Halfway through 2024, the U.S. commercial real estate industry is showing signs of both optimism and cautiousness. While the fundamentals for the multifamily, retail and industrial sectors remain solid, experts say there are also headwinds including escalating office vacancies, higher-for-longer interest rates, and global political uncertainty including the upcoming elections and the Russia-Ukraine war.
While the U.S. economy dodged a recession that was predicted for 2023, some economists are now forecasting a “soft landing” for the U.S. economy, as inflation is cooling, hiring remains strong and consumers have proven resilient. “A soft land in the U.S. is extremely rare,” says Richard Barkham, CBRE’s Global Chief Economist and Global Head of Research. “The economy continues to grow and inflation is coming under control, but I think we're in a zone of uncertainty.”
The Federal Reserve held its ground on interest rates, doing whatever it takes to bring inflation down to 2 percent , reported J.P Morgan. That means holding off on interest rate cuts until at least the second half of 2024. “We see two cuts this year and probably four next year,” says Barkham. “I think by 2026, we might have interest rates in the low to mid-threes. The world of real estate has to get used to a different interest rate environment.” The current rate is at a target range of 5.25 to 5.5 percent. However, in the decade of 2009-19, interest rates were 1 percent or less. “I don’t think we're going back to that world of low interest rates,” says Barkham.
Not what CRE industry expected
“At the beginning of the year, it felt like the markets had convinced themselves that we were going to see four to six interest rate cuts this year,” says Erik Coglianese, senior associate, Transwestern's Midwest Capital Markets and Asset Strategies. “People were talking themselves into deals and looking ahead and thinking that they were going to be able to make an exit on properties, specifically office assets, and get out unscathed.” As the year has progressed, it became clear that it remains an elevated interest rate environment, and that a lot of that strategy and thinking has gone by the wayside, Coglianese notes.
It has made it very challenging for some owners to make their exits. “Now, they're going to continue to hold, hoping market conditions improve,” Coglianese adds. “There’s some optimism that we may see one interest rate cut later this year. That will be good for the sectors that have strong fundamentals and will help spur some transaction and investment activity. But a 25-basis point cut isn’t going to be enough to save the office market.”
Transaction activity is depressed
Commercial property sales volume in 2023 dropped 51 percent from the year before, to only $374.1 billion, according to the MSCI Real Capital Analytics 2023 Capital Trends report. “There’s still a buyer/seller standoff in the investment market,” notes Barkham. “But the sellers are not particularly under stress.” They're thinking maybe interest rates will be lower next year. They’re holding out for a better prices, and there’s a gap between sellers and buyers. “I think in some areas, that's closing, and it's really small, but it's still there,” Barkham adds.
There’s also a decline in commercial pricing. According to Green Street’s Commercial Property Price Index , prices fell 7 percent over the past year. Since the market’s pricing peak in March 2022, prices have fallen by 22 percent. “Properties are repricing, but it hasn't quite repriced enough to really bring investors back in,” explains Barkham. He says transaction activity will only start to gain traction when the Fed starts making that first interest rate cut, which he predicts will be at the end of the year.
THE SECTORS
Future of office remains uncertain
The shift to remote and hybrid work, which took off during the pandemic, has fueled ongoing challenges for the office sector due to lack of tenant demand—primarily for Class B and C and downtown properties. The national office vacancy rate increased to a record-breaking 19.6 percent in Q4 2023, according to Moody’s.
Work from home could have a 14 percent impact on office demand with 24 percent vacancy by early 2026, Moody’s predicted in a new report.
Flight to quality and location
Experts say the most desirable office properties with the most sought-after amenities in the most attractive locations will likely outperform. This puts greater responsibility on investors to “evaluate risks and opportunities asset by asset, deal by deal,” according to J.P. Morgan.
“We're continuing to see a large bifurcation in the office market, and that's the well-located properties with Class A finishes and high-level amenities are still attracting tenants and performing really well,” says Coglianese. “It's all the other properties that are not the diamonds that are really continuing to struggle.” Mike Salmen, managing principal, Transwestern Midwest Capital Markets, agrees. “The office market is still segmented both in terms of user demand and sales. Any sales that we're seeing now are primarily distressed sales. Although there may be some owner/user-type sales.”
Office bargains
With upcoming loan maturities and lagging office demand, some office properties will go back to the lenders, and “a lot of those will probably hit the market at pennies on the dollar. If sales occur, they will happen at significant discounts,” says Salmen. There'll be opportunities for opportunistic buyers with a strong cash position to acquire distressed assets.
