National and international factors shaping the real estate market of today

As we draw closer to the end of the year, and in presence of clearly apparent headwinds and tailwinds, it is important to take stock of the overarching trends and sentiments that are shaping real estate markets nationally and globally.

Global factors are shaping the economy

Stormy waters have persisted throughout much of the world. During the year, the global economic growth rate was downgraded three different times, to a recent level of 2.7%. Although still positive, the 2022 growth rate is at its weakest level since 2001. The decline can be attributed to myriad factors, including the war in Ukraine (and the threat of military conflicts in other parts of the world), the intensity of inflationary pressures being experienced throughout the world, and increasing energy prices. Not to be overlooked are the fears of a global recession, accentuated by economic conditions in China.

These factors, among others, have made 2022 more turbulent than anyone expected.

In spite of these conditions, as well as our own domestic issues, the U.S. continues to be regarded as a safe haven for investing—especially during times of turmoil. In fact, the U.S. continues to attract approximately 70 percent of the capital being invested in commercial real estate.

Domestic factors are mixed

The confluence of inflation and interest rates have been a powerful force for commercial real estate (CRE) investors, developers and owners to overcome in 2022. With the Fed’s most recent interest rate hike, mortgage rates are at a 20-year high at 7.27%. At the same time, they are approximately 50 basis points below the historical average of 7.76%. Further, because 25% of all commercial mortgage-backed security (CMBS) loans have a floating rate component, properties across all sectors face increasing challenges and may even find themselves in a position of negative leverage which could portend to significant future financial distress.

In contrast to the uncertainty that inflation and interest rate volatility create, the employment sector, at least for now, continues to provide a certain degree of balance. While the unemployment rate is 3.7%, a positive sign for the U.S. economy, the labor force participation rate has reached a 45-year low of 62.2% (excluding the post-pandemic period). While this can be attributed in part to the aftermath of COVID-19 and the Great Resignation, the rate has been trending downward since 2001. Other factors that continue to give at least some semblance of hope include a continued increase in the level of onshoring.

Evolving from COVID-19's initial impact to the present

Thirty months past the original COVID-19 lockdown, we continue to live, work and play in a world that has been heavily shaped by the pandemic. Its impact significantly accelerated the trajectory of issues and trends occurring in different CRE sectors. For some, namely the multifamily and industrial sectors, that trajectory was generally positive. For others, such as the office sector, the impact has been negative and may in fact pose a threat to the greater urban office ecosystem. And somewhat surprisingly, the pandemic’s impact on the retail sector helped to accelerate a transformation that has created opportunities.

Among the trends and observations worth noting include:

• There is a real tug of war in the office sector as businesses look to lure more and more of the workforce back to the office, in part by focusing on amenity space and, borrowing a page from retail, being more experiential. Further, because of the weaknesses that were accentuated by COVID-19, the office sector is experiencing the have/have not characterization where office users are able to trade up to Class A space, creating further struggles for Class B and C properties. The plight of office threatens the urban office ecosystem, which includes retail, restaurant and entertainment venues that rely on consistent daily foot traffic.
• The pandemic, and the push for a vaccine and accurate testing, created a greater opportunity in the already booming life sciences space. The existence of variances and the threat of the spread of other viruses likely will sustain this sector, creating development and, potentially, conversion opportunities.
• Some of the top owners in the student housing sector are reporting pre-leasing rates that are 10-15% higher for 2023 than they were for 2022 as students look to fully take in the back-to-school experience. Experts expect this strength will continue for the near term.
• A number of market forces continue to stoke the appeal of the multifamily sector, which hasn’t wavered through the pandemic. Fundamentals are solid, with the strongest among them rent growth which has been as much as 10-15% annually, depending on the market. For some investors/owners, strong NOI levels reduce the motivation to sell, unless there are mitigating circumstances. That explains, in part, why cap rates may have increased only 50 bps even though interest rates have doubled.
• An offshoot of the multifamily sector is the increasingly popular build-for-rent (BFR) market. As interest rates rise to between 7% and 8%, experts suggest that less than 15% of would be first time homebuyers that can afford the mortgage on a $400,000 home (and that doesn’t include making the down payment). This has produced millions of “trapped renters” who are forsaking traditional multifamily dwellings for BFR communities that offer more space, greater privacy, and increased flexibility and desired amenities.
• The industrial sector’s trajectory seems to be slowing. While slowing trajectory has been inevitable, it will remain an attractive, strong asset class for the foreseeable future, as demonstrated by occupancy levels ranging from 95-97%, depending on the market. Further, in certain situations, owners are transitioning to shorter-term leases to provide a hedge against the inflation rate.
• One of the greatest surprises has been that the death of the retail sector has been grossly over-exaggerated. The best retail typically always has a great location which gives it an advantage in any type of conversion effort—whether that means being more experiential (or convenient) or being transitioned to a higher and better use. While not all retail has been successfully transformed, many retail properties have performed better than otherwise expected.

With a recession of unknown duration growing more imminent, the important lesson learned over the last 24-30 months become increasingly important. Flexibility, patience and innovation have allowed the CRE industry to perform in a supercharged manner, during times of great challenge. Many believe this focus on flexibility, patience and innovation has shown us what we can get through.