Commercial real estate professionals upbeat about longer-term prospects

According to PricewaterhouseCoopers International Limited (PwC) and the Urban Land Institute’s Emerging Trends report, most commercial real estate professionals are reasonably optimistic about longer-term prospects. 

While two straight quarters of declining gross domestic product indicate that the U.S. economy entered recession in the first half of 2022, other economic metrics do not support this conclusion. They include:

• Job growth continues to be strong while unemployment claims are at their lowest levels since the 1960s

• The prices of homes and rents are at record levels in most markets and continue to rise

• This year, consumer spending has been mildly positive each month (through July 2022), which accounts for two-thirds of the economy.

Here are some of the top trends being for predicted for 2023 and beyond based on almost 1500 interview responses:

Normalizing

• Fundamentals of the property market are “normalizing” as some markets weaken due to diminishing pandemic tailwinds and cyclical economic downturns. In some property segments, such as residential and industrial, temperatures may cool, while others, such as hotels and retail, may reach historical averages. While cap rates rise and transaction volumes drop from record levels, returns and prices of most assets are declining, while rent gains for others are merely moderating as demand returns.

The Warehouse Pause

The industrial market seems also set to cool after many years of growth and rent gains that have seen rents a lot higher than prior records.

Investment Returns

Property investment returns will be coming down. The 43 economists and analysts surveyed in October 2022 by ULI’s Center for Real Estate Economics and Capital Markets expect total returns to drop to 3.8% in 2023, and recover to a moderate 7% in 2024. This means a return to normal. 

Things Have Changed

As you know, we’ve seen major shifts in how people live, work and play, and many of these changes seem to be sticking around. 

And while online spending is backing off from its pandemic peaks, it’s not likely to return to pre-pandemic levels. With growth in online spending slowing, brick and mortar retailers will have an opportunity to regain some lost market share, especially those who can “bridge the gap between e-commerce and bricks and sticks. They survived very well in the pandemic and will probably continue to do well,” said one investment consultant. Other winners will be the resourceful retailers that provide consumers with compelling shopping experiences. But the permanent shift to greater online spending ultimately means that fewer shopping centers and retail spaces can survive. 

Business Travel Impacts

As well, business travel is unlikely to recover to pre-COVID-19 levels for at least several years, meaning business hotels, fine dining, and conference facilities will continue to face challenges. Demand for office space could also suffer as firms have less need for space to accommodate client visits. Business travel will continue to recover over time, but few expect levels to attain prior levels soon. A U.S. Travel Association study shows business travel flattening in 2023 short of pre-COVID-19 levels. 

Office vs Home

We keep reading and seeing stories about the skirmish between companies and their employees in regards to where to work. For now, tight labor markets ensure that employees have the upper hand in negotiations about returning to the office five days a week and will resist employer desires to have workers return. But that could change if unemployment rises. The collective wisdom of the experts interviewed  is that “probably somewhere between 10 and 20% of the stock needs to be removed or repurposed, leaving the 80% that really does a better job of delivering what tenants want.

Tenants cannot afford to keep empty space indefinitely, however, so office landlords should not be lulled into complacency by the relatively benign vacancy levels. 

Firms continue to downsize or not renew expiring leases, so vacancy rates are still slowly rising, in contrast to every other major property sector. Plus, tenants are dumping unused offices by trying to sublet the space until their leases expire. Brokers report that a record level of office space is available for sublease, and more is hitting the market every quarter. Much of this space will eventually turn into outright vacancies as leases turn, unless firms eventually reverse course. However, no one expects a mass exodus from office buildings. Even under the most pessimistic scenarios, most acknowledged work will occur in company offices. But it will take more time for firms to figure out how much space they need, how it should be configured, and where it should be located. 

Shift of Capital

There continues to be deep and wide investor demand for just about every type of real estate, except central business district (CBD) office and regional malls.  

However, several forces look to restrict investor demand, starting with lower expected returns. Rising interest rates are making acquisition and construction debt more expensive, just when operating incomes seem destined to slide as the economy weakens in the forecasted downturn. Debt is getting more difficult to obtain and limiting investor demand, and the survey expects underwriting standards to get even more rigorous. Also, rising bond yields means that real estate and other alternatives are going to be facing less availability of capital and some outflows.

Niche Markets Continue to Do Well

Investors and developers seem to be preferring three distinct types of opportunities:

• – The security of major product types with the strongest demand fundamentals, notably industrial and multifamily housing, which essentially tie for top investment ratings in this year’s Emerging Trends survey;
  
• – Best-quality assets in sectors undergoing significant demand disruption, especially retail and office; and
•  – Narrowly targeted subsectors (like student housing) and newer “niche” asset types (like single-family rentals). 

Renovation and Repurposing

As with failing retail centers, many of these older office assets will need to be either upgraded or converted. The biggest challenge is the enormous cost of renovating a 40-year-old building to the health and safety and sustainability features and modern design standards offered by the top-tier properties.

Demographic trends and structural demand shifts magnified by the pandemic have rendered countless existing buildings either redundant (no tenant demand for the current use or at the location) or obsolete (unable to lease in its current condition and/ or configuration). But many—though not all—of these can be either repurposed or upgraded to meet new market standards. The many opportunities include the following: 

• Converting older offices to residential uses, or upgrading them into modern offices, where feasible and supported by the market
• Repurposing excess retail space for other uses (including fulfillment, service office, and residential) or improving with mixed use (especially residential, office, and hospitality)
• Scraping buildings to create development land where conversion is not feasible, or where density can be increased, to site new housing.
  

In summary – every obstacle represents an opportunity. Perhaps we will just need to be a bit more diligent in teasing them out for a while.