The beleaguered commercial real estate (CRE) industry has been facing headwinds since the onset of the COVID-19 pandemic, and many of the persistent challenges being endured by this important part of the U.S. economy will continue throughout 2024.
There are bright spots in the CRE outlook — mostly in the strong demand for multi-family (apartments), the digital economy (cell towers and server farms) and industrial (warehouse) property — but a comprehensive re-assessment and revitalization of the CRE industry is needed.
— Difficult economic realities.
— A closer look at CRE classes.
— Confronting the challenges.
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Difficult Economic Realities
Cost and Availability of Capital
The U.S. is in a period of rising interest rates that began almost two years ago when the Federal Reserve began raising rates to combat inflation.
The primary effect of rate hikes is obvious. The cost of borrowing has increased dramatically and will likely remain high indefinitely. Higher mortgage rates aren’t good for any borrower, but can be devastating for CRE investors who borrow heavily and generally need to refinance every three, five or seven years.
The problem is being exacerbated by banks tightening their lending standards or refusing to make CRE loans at all. Federally regulated banks hold virtually all of their reserves in U.S. government bonds. When rates go up the value of bonds goes down. By necessity, banks are being very conservative in making loans. Not only do CRE loans cost more today, but they are harder to find.
Potential Recession
The causes of the post-pandemic inflation we’ve been experiencing are disputed by economists, but the phenomenon is real. The Federal Reserve responded to inflation with rate hikes. The goal of raising rates is to combat rising prices by slowing the economy. Unfortunately, rate hikes, particularly the rapid and dramatic ones we’ve seen, can push an economy into recession.
In other words, the CRE industry is facing the significant possibility of an economic slowdown in the coming year.
A significant downturn would mean commercial landlords will struggle to fill vacancies and find it difficult, if not impossible, to raise rents.
Persistent Inflation
A prolonged period of low inflation and relative price stability ended abruptly three years ago. After an initial and alarming spike, the inflation rate has since moderated, but it’s still too high and overall price levels have been slow in receding.
Commercial property investors are certainly not immune to the effects of inflation. The cost of operating and maintaining a building and providing amenities to tenants is dramatically higher than it was 36 months ago. When we consider large increases in labor costs, the problem becomes especially pronounced. This is particularly true for construction and development firms that depend greatly on specialty labor.
Inflation also causes anxiety in individual consumers who are the end-users of CRE. In inflationary times, the commercial property owners suffer as people cut spending which, in turn, causes businesses to delay or cancel expansion plans that otherwise would have included renting real estate.
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A Closer Look at CRE Classes
Office
The work-from-home trend that gained traction during the pandemic severely disrupted the office sector. In fact, “disrupted” may be an understatement. Despite several million new jobs being added to the U.S. economy during the pandemic recovery, offices have lost several hundred million square feet of occupied space. Property values have decreased correspondingly.
Corporate managers, who fear that work-from-home will erode corporate culture and discourage employee coordination, are doing what they can to bring employees back into office buildings. But, in America at least, their efforts are falling on deaf ears. Office space utilization in the U.S. is only around 50% of pre-pandemic levels.
The outlook: Workers who like being home are a stubborn lot, and CEOs who want them back in their cubicles have very little leverage. Expect U.S. office space to continue to be underutilized unless and until that dynamic changes. A job-killing recession, for instance, would tip the balance toward employers and allow them to force office attendance.
Retail
Retail performance is a function of consumer sentiment, which was weak in the first half of the year but began to recover in the second half. That recovery can be attributed to a corresponding easing of the inflation rate (mentioned above) and moderation in energy prices.
As evidenced by bankruptcy filings, weaker retailers are falling by the wayside, but healthier, higher-quality stores are doing a great job picking up the slack. Store openings have outpaced store closings so far in 2023.
The outlook: In general, better retailers in better locations offering good service and decent quality will continue to absorb and displace weaker competitors. The demand for retail rental space should be maintained in 2024, but by consolidation rather than overall growth.
A recession or a resurgence of inflation would depress consumers and the retail sector.
Multi-family
Rising mortgage rates have, unfortunately, placed homeownership out of reach for many in the middle class. This is in addition to a low-income housing shortage that’s been plaguing the housing market for decades. The result is high and fast-growing demand for multi-family apartment properties and residential rentals. Multi-family is among the few CRE classes enjoying strong rent growth and increasing property values.
Finding equilibrium in the housing markets will take some number of years. While that’s not good news for homebuyers or renters, it is good news for owners of apartment buildings.
The outlook: Interest rates are cyclical and will eventually come down. If that process starts in 2024, some renters will opt for homeownership, but it will be a slow process and shouldn’t cause a dramatic change in the profitability of rental housing.
No relief is in sight for the low-income housing crisis. Stable rents are expected, and demand for affordable housing will remain consistently high.
Industrial
After suffering major disruptions during COVID lockdowns, the trucking and warehousing sectors of the CRE industry have experienced a boom. Driven by strong consumer spending, competition in e-commerce and “nearshoring” — relocating operations closer to home — industrial real estate construction achieved record levels in 2023. Subsequently, industrial landlords are enjoying excellent rent growth and full occupancy.
The outlook: The nearshoring or “onshoring” phenomenon is a long process that is in its early stages. The intense competition among retailers for faster home delivery, likewise, shows no signs of slowing down. This bodes well for industrial CRE. The 2024 outlook calls for more trucking terminals and more warehouses.
Consumer spending will ease if the economy slows, but unless we have a severe and prolonged recession, it won’t be enough to dim the prospects of this sector.
Digital
The relatively new digital economy has created and is sustaining a huge new sector in CRE made up of things like server farms, data centers and cell phone towers. Expansion and growth in this area has been unceasing for 20 years.
The outlook: The three big catalysts for digital CRE are the increasing connectivity of the world, the ongoing rollout of 5G communication technology and the emerging commercialization of artificial intelligence, or AI. All of these things seem to be happening at hyper speed and all of them will require a tremendous amount of real estate in 2024 and beyond.
The current risks to the sector are construction constraints — land, labor and materials shortages — and high energy costs. It’s difficult to build or convert facilities fast enough to keep up with growth, and cooling computers and servers takes a tremendous amount of expensive electricity.
Confronting the Challenges
A 40-year period of low inflation and steady economic growth fueled by low interest rates appears to have come to an end. Commercial property owners and investors must confront this new reality.
In short, the industry must undergo a rehabilitation in the coming years. The first step in this process has already been taken: a realistic adjustment in expectations including the realization that the industry can’t count on things going “back to normal.”
The following are other themes to be addressed by CRE owners and prospective investors:
Upgrade properties. Modern, higher-quality facilities consistently outperform outdated ones. Upgrades and rehabs are a must.
New capital sources. Borrowing from banks is expensive and has become unreliable. New capital structures and alternative sources should be developed.
Technology. Better tech means efficiency, which means profitability. CRE executives need to explore and adopt new technology, such as AI.
Sustainability. Governments and tenants are demanding greener buildings, and energy efficiency means lower costs.
Hybrid work. Roughly 25% of the American workforce is firmly committed to working from home at least part of the time. If landlords and CEOs can’t beat them, they had better join them with realistic accommodations.
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The Commercial Real Estate Outlook for 2024 originally appeared on usnews.com
