Commercial Real Estate at an Inflection Point
The dynamics of the market are changing and, while it will cause problems for some, those that can adapt and adjust their businesses to embrace the new dynamic will have the chance to do very well.
—Respondent Comment “ “
The commercial real estate industry is continuing to respond to the sweeping, abrupt changes brought about by the pandemic and its aftermath. It is contending with a dramatic shift in the way people live and work—and where they want to live and work—that has swept away longstanding assumptions about the resiliency of sectors like office or retail. At the same time, the industry as a whole is challenged by the rapid run-up of interest rates as the Federal Reserve attempts to tamp down inflation.
To better assess how the industry response will evolve over the next year, Commercial Observer commissioned a comprehensive market sentiment survey in September 2023, eliciting responses from 550 industry leaders (at the director level or higher) on issues related to the future of commercial real estate. Of the respondents, one-fifth were founders, owners, or principals of their firms while another 9% were either chairs or C-suite executives [Chart A].
Which of the following best describes your seniority level/job title?
Chairman 1% C-Suite 9% President 3% Founder/Owner/Principal Partner/Shareholder VP/AVP/SVP/EVP Managing Director (Any level) Director (Senior, Associate, etc.) 20% 12% 28% 10% 18%
Respondents were well aware of the challenges the industry faces but were confident that there were opportunities for those with the resources to seize them.
Among the most important findings:
• Respondents are unsure about the future of the economy but were more definite about the direction of interest rates. While they were equally split about the likelihood of a recession during the next 12 months, they felt that higher rates are here to stay.
• Extreme weather is not only putting pressure on net operating income (NOI) but is also beginning to influence investment decisions.
• Concerns about the bottom line are also causing commercial real estate companies to foresee tightening their hybrid work arrangements over the next 18 months. Almost half the respondents said their firms expect employees to be in the office either four or five days a week at the end of 18 months.
• Technology is viewed as both a disruptive and constructive force. Executives are worried about the rise of online marketplaces and listing services while excited about the potential of artificial intelligence (AI).
• Multifamily and industrial topped the list of high-performing sectors while office came in last. But despite the many challenges office faces—and in many instances because of them—almost a fifth of respondents (19%) said their companies plan to invest in office over the next 12 months.
Interest Rates are Top of Mind
High interest rates are trickling down into all aspects of commercial real estate.
—Respondent Comment
The sudden rise in interest rates to levels not seen in 15 years is reshaping commercial real estate, causing immediate issues for investors refinancing their loans over the next two years as well as longer-term corrections as the industry adjusts to higher rates for the foreseeable future.
When asked to name the greatest opportunity and/or challenge facing the commercial real estate industry, a significant number of respondents focused on the challenges posed by higher interest rates.
Of slightly more than 200 free-form summary responses at the end of our survey, industry executives mentioned interest rates 93 times. There is a widespread conviction that although rates may decline slightly, higher rates are here to stay. Survey participants were close to evenly split between those who predict that the 10-year treasury yield will be at least 4% in 12 months (53%) and those who think it will be less than 4% (47%) [Char t B].
1.99% or lower 2% 2.00% to 2.99% 10% 3.00% to 3.99% 34% 4.00% to 4.99% 5.00% or higher 43% 10%
Where do you think the 10-year treasury yield will be 10 months from now?
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These higher rates are having several consequences. Many respondents foresee an increase in distressed assets as investors face the prospect of refinancing low-interest loans at current rates at a time when banks, in particular, are tightening credit standards for CRE borrowers. As one industry executive said, “The interest rate environment and revaluation of many buildings will make it almost impossible for many owners to keep their assets.” These difficulties may be one reason that respondents predict that nonbank financial institutions (40%) and debt funds (22%) will be the most significant source of financing in the next 12 month, far exceeding regional banks (14%) and money center banks (9%) [Chart C].
Of course, one investor’s challenge is another’s opportunity. As one executive pointed out, the high-interest rate environment “will force properties held for generations to be sold at a discount and [enable] those holding large sums of cash to buy at a good basis, allowing them to improve the asset.”
Currently, cap rates have not risen commensurately with interest rates, but this may start to change as more assets come to market and the bid-ask gap begins to close.