While well-positioned, well-occupied buildings could work their way through this distressed scenario and come out okay, some Class B and C buildings will get demolished, repurposed or possibly re-tenanted but at very different rates and transaction terms than in recent years, says Salmen. “People are still trying to figure out this hybrid/remote work,” he continues. “We still haven't had large corporations mandate people back to the office, and if they have it's been on an abbreviated basis. The five-day workweek is long gone.”
Salmen says vacancies will get worse before they get better. “I think we've got a couple of years before we kind of get back to some sort of normalcy,” he explains. “That's just not going to look like it did five years ago pre-pandemic. The truth is we've got a large inventory of obsolete properties in poor locations that just aren't going to have a viable future as an operating office domain.”
Those assets, Salmen says, may sit vacant for a long time before somebody figures out what to do with them. “Only a small portion of existing projects can get repurposed,” he adds. “It’s unfortunate, but not every building can be turned into an apartment building or medical office building.” And those projects are highly capital intensive. Owners/investors will have to be creative to find a repurpose for many older, obsolete office buildings. Data centers, life sciences and healthcare are growing industries with strong demand; perhaps, Salmen says, there are some limited opportunities in those sectors.
Retail surpassing expectations
Of all the asset classes, retail is outperforming on a fundamental basis, says Barkham. “Retail is really surprising everybody with how well it’s doing. Vacancy has continued to fall, and we’re seeing some rent growth.” Driving retail success is resilient consumer spending. Also, weaker retailers filed bankruptcy or Chapter 11 reorganization during the pandemic and dropped out of the market. Additionally, most retailers have honed up their omnichannel strategies, and there’s been a lack of new retail development over the past decade-plus.
Retail vacancy rate is steady at 10.4 percent , according to Moody’s. While some malls struggle, particularly those dependent on big-box retailers, newer, mixed-use retail and centers offering a shoppers an “experience” are successful. Also, grocery-anchored and neighborhood centers are performing well.
Multifamily still solid, but some oversupply
There remains strong investor interest in multifamily as evidenced by the recent Blackstone Real Estate deal , in which the investor paid roughly $10 Billion for AIR Communities – its largest-ever transaction in the multifamily market. However, an oversupply is anticipated. The largest wave of new apartment supply in decades will moderate rent growth and increase vacancy, according to CBRE . The delivery of 440,000 new units is projected in 2024 and more than 900,000 additional units are under construction.
But not so fast, says Barkham, as roughly 60 to 70 percent of units being delivered are being absorbed. According to Moody’s, Class B and C properties recorded a 4.6 percent vacancy rate in 2023, reflecting the need for more affordable rents. Upscale properties’ vacancy rate was 6.5 percent, prompting some Class A properties to offer concessions. The limited single-family housing supply and expensive mortgages are two factors driving demand for multifamily.
Industrial still strong, but settled down to more normal levels
Industrial was on a tear because of the growth of e-commerce, says Barkham. “Of course, during COVID when e-commerce was all that people could do, we had hugely elevated levels of absorption of space,” explains Barkham. “The market really has settled back down to more normal levels of net absorption.” As the market moves toward a state of balance, new construction starts slowed, due to rising interest rates and less demand. This slowdown is expected to result in a decrease in project completions in 2024, reports Moody’s .
Since Q2 2023, the vacancy rate has increased to 6.5 percent nationally. Despite the rise, the rate is substantially lower than the sector's pre-pandemic average. “Industrial seems to be getting its footing back,” notes Salmen. “We had a little lull in terms of development and sales, due in large part to rising rates.” However, industrial demand on the user side has continued to thrive, and now that the market has an outlook on what the next six to 12 months might bring, some developments are breaking ground, some sales are happening, and even more importantly, portfolio sales are happening, Salmen notes.
“Even though rates aren't coming down quite as quickly as we'd like that, demand on the user side has really held up the industrial market,” says Salmen. That includes e-commerce, which has buoyed the demand for industrial warehouses and fulfillment centers. Also, the growing trends of nearshoring and offshoring are continuing to bring manufacturing back to the U.S.
“The fundamentals are still so strong in industrial,” says Coglianese. “User demand is still strong. It’s not quite as robust as it was 24 months ago, and some of the deals are taking longer to come to fruition. With that said, rental rate growth is still a very real thing. Also, speculative development has slowed considerably, helping to keep a lot of those fundamentals in check in the supply-and-demand equilibrium.”
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