Commercial Real Estate Insights
Commercial Real Estate Trends and Office Conversions
While there are bright spots across commercial real estate as the economy slowly recovers from high inflation and interest rates, some sectors continue to face challenges. In particular, the office space sector has not recovered from the downturn in activity following the pandemic. Many office workers continue to operate remotely or in a hybrid fashion, even as companies adopt return-to-office policies. Adding fuel to the fire is the fact that many CRE loans will need to be refinanced at a time when lending conditions have tightened considerably. What is driving these trends, and how might they impact CRE more broadly in the second half of the year?
Economic Headwinds
The CRE landscape has continued to evolve rapidly in response to the economic shocks of the past year. In particular, the risk of a national recession and rapidly increasing interest rates have impacted CRE at all levels by softening demand and increasing costs. Fortunately, some of these factors appear to be easing.
While the possibility of a recession continues to drive policymaking decisions and business strategies, improving inflation and steadier interest rates have
increased the odds that the economy can weather the storm. At its latest Federal Open Markets Committee meeting, Federal Reserve officials indicated that “given the continued strength in the labor market, and the resilience of consumer spending… [the Fed] saw the possibility of the economy continuing to grow slowly and avoiding a downturn as almost as likely as [a] mildrecession.” In other words, policymakers are more optimistic today than even just six months ago.
. . . The risk of a national recession and rapidly increasing interest rates have impacted CRE at all levels by softening demand and increasing costs. Fortunately, some of these factors appear to be easing.
Interest Rates in Perspective
10-year yield over different time frames, reindexed
Latest data point is Jul 21, 2023
Sources: Clearnomics, Federal Reserve
A stable economy in the face of higher interest rates and economic uncertainty may create opportunities in CRE as both consumer and business demand recover. Recent trends have already helped moderate inflation and could help alleviate the labor shortages that have been a headwind to the growth of many businesses. The job market continues to be extremely tight across most of the country, especially in hospitality and healthcare sectors that require trained workers.
The outlook for interest rates has shifted as well. At the beginning of the year, markets expected a reversal in monetary policy before the end of the year. However,
the strength of the economy has led the Fed to plan for additional rate hikes instead. Market expectations now indicate that the fed funds rate could increase another one-quarter to one-half percent in 2023, and then remain higher for longer.
However, the positive news is that market interest rates may already reflect these increases. In fact, with a 10year Treasury yield of around 3.8%, long-term interest rates remain below their post-pandemic peaks. So, while interest rates are higher and lending conditions more restrictive, they are also more stable compared to a year ago when inflation was surging.
Solutions for Lower Office Occupancy Rates
CRE in the Twin Cities and other parts of the Midwest has not been immune to these economic trends, including the slow recovery in office occupancy rates and activity in downtown areas. Many diverse sources of data point in this direction, including research conducted at the University of Toronto showing that Minneapolis has recovered only 40% of its pre-pandemic mobile device activity, a proxy for economic activity. While many companies and property owners are encouraging a return to the office, other solutions may be needed.
For example, there has been a wave of office-toresidential conversions across the country. A successful transition of unused space to more desirable residential
housing can both increase property values and help improve the supply of multifamily housing. Active housing inventory listings in the Minneapolis-St. PaulBloomington area have declined 4.7% year-over-year, while home prices in the area have moderated only slightly from their pandemic highs.
Of course, conversions are major undertakings that require capital and local support. Fortunately, there appears to be public enthusiasm for these projects in the Twin Cities. In his 2023 Minneapolis State of the City address, Mayor Jacob Frey emphasized the need for conversions as well as “directed Community Planning and Economic Development to… keep Minneapolis ahead of the national curve” in how office space is used.
Twin Cities Housing Prices
All-Transaction House Price Index for Minneapolis-St. Paul-Bloomington, MN-WI, NSA
Latest data point is Q1 2023
Sources: Clearnomics, Federal Housing Finance Agency
Revitalization efforts are often encouraged by public officials, since increased economic diversity in downtown areas can have a multitude of positive effects. When residential properties are mixed into office space, downtown foot traffic grows and encourages further development of retail space, restaurants, hospitality and more.
For example, the historic Northstar Center in downtown Minneapolis is currently being redeveloped into a multiuse space. The Northstar Center was originally completed in 1963 as a mixed-use building consisting of office, retail, and hospitality space. Redevelopment is now underway to turn the center into multi-family housing, modern offices, event space, restaurants, and a hotel. This modernization aligns with other goals such as increasing the affordability of housing in the area. Combining many uses with its central location in the downtown business district, both the developers and public officials are hoping to restore the space as an attractive destination for living, work, and leisure in downtown Minneapolis, enhancing the livability of the area.
Thus, successful conversions could help fill demand and lift supply in the multifamily housing sectors at a time when office demand has fallen. This also offers property owners attractive options in a challenging economic and interest rate environment. This will only grow in importance given the need to refinance many properties in the coming years, and due to the climbing levels of distressed CRE debt.
Opportunities for CRE Leaders
In the second half of the year, CRE leaders will need to balance both nationwide and regional trends to successfully navigate higher interest rates. Despite these uncertainties, there are clear opportunities for leaders to better allocate resources and benefit from long-term trends such as office-to-residential conversions. Strong banking and financing relationships can help CRE leaders successfully obtain attractive financing opportunities to operate and grow through these challenging times.