What will be the most significant source of financing during the next 12 months?
Nonbank financial institutions 40% Debt funds 22% Regional Banks 14% Money center banks Insurance companies CMBS Other 9% 7% 5% 3%
Well over half of the commercial real estate executives in our survey believe cap rates will increase either somewhat (50%) or significantly (8%) in the next 12 months, more than triple the percentage who believe that cap rates will decrease (18%) [Chart D].
How
What
The likelihood of a recession—and its effects on interest rates— remains a wildcard. Our participants are split. Slightly more than half (55%) predict that the economy will experience a hard (20%) or soft (35%) landing in the next twelve months. Forty-five percent anticipate continued slow growth (37%) or a steady recovery (8%) [Chart E].
Increase significantly 8% Increase somewhat 50% Remain the same 25% Decrease somewhat Decrease significantly 16% 2%
will cap rates move in the next 12 months?
Hard landing 20% Soft landing 35% Continued slow growth 37% Steady recovery/solid growth Strong recovery 8% 0%
is your prediction about the economy in the next 12 months?
CRE Investors Have a lot on Their Plates
We must redefine the way we conduct our business.
—Respondent Comment
If there is one constant in commercial real estate, it is change. Owners and operators are coping with an unprecedented rise in insurance costs, driven in part by climate change. They are trying to reconcile productivity with employee expectations about remote work. And they are considering how to respond to ever more powerful and pervasive advances in technology that will redefine how they conduct their business.
Investment decisions are becoming increasingly complicated. An increasing number of CRE professionals, for instance, plan to factor climate change into their plans. Close to half (45%) said it will have some effect, while 11% said it would have a decisive effect [Chart F]. But extreme weather is also posing operational challenges. Faced with unprecedented payouts, some insurance companies have abandoned markets and virtually all have raised rates, not just in vulnerable areas but across the board. The result, insurance costs were mentioned by a large number of respondents as one of the greatest challenges facing the industry.
What
Decisive effect 11% Some effect 45% Minimal effect 30% No effect at all 14%
effect will climate change have on investment decisions over the next 12 months?
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Roughly three-quarters of the sample (74%) are implementing strategies to mitigate or offset higher premiums. The most common strategy (52%) is simply to pass the costs on to tenants/customers in the form of higher rents or prices, although others, perhaps hesitant to impose another large increase, have increased their deductible (41%) or are investigating changing their insurer. Relatively few are self-insuring or creating a captive insurance company (14%) or hiring a third-party management firm to secure insurance (13%) [Chart G].
What strategies are you implementing to mitigate or offset sharply rising interest costs?
loss-prevention strategies
Reducing and/or eliminating certain coverage
Starting policy renewals earlier
Taking advantage of geographic portfolio diversity with a blanket policy Self-insuring or creating a captive insurance company
Concerns about the bottom line are also causing commercial real estate companies to foresee tightening their hybrid work arrangements over the next 18 months. By the end of this period, 18% of respondents said their companies will have imposed a total return to the office, while another 30% said that they plan to have employees back in the office four days a week. Together, those firms requiring either four or five days in the office (48%) exceed those requiring just three days (31%), now widely considered the norm. Firms requiring just one (2%) or two (3%) days in the office will be a rarity [Chart H].
Passing on some
to
higher
52% Increasing my deductible 41% Considering a change in
39% Implementing
costs
tenants/customers in the form of
rents or prices
insurers
Secure
Other 29% 25% 25% 18% 14% 13% 1%
insurance through a third-party management firm
What is the most likely work arrangement for your firm over the next 18 months?
Employees will be back in the office 5 days a week 18%
Employees will be back in the office 4 days a week
Employees will be back in the office 3 days a week
Employees will be back in the office 2 days a week Employees
in the
Investors also see technology as both a constructive and disruptive force [Chart I]. Sixty-five percent believe artificial intelligence will produce transformative changes in building information management (68%), property management (57%), and deal sourcing and matching (50%) [Chart J]. On the other hand, 49% feel that online marketplaces and listing services will gain in prominence over the next five years, supplementing or even replacing, traditional relationshipbased models.
Select the technologies that you believe will hold the greatest significance or relevance for CRE over the next five years?
