Commercial Real Estate Outlook
A year of bank closures, rising interest rates, unrelenting Fed rate hikes, moderating rent growth, and transaction declines have made quite the uphill battle for commercial real estate. These market disturbances have amplified economic uncertainty and led several investors and owners to wonder what will happen next. However, several CRE sectors have stayed afloat despite the volatile environment, including multifamily, industrial, and neighborhood retail sectors.
Retail Market Overview
Despite mounting worries about escalating expenses and an economic downturn, the U.S. retail sector has experienced stable growth for the first half of 2023. This was primarily due to steadfast demand from various sectors and a lower-than-average rate of store closures.
The retail sector’s resilience also lies in the fact that e-commerce constituted approximately 15% of overall retail in Q1 2023, according to the U.S. Census Bureau, indicating that not everything can be obtained online. Certain services still strongly prefer or even necessitate in-person visits. For instance, visits to nail salons, barbershops, and restaurants remain customary.
The U.S. retail real estate market is currently experiencing its tightest conditions ever recorded, with approximately only 4.7% of all retail space available, according to CoStar Group. Over the past year, retail availability has decreased by 50 basis points and is nearly 200 basis points lower than its historical average of 6.8%. Due to such limited available space, market participants have reported challenges for expanding tenants in finding suitable locations, particularly for mid-sized retail spaces and outparcels in primary corridors.
A note from Matthews™ Market Leader Keegan Mulcahy:
“I’m seeing deals under $3M are still trading in net lease and would have much higher transaction volume than higher price point deals. Almost as if there are two different markets.“
Retail Fundamentals are expected to remain balanced in the foreseeable future. This can be attributed to the minimal availability of retail space and a lack of new supply, which mitigates the potential increase in store closures. Source: CoStar Group
2023 has also been the year of 1031 Exchanges, especially for more passive assets like STNL properties. One of the main causes for this rise in popularity is that the 100% bonus depreciation introduced in the 2017 Tax Cuts and Jobs Act expired on January 1, 2023, and was reduced to 80%. This percentage will decrease by 20% each year until it completely phases out in 2026. The accelerated depreciation has been highly beneficial for exchange buyers, allowing them to deduct the entire cost of qualifying investment property in the first year. This was advantageous for offsetting significant gains, such as those resulting from the sale of a business, in the same year. With the gradual expiration of this tax-saving measure, more investors are realizing that this opportunity is closing and are positioning themselves to take advantage of it while they still have the chance.
A note from Matthews™ Market Leader J.A. Charles Wright:
“I find it fascinating that we are in a moment where it is very beneficial to sell a property for an investor motivated to exchange. All we hear is that the market is down, but if you exchange proceeds for a different asset, the market is down on the sale and on the purchase. The major difference is how much inventory is out there for that purchase. So often in years past, there has been an incredible amount of competition circling very few deals for people in exchange. Right now, that is not the case. Exchange buyers have a ton of properties to choose from.”
Multifamily Market Overview
Multifamily continues to be one of the most sought-after asset classes. The national vacancy rate is 6.8%, while year-over-year rent growth remains low at 1.2%, according to CoStar Group. The Midwest and Northeast regions exhibited the strongest performance in the past year, with Indianapolis, Cincinnati, and Northern New Jersey emerging as the leaders in rent growth, experiencing rates ranging from 4.5% to 6.6%, according to CoStar Group. Conversely, Sunbelt markets witnessed a significant deceleration in rent growth over the past year. Las Vegas and Phoenix, previously recording rent growth rates of 19% and 17%, respectively, have now experienced a decline to -1.9% in both markets.
This deceleration in rent growth is projected to persist throughout 2023, as the looming risk of a recession affects the economy, and many markets face an oversupply of rental properties. Source: CoStar Group
A total of 12 markets are expected to experience a surge in new property constructions for the remainder of 2023, potentially reaching record-breaking levels. Sunbelt locations dominate this list, with Austin, TX, at the top. With an estimated 17,000 new units anticipated to be delivered this year, Austin surpasses Atlanta in terms of new unit supply, despite having only half the inventory of the Atlanta market.
While temporary obstacles like declining household formations, rising supply deliveries, and weakening demand may arise for multifamily, a significant housing shortage continues to persist nationwide. Consequently, rent growth is anticipated to rebound and exceed historical averages in the near future, reaffirming the multifamily sector’s prominence as a top investment opportunity.
