry and other sectors for a loop,” he says. “Last December a client started work on a 287,000 square foot spec warehouse and ordered materials at $848,000 for structural steel. Now in the spring, they wanted another 280,000 square foot building and they started to order steel; for basically the same building it was $2.4 million. That’s 50 basis points of their yield on that property. This will force a lot of developers/owners to try to recalculate what their yields and returns will be on these properties.”

Jones also foresees a challenge as prices have risen. “Like everywhere, the construction climate is hindering transactions and forcing more tenants to renew, even though rental rates remain unchanged,” he observes. “Tenants looking to relocate and shrink their footprint are finding that, due to the high costs of upfitting a space, the economics of renewing make the most sense—sometimes it’s even more expensive to downsize.”

A relocation, he continues, would likely require a tenant to come out of pocket for an upfit, sign a longer-term deal, and have the disruption and costs of the actual relocation.

“For these reasons, we have a lot of tenants exploring relocating, but ultimately staying put,” says Jones. He adds that new lease transactions and development activity for the remainder of 2021 will depend on both the impacts of the rising cases of the Delta variant and on construction pricing trends. “Hopefully, both of those begin to trend downward, or level off (at a minimum),” he says.

“We’ve had to go ‘old school’ to procure property, getting in front of people what the market looks like, where financing is at,” says Griffin. “In some ways that’s good. It puts us in an advisory capacity more than a brokerage capacity—which I actually like better.”

For Griffin, the rest of the year looks good. “For our company, and my team, this will be a record year for us; last year was, too, but we’ve already exceeded that. Interest rates are low, so many companies are finally plunking down cash, fearing they’d be paying more in the future.”

Still, he says, success will come down to how the individual real estate professionals serve their clients. “For myself and other brokers who do what I do, relationships will be more important than ever,” he concludes.

Source: “A Questionable State of the Industry“