In what areas do you anticipate AI to have the most impact?
will be back
office
day a week Employees will all be working from home Employees will be able to choose how many days they will be in the office 30% 31% 3% 2% 7% 10%
1
Artificial intelligence Building information modeling 65% 68% Online marketplaces & listing services Property management 49% 57% Process automation Deal sourcing and 37% 50% Cybersecurity Finance Solar power Investing Virtual & augmented reality Other Blockchain & tokenization Other None of the above None of the above 34% 42% 32% 41% 23% 3% 13% 2% 4% 2%
Different Sectors Have Dramatically Different Outlooks
The next few years ahead represent a huge opportunity for change.
—Respondent Comment
Like other commentators, the respondents see a sharp divergence in the performance of the five classic real estate sectors, with multifamily and industrial faring well, hospitality and retail recovering, and office confronting an era of turmoil. But even in office, some investors see opportunity.
The two major CRE sectors that these executives expect to perform best in the next 12 months are multifamily and industrial, with nearly two-thirds picking multifamily (66%) and over half (57%) choosing industrial [Chart K]. But their investment plans don’t always align with their performance expectations. For instance, just 47% plan to invest in industrial. The situation with hospitality is similar. Thirty-five percent of respondents named hospitality as a top-two sector, while just 25% plan to invest in it. On the other hand, while 4% named office as one of their top two, 18% see it as an investment opportunity.
Which CRE sectors do you expect to perform the best in the next 12 months? Which segments would you be most likely to invest in if you had the opportunity?
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Multifamily Sector Best Investment Best Performing 67% 66% Industrial 47% 57% Hospitality 25% 35% Retail Office Other None of the above 25% 25% 18% 4% 7% 6% 1% 1%
Multifamily
The persistent housing shortage is sustaining performance and investment in multifamily. By far, the most frequently named tailwind driving the multifamily market in the next 12 months is supply/demand dynamics (76%), while interest rates were the overriding choice for top headwind (78%) [Chart L] Lowering these rates was also viewed as the most important impetus for developing additional affordable housing [Chart M].
What will be the top two tailwinds and headwinds for multifamily during the next 12 months?
What change would have the most impact on your ability to develop and/or renovate affordable properties?
Chairman C-Suite
Lower interest rates for loans including affordable units 43% Real estate tax relief Expansion of the tax credit program Zoning changes & waivers Other 20% 19% 18% 0%
Supply/demand dynamics High interest rates Tailwinds Headwinds 76% 78% Slowdown in the single family home market High insurance costs 55% 44% Falling interest rates Real estate reassments/tax increases 25% 29% Growth in household formation Wages & Material inflation Other Labor shortages None of the above Other None of the above 22% 26% 2% 9% 4% 2% 1%
Industrial
The two most powerful tailwinds driving the industrial sector are the continued growth in e-commerce (67%) and technological innovation in robotics, autonomy, and automation (53%) [Chart N]. There is no strong consensus about the best-performing subsectors. Data centers (32%) and distribution centers (29%) remain popular, but there is some indication that investors are investigating such new categories such as factories related to energy transformation (20%) [Chart O]. But even a sector as robust as industrial still faces headwinds. They come from a variety from a variety of directions: wage and materials inflation (56%), labor shortages (53%) and interest rates (53%).
What will be the top two tailwinds and headwinds for industrial during the next 12 months?
Where do you think most growth will occur in industrial
Chairman C-Suite
Data centers Distribution centers 32% 29% New factories related to energy transformation Chip fabs Other None of the above/no growth 20% 16% 2% 1%
during the next five years?
Growth of e-commerce Wage and materials inflation Tailwinds Headwinds 67% 56% Robotics/autonomy/automation Labor shortages 55% 53% On-shoring/re-shoring High interest rates 38% 53% Continued growth in
Return to in-store shopping Other Other None of the above None of the above 27% 19% 2% 4% 1% 3%
inventories
Hospitality
A solid majority of the executives in our survey named the resurgence of leisure travel as one of their top two tailwinds (63%) in hospitality [Chart P]. They were, however, of mixed mind about business travel. Forty-five percent named the return of the midweek business traveler as a top tailwind, a response that seems to contradict their top two headwinds: reduced corporate travel budgets (70%) and the spread of videoconferencing (42%). This discrepancy might account for the 10-percentage point gap between performance and investment expectations.