A note from Matthews™ Market Leader Daniel Withers:
“We are seeing a lot of owners that have debt coming due and did not get the NOI growth over the last three to four years due to COVID or having to bring money to the table to complete a refinance. We anticipate a high amount of properties coming to market as a lot of the investor community does not want to shell out money to successfully satisfy their refinance. In some situations, sellers may have to discount their property to sell, potentially losing them money.”
Industrial Market Report
There are indications that the industrial sector, driven by e-commerce and the rise of on-demand services, may be entering a stabilization phase. The national vacancy rate is expected to stay below its 20-year average of 7.3%, as reported by CoStar Group.
According to Commercial Edge, there has been a notable decline in the construction of new industrial space between January and May 2023. During this period, 109.6 million square feet of new space began construction, which is significantly lower than the 240.5 million square feet that started during the same period last year. Given the current high-interest-rate environment and the ongoing normalization of demand for industrial space, the slowdown in development comes as no surprise. However, Phoenix and the Dallas-Fort Worth metroplex stood out from this trend by experiencing significant new construction starts this year, with 13.5 million square feet and 13 million square feet, respectively. Remarkably, these two markets accounted for almost a quarter of all industrial space that initiated construction in the year.
Commercial Edge reports that industrial transactions totaling $16.3 billion have been recorded nationwide this year. Although the industrial sector continues to be an appealing asset class for investors, sales have declined. Industrial property prices have remained relatively steady despite the decrease in sales volume. In Q2 2023, the national average price per square foot stood at $134, experiencing only a marginal decline of 1.3% compared to 2022.
Office Market Overview
As of mid-2023, the office market continues to encounter challenges, leading industry participants to anticipate a prolonged period of difficult market conditions. The future of office space remains uncertain as remote and hybrid work arrangements have significantly decreased the demand for physical office environments. However, class-A properties continue to demonstrate resilience and perform well in the current market. Office properties with long-term leases of 10 years or more may be better positioned to navigate the ongoing market correction. On the other hand, class B & C office buildings, particularly those with shorter leases situated outside prime locations, encounter challenges as the workplace landscape evolves.
Since January 2023, tenants have left nearly 40 million square feet of office space, indicating that 2023 is on track to record the highest level of negative net absorption in history.
The vacancy rate is at a record high of 13.1%, and it has shown no signs of sowing down. Source: CoStar Group
A prevailing atmosphere of uncertainty persists within capital markets, causing investors to adopt a cautious approach and refrain from active participation. Consequently, the industry finds itself looking for favorable investment opportunities, the types of assets that investors are currently acquiring, and the lending preferences of financial institutions. However, there is growing optimism that the economy will regain stability in the coming months. With the moderation of inflation and other economic challenges, market conditions are expected to improve, creating a window of opportunity for issuing more advantageous investments within capital markets.
There are still available funds to support investment deals; the key lies in investors’ ability to locate them. Two notable sources in this regard are Fannie Mae and Freddie Mac, government sponsored enterprises that play a significant role in financing multifamily properties within the commercial real estate sector. These agencies continue to actively provide various fixed and floating-rate nonrecourse loan options to multifamily owners and developers.
Additional Trends for the Remainder of 2023
Interest Rate Hikes
The impact of increasing interest rates has been quite noticeable during H1 2023. However, robust job growth and a resilient consumer base have helped maintain the economy’s overall health. While a slight contraction in GDP is anticipated later this year, the labor market remains relatively soft, although it continues to add jobs overall. The consensus estimate for the unemployment rate suggests a slower pace of job growth or potential net losses compared to the analysis provided by Green Street. Regarding the next Fed rate hike, policymakers on the Federal Open Market Committee (FOMC) predict two additional rate hikes for 2023.
American suburbs have experienced a revival, with demographic shifts, housing preferences, and remote work driving the trend. Census data shows a 10.5% increase in the share of Americans living in the suburbs between 2010 and 2020, a trend accelerated by the pandemic. Contrary to expectations, many millennials are opting for suburban homeownership, with 45% planning to buy homes outside of cities, according to Axios. The rise of hybrid and remote work arrangements has made longer commutes more manageable, further fueling suburban migration. Additionally, the revival has brought new businesses to suburban town centers, while urban retail vacancies have surpassed suburban vacancies.