Gloomy Forecast, With A Few Rays Of Sunshine

By Ruxandra Niculescu, Geographic Services Inc. and Dianne Crocker, Lighbox

I recently attended a Broker’s Mid-Year Update in Sacramento, CA. Everyone was in high spirits, chatting and having an overall good time. That is, until the panelists took the stage. As we were presented with updates from five brokers representing the the office, investment, industrial, multi-family, and retail sectors, a cloud seemed to fall over the entire audience.

Despite one broker’s upbeat sentiment as she described her wish-list for the return to office, it was clear that even she did not practice being in the office five days a week. There was much discussion of converting office space to mixed use, with some commenting that science and laboratory uses were much needed in the area, while others advocated for multi-family residential conversions, despite the cost associated with such an endeavor.

From the investment perspective, it was like everyone had hit a pause button and was waiting to see what happens next. No one was willing to make the first move. Investors, who had spent 10 million on a property, are not willing to sell for eight. The problem here, being that if they continue to hold the property, there’s a very real possibility that next year the same property will be worth seven million or less. Add to this the fact that construction costs have gone up (though in some areas prices have started to fall), and we have an overall bleak outlook.

Despite this, the industrial sector appeared to be doing well, with one panelist saying development had continued and prices on space had gone up. In many areas developers saw industrial space rivaling big box store and former office space square footage prices. While this seemed positive, the speaker made a point to say he was cautious of being too optimistic as many of their projects would close out by February 2024 with no new projects slated for construction on the horizon. This was echoed by the multi-family residential broker, who lamented the lack of tenants willing to pay the current market rates. Reportedly, property owners have been reducing rates in an effort to attract qualified tenants, with minimal results.

Following the disheartening speech, the speaker for retail assets commented that he rarely liked presenting after multi-family residential, because his assets rarely performed as well. Today, was an exception, and he asked if his fellow panelist wanted a hug. This lightened the mood in the room, and the final speaker said that despite obvious changes, like Bed, Bath & Beyond moving out of some locations, they’ve already had many of the vacancies filled with newer operations seeking space for conversion to other uses. He seemed almost embarrassed to report that they had seen little change in rent and leases and were actually struggling to find space for some of their prospective clients.

While Sacramento is a small microcosm of the nation as a whole, many of these sentiments are felt across the country. Incidentally, at the same time the panel of brokers was presenting their Mid-Year Update, a group of individuals was brought together by LightBox to present the Sentiment Survey Report discussing expectations for the market in the 2nd half of 2023. The report looked at the complex market conditions through the lens of commercial real estate lending, brokers, investment, appraisal, and environmental due diligence sectors.

A few of the results from the discussion are outlined below:

• Recessionary concerns, pricing uncertainty, and the wave of loan maturities over the next 18 months are the top-of-mind concerns. Adding to the uncertainty. Is the stillrising interest rate environment, and the unknowns about where rates will ultimately land. The expectation is Powell is going to announce another few hikes this year after hitting the brakes at the June meeting.

• Deals are difficult to complete right now (we’re seeing declines of 30-40% year over year across selling, appraisal, environmental due diligence notwithstanding differences by geography and asset class). Buying, selling, and refinancing related activity is down 30-40% across geographies and asset classes. The report data suggests we’ve seen the bottom, a U-shaped recovery, with early signs that activity is picking up.

• Capital flows are subdued, and property valuations are in flux. The market is bracing for a wave of nearly $900 billion in loan maturities over the next two years for which refinancing may prove difficult, especially in the office and retail sectors.

• The bank failures of the first half of the year sparked even greater caution so lending will likely be more constrained and certainly more cautious. Scrutiny on lenders’ risk exposure is intense and some banks are already actively planning to divest some commercial real estate loans to reduce risk, redeploy capital, and drop potentially distressed assets.

• In terms of outlook, there are a lot of unknowns so not surprising that the survey responses about the forecast were notably a mixed bag. Only one in five respondents was bullish about the second half of 2023, while most respondents (48%) were neutral.

• It is clear the stage is set for a challenging second half. There is excitement and cause for concern, with potential for opportunities and distress ahead. Capital will be poised to jump on new opportunities, and the banking system remains fundamentally strong, which should help contain any fallout from recent bank failures.

As the second half of the year takes shape, market barometers to watch include:

• Whether the Fed resumes modest rate increases at its July and September Federal Open Market Committee (FOMC) meetings.

• Whether sellers make price concessions to narrow the bid-ask gap which thwarted deals in the first half of 2023.

• When/whether loan defaults tick up as loans maturing in the higher interest rate environment.

• How property fundamentals change by asset class/metro as vacancy rates increase, rent growth decelerates and prices reset.

• How companies’ decisions about office usage translate into demand for office properties and decisions about property reuse.

The results of the annual Sentiment Survey reflect that the stage is set for a challenging second half of 2023. Myriad concerns about a possible recession, constrained debt capital, price uncertainty, future interest rate hikes and a spike in distressed assets are casting a shadow of uncertainty over the market forecast. However, survey respondents are poised to shift to new areas of opportunity as they emerge. Despite the bleak outlook one may feel in the depth of winter, spring does eventually come, and Economists have referred to the term “green shoots” to signify small signs of recovery and growth from the ashes of a downturn. There is excitement and cause for concern; there will be opportunities and there will be distress; and there will be pain and there will be green shoots. These contrasts will unfold against a backdrop of a banking system that remains fundamentally strong.

Until the market finds a new equilibrium, investors’ and lenders’ underwriting should reflect the growing caution in the market, and assumptions should be tested under various scenarios to ensure prudent decision-making appropriate for today’s uncertain investment climate. Environmental consultants stand ready to assess properties for environmental rate, and increasingly, climate risk exposure, particularly flood and wildfire. In this time of transition, the commercial real estate market is entering a new phase of the cycle as it adjusts to higher interest rates, shifting demands for space, the coming wave of distress and intense pressures on market participants to close deals quickly.

Dianne Crocker is the Principal Analyst at Lightbox, a leading technology provider of due diligence, risk management, location intelligence and workflow solutions to consultants, lenders, appraisers, brokers and other stakeholders in CRE transactions. She is a highly respected expert on commercial real estate market trends and forecasting; property due diligence and risk management; and technology trends. With more than 20 years’ experience in the commercial real estate industry, she has analyzed the market through three cyclical downturns. Globe St. Real Estate Forum recently recognized Dianne among their 2022 Women of Influence based on career achievements, community outreach and mentorship within the industry. She was also selected by Connect Media as one of ten national winners of the 2020 Women in Real Estate Awards, which honors the achievements and inspirational stories of women who have reached respected positions of leadership and play key mentorship roles for others. She is also a cofounder of the Developing Leader mentoring program, now in its third year of connecting young environmental professionals in the consulting and lending sectors with veteran mentors.

Dianne is a passionate member of CREW Boston, currently serving as her chapter’s Delegate to the global organization, CREW Network, and as a member of CREW Network’s Industry Research Committee.

Ruxandra Niculescu is the Chief Executive Officer of Geographic Services Inc. (GSI), a WOSB that provides a variety of services in environmental consulting and remediation. With over 20 years of experience in the industry, she enjoys providing insight on how to navigate the regulatory landscape and find solutions to complex problems. Ruxandra has held talks and presentations on the due diligence process for a wide audience of lenders, brokers, and other interested parties, both in California and New Jersey. Locally, Ruxandra is also involved in various organizations including the Sacramento Association for Commercial Real Estate, CREW-Sacramento, and the American River Parkway Foundation.