What will be the top two tailwinds and headwinds for hospitality during the next 12 months?
Resurgence of leisure travel Reduced corporate travel budgets Tailwinds Headwinds 63% 70% Return of the midweek business traveler Spread of videoconferencing 45% 42% Emergence of “bliesure” travel High interest rates 36% 30% Return of inbound international travel Competition for labor from other sectors Other Reduction in airline/air traffic control capacity None of the above Residual pandemic fear of travel Other None of the above 31% 16% 4% 15% 3% 14% 3% 1%
Retail
There was no consensus about prevailing retail tailwinds or headwinds [Chart Q]. No single option garnered more than 50% of the responses to either question. Mixed-use development (44%) led the list of tailwinds, followed by resurgence in dining out (39%). About half of the respondents chose high interest rates (50%) as a top-two headwind while about the same number (49%) selected e-commerce and 40% chose bankruptcies and right-sizing of major chains. When asked for a single choice, they were more decisive about the best location for retail [Chart R], with 50% choosing grocery-anchored shopping centers. Just 19% selected central business districts.
What will be the top two tailwinds and headwinds for retail during the next 12 months?
What will be the best location for retail during the next five years?
Chairman C-Suite
Grocery-anchored suburban shopping centers 50% Town center developments Central business districts Other 30% 19% 1%
Mixed-use development High interest rates Tailwinds Headwinds 44% 50% Resurgence in dining out E-commerce 39% 49% Flight to quality Bankruptcies & right-sizing of major chains 30% 40% Declines in new space delivered Labor shortages Clicks to bricks Oversupply Growth in grocery stores Other Other None of the above None of the above 24% 29% 23% 22% 21% 1% 2% 1% 4%
Office
Predictably, the office sector fared least well in our survey. Two-thirds expect work from home and hybrid work policies to remain the chief headwind going forward, but another group of respondents (70%) believe that management mandates related to return to the office will help sustain occupancy [Chart S]. According to respondents, conversion of some kind is the likely fate for older buildings [Chart T], while they asserted that the most effective measure landlords can adopt to retain tenants is to offer better pricing and other concessions [Chart U].
What will be the top two tailwinds and headwinds for office during the next 12 months?
Management mandated return to office Work from home/hybrid work Tailwinds Headwinds 70% 66% Influx of new, amenitized Class A buildings High interest rates 36% 36% Long-term lease structures Glut of pre-1980s buildings 26% 33% Recovery of coworking sector Low vacancy rates/oversupply Growth in white collar work Rising costs associated with securing new tenants Other Other High insurance costs Other None of the above 19% 32% 16% 18% 2% 8% 8% 1% 0%
What is the likely fate of older office buildings?
Which characteristic will be most important for office tenants as they renew their leases?
Converted to other uses, especially residential 46% Renovated & repurposed for the modern workforce 23% Torn down & replaced by newer buildings 22% Stay as they are Other 8% 1%
Concessions/pricing 46% Space in Class A buildings 19% Proximity to public transportation 18% Suburban locations City center locations Open floor plans Other 7% 6% 3% 3%
Conclusion: A Period of Adjustment
The greatest challenge for the industry over the next 18 months will be the continued adjustment to higher rates and more expensive debt.
—Respondent Comment
The pandemic represents a sharp dividing line between the low-interest, easy credit environment of the 2010s and the high-interest, tight-credit of the 2020s. The shock of this abrupt transition initially produced a stubborn bid-ask gap, but the surge of loans that must be refinanced in 2024 and 2025 will help break the gridlock in the markets and accelerate the transition to a new normal.
Sectors like multifamily and industrial, favored by the societal changes induced by the pandemic, will navigate this change quickly, but for office, the period of adjustment is more likely to be prolonged and more painful. But the responses of this survey show that there are significant tailwinds favoring each sector and that challenges for some parties represent opportunities for others. The mandate of CRE leaders is to find ways, as a respondent put it, “to adapt and adjust their businesses to embrace the new dynamic.” Those that do, “will have the chance to do very well.”
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