By Stephen Swett
In last year’s look at commercial real estate trends, we discussed the evolution of work-from-home policies post-COVID, housing prices, and continuing trends toward flexibility, lifestyle and convenience. Given economic shifts, 40-year-high inflation rates, and almost constant talk of recession, what might 2023 look like for the commercial real estate (CRE) sector?
The Direction of the Economy will be Critical to Performance of the Public REITs. The strong recovery out of the pandemic resulted in significant economic growth, with real GDP up 5.9% and unemployment falling to 3.7% in 2021. However, in late-2021 and into 2022, inflation rose to 40-year highs, and interest rates surged, with the 10-year reaching its highest levels since 2010. The Fed pivoted to a hawkish stance to combat inflation, raising its target range by more than 350 basis points during 2022, and signaling its likely target is in the 4.5-5.0% range, reflecting another 100 basis points of increases. Amid this backdrop, the yield curve inverted to its steepest level since 1981, and nearly 70% of economists, recently surveyed by Fortune, now predict a recession in 2023. Recent comments from Fed Chairman Powell suggest some moderation in future target rate hikes, but how the Fed manages a potential “soft landing” remains uncertain. Already, a rising number of employers have announced significant layoffs, including major tech companies such as Google, Twitter and Amazon. For REITs, this has historically had negative implications for office, mall retail, and industrial, although in the current environment, industrial should continue to benefit from the long-term shift to on-line sales and the need for massive amounts of distribution space, so the impact will likely be seen in slower lease up of new development deliveries.
Will Housing “Unaffordability” Drive Home Price Deflation? Home values were up about 10% in the 12 months ending June 2022, and up 40% since 2019. This appreciation was driven by significant demand coming out of the pandemic, a chronic shortage in quality housing stock, and record low interest rates. Today, the outlook is less certain. Nationally, home prices have only fallen over a sustained period once in 60 years of data (2006-2009 during the global financial crisis) but given recent home price appreciation is well in excess of incomes, and the fact that mortgage rates have doubled from 2020 lows, affordability has declined to its lowest level since 1986, according to the National Association of Realtors. As a result, over the past year, home sales have fallen by about 30%, and mortgage originations have fallen over 40%. While housing experts differ in the expectations, the overall prediction is for a modest decline in home prices nationally, as lower affordability is offset by continued demographic-driven demand and the overall shortage of quality housing. In any event, we expect continued demand for rental housing — multifamily and single family — to remain very strong throughout 2023, albeit with moderated rental rate increases.
A More Pronounced Return to In-Person Work is Possible. The U.S. remains behind many countries in the world in employees returning to the office, but major companies are gradually pushing for in-office presence. On Wall Street, investment banks are beginning to require employees to return to the office. While many companies will continue to allow remote work — and many workers may continue to prefer it — a recession may be a bit of a wild card. On the one hand, a rise in unemployment could provide a negotiating benefit to employers to require or encourage in-person work for at least a minimum number of days per week. On the other hand, the “Great Resignation” has resulted in a smaller overall labor force, so the competition for talent will likely remain high. Further, current employees — particularly critical employees — are likely to continue to pursue their own preferences, and firms are not going to want to lose talent. Many firms, and office landlords, are taking actions to enhance the work experience, with expanded amenities, but higher commuting costs and inflation will discourage some workers from resuming prior commuting habits. The uncertainty around office utilization is likely to push office demand for flexible space design with shorter lease durations at higher quality buildings in transportation-oriented locations.
Expense Inflation Will Create Margin Pressure. With inflation at a 40-year-high, landlords will need to aggressively manage operating expenses. Certain expenses (including payroll, administrative fees, landscaping, repairs and maintenance, etc.) can be managed somewhat, but other expenses (taxes, insurance, utilities, snow removal, etc.) are out of a landlord’s control. How this impacts commercial real estate portfolios will depend on several factors, including NOI margins and the ability to pass through costs to tenants. In terms of NOI margins, multifamily and hotels have historically had lower NOI margins. For multifamily assets, outsized revenue growth in the past year-plus has masked some of these inflationary pressures, but as rental increases slow, rising expenses, which represent 30% to 40% of revenue, will pressure margins and could drive NOI down. For hotels, NOI margin is highly dependent on the level of service provided, but inflationary cost pressures may have a double impact if revenue drops in a recession, which has been the norm. For other commercial property types (office, industrial and retail), most landlords utilize a lease structure that allows some or all property expenses to be passed through to the tenant, limiting the near-term impact of inflation on the landlords.
NAVs Will Likely Fall as Higher Cost of Capital Impacts Cap Rates and Valuations. The sharp rise in the cost of capital has resulted in commercial real estate buyers stepping back to assess the market and target returns. Historically, buyers always recognize a change in market dynamics more quickly than sellers, who look more to recent transactions as a guide, and the result is a significant slowdown in transaction volume until pricing clears. Additionally, as publicly traded investments, REIT values correct more quickly than privately held real estate. Year-to-date, REITs are down over 20%, and implied cap rates have increased from 100-125 basis points. If market cap rates ultimately trace a similar trajectory, then commercial real estate values should adjust downward about 20%, and REIT NAVs would realign closer to the current share price, assuming no recessionary / inflationary degradation in NOI. Over time, REITs have not typically traded in line with NAVs, but rather reflect forward expectations on NOI and cash flow, so what happens on the inflationary and recession front will ultimately prove more important in terms of REIT performance than a static NAV estimate.
Follow the entire ICR 2023 trends series on the ICR Insights blog.