Commercial Real Estate Resets, But Does Not Fumble
A challenging year lies ahead for real estate markets – but 2008 this is not. The combination of high inflation and high interest rates will have an expected hit on the entire real estate sector in 2023, but underlying fundamentals point to a market that will persevere.
Last year saw ten-year financing costs rose significantly. Higher financing expenditures, and stricter lending standards have pushed property values down and capitalization rates up. Recent strains in the banking sector are also likely to influence investor confidence in the wake of Silicon Valley Bank and Credit Suisse’s meltdowns.
Despite the difficulties, there are still strong indicators in the U.S. economy overall that differentiate current real estate woes from the last housing crisis. Unemployment sits at historic lows, national consumer spending and overall business activity continue to be healthy and corporate balance sheets remain far more sustainable than they were the last time the real estate market faced difficulties.
A market reset
Post-pandemic, the real estate market has transformed. Malls and office space markets have considerably declined. The trend of remote work and further digital integration of almost every consumer daily good adopted during the pandemic has stuck to consumer’s ways of life. While some major corporations and banks have pledged full return-to-office schedules, many other corporations fell into the pattern of hybrid working models.
This will continue to put a strain on office space markets and reshuffle sector leaders. Conversely, other players have now emerged at the forefront of commercial real estate.
Apartment complexes, multi-family units, self-storage, life sciences and industrial sectors have reported sizable growth in recent years. Even malls have been repurposed for growing warehouse needs and industrial spaces, among other uses.
One particular area in the United States that has experienced growth are the cities surrounding the Sun Belt, comprising of the lower southern tier of the U.S. that stretches from the southwest to the southeast. Steady migration out of greater metro areas like Los Angeles and New York and corporate relocations have acted as tailwinds for this region and its premier suburban areas.
Cap rate forecast
Capitalization rates are likely to expand, but the level is highly dependent on risk profile. High-quality assets with strong growth expectations and strong net operating income will make a significant difference in the assets that fare well and those that do not.
Another crucial factor influencing commercial real estate markets is the amount of money sitting on the sidelines simply waiting. By some accounts, there is upwards of $150 billion in commercial real estate dry powder in the private equity space. Investors stockpiled earmarked money as rates began spiking and construction costs peaked. Current macro conditions put these investors in a bit of a bind though. Inflation has come off slightly from 2022 highs, but the Consumer Price Index currently sits at around 5 percent. Concurrently, the construction costs have hit historic highs.
Investors need to offload this cash, but the challenges might currently outweigh the opportunities and see investors waiting for signs of distress before they enter the market.
Opportunity in new places
The ongoing digital transformation will create new pockets of opportunity for the private real estate market. In addition to industrials, the increased need for data centers and logistics housing will be an area of interest for investors and have already delivered favorable returns over the past several years.1
The rising global challenge of food sustenance will create opportunity for investors of land and farming real estate. Senior housing facilities is another area with increased need. Whether existing structures are repurposed or new housing for seniors is constructed, the value of land-based resources for this demographic is expected to rise in the coming decades.
Overall, investors should take a long-term lens to the real estate market as we move further into 2023. The long-term prospects of real estate fundamentals continue to be strong for the private investor, despite current difficulties. Market dislocations might actually create strong buying opportunities in the next 12-18 months.
In the long run, patience will be key for the private commercial real estate space this year. There is an incredible amount of dry powder waiting to be deployed, demand is still strong, and consumer spending is healthy enough to maintain the advancement of sectors that have recently risen in popularity. Secular tailwinds have already seen malls turned into Amazon warehouses and massive gaming centers; the possibilities truly are endless.
Fundamentals will now be more crucial than ever in selecting the next commercial real estate investments. High cash flow and solid risk adjustments will be key in ensuring minimal downside exposure. Opportunistic investors need not only search for distressed assets, as they will do well in looking to the future to find what investments best suit them today.
1 Based on industrial properties as measured by the NCREIF Property Index, ending December 31, 2022.
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