By Jason Chudoba & Megan Kivlehan
Recession fears and uncertainty are dominating conversations in the commercial real estate industry as we head into 2023. This is a stark difference from the mood we’ve seen since we rebounded from the global financial crisis (GFC) over a decade ago – a historically long upcycle that saw record growth across most sectors and the emergence of the single-family rental sector, which has since become one of the most compelling categories in the industry.
There continues to be a record amount of dry powder on the sidelines – particularly in private equity real estate – however, we have seen a rapid decline in the deployment of that capital as investors take a more cautious wait-and-see approach. The pressures of inflation and rising interest rates are likely to have a marked effect on asset valuations, which is shaking investor confidence. In the public markets, REITs are down 20% year-to-date, and implied cap rates have increased from 100 to 125 basis points. Despite these challenges, the real estate asset class as a whole remains attractive, as real estate has typically served as a hedge against inflation and a stable source of income.
Historically, fluctuations in real estate values tend to lag behind the public markets, and some of the slowdown we’ve seen in capital deployment can be attributed to the denominator effect. In fact, a recent survey by Hodes Weill & Associates and Cornell’s Baker Program in Real Estate found that one-third of global institutional investors are overallocated to real estate as a result of the outperformance of this asset class against others. However, as real estate valuations catch up in 2023, investors are anticipating compelling investment opportunities will arise, leading to a 30-basis-point increase in target allocations year-over-year.
Savvy investors who are well capitalized and have navigated prior downcycles will be well positioned to weather the pending storm. However, investors who got into real estate to capitalize on the upcycle and haven’t yet navigated a downcycle may be in for choppy waters. The abundant debt financing environment in recent years has all but evaporated. Banks have significantly rolled back lending activity, and non-bank lenders who have traditionally stepped in to fill the void are becoming more cautious. Inexperienced investors who took on floating rate debt may face trouble refinancing, which may force them to take on new partners or sell their assets. This distress will ultimately create opportunity for experienced and well-capitalized players.
While we are in the early stages of a difficult macroeconomic environment, the long-term fundamentals across a variety of real estate asset classes remain remarkably strong. Even the asset classes that are perceived to face bigger challenges – including office and retail – have bright spots.
Multifamily. This asset class continues to be one of the most favored and best performing across the commercial real estate industry. The high cost and chronic undersupply of for-sale housing, combined with shifting consumer preference for convenience and amenities, have all benefitted the multifamily industry – which saw record rent growth and occupancy through mid-year 2022. While rent growth has cooled, the same fundamentals that have supported strong performance remain intact, and these assets will continue to attract capital. The general consensus is that as rent growth cools, cap rates and valuations will have to moderate, creating more buying opportunity.
Single-family rentals and build-to-rent. Emerging out of the GFC, the single-family rental and build-to-rent sector has grown into a massive institutional asset class, amassing a record $60 billion in investment between July 2021 and July 2022. This category capitalizes on many of the same fundamentals that benefit multifamily, and offers optionality to renters seeking more space, the benefits of living in top school districts, and the amenities of multifamily without the hassle of homeownership. The build-to-rent sector in particular is creating new supply in severely constrained environments – according to RentCafe, the amount of BTR homes under construction in 2022 increased 106% year-over-year – and will continue to see strong investment activity.
Office. The pandemic had an outsized effect on the office sector as many companies implemented mandatory remote work policies to stop the spread in the early days. This has resulted in a massive corporate culture shift, with employees largely preferring flexibility in their work schedules. While many companies are still in the process of figuring out exactly what their long-term strategies will be, indications point to hybrid policies that require at least some time in office. Some large employers – including a number of investment banks – have mandated or plan to mandate full-time returns to office. Demonstrating the increasing return to office, New York has seen steady increases in office occupancy since last year’s Omicron wave, reaching 47% in November. While there has been much disruption in the space, high-quality, well-located assets that offer desirable tenant amenities continue to see strong leasing and renewal momentum. Underperforming assets are expected to be converted into other uses such as multifamily, however, high conversion costs mean that it will take time for this to play out at scale.
Retail. All retail is not created equal. While malls are in the midst of an identity crisis, and operators are working to determine how to reposition these properties for long-term performance, open-air and neighborhood grocery-anchored shopping centers continue to perform. These assets benefit from prime locations at the hearts of communities, and the retail mix at these shopping centers is heavily skewed towards necessity. These hyperlocal shopping centers have also seen strong demand from top retailers, who recognize the powerful solution these locations offer in advancing last-mile fulfilment strategies, and they are using their brick-and-mortar infrastructure to support these efforts, demonstrating that having a physical store remains critical to the success of retailers. With a dearth of land available for development in desirable locations, we could see continuing consolidation in the sector as owners of these assets look to gain scale.
Industrial. This real estate asset class continues to see significant investment as it remains a critical component of the global supply chain. Cushman & Wakefield’s Q3 Industrial MarketBeat noted that Q3 marked the highest quarterly total on record for development, with 148.2 million square feet of industrial facilities delivered. Net absorption remained strong at 108.2 million square feet, reflecting strong demand for these assets and representing the eighth consecutive quarter where net absorption exceeded 100 million square feet. That said, a recent JPMorgan report noted that industrial may face challenges over the medium term due to its longer-term leases, which generally account for 2% to 3% inflation – far below the 7.7% reported in October. It’s been reported that a number of institutional investors that had invested in industrial during the pandemic are now switching to treasuries due to high inflation. However, the continued growth of e-commerce and the favorable long-term supply/demand dynamic will continue to support investment and performance of the asset class.
Hospitality. “Revenge travel” has taken hold as consumers who were cooped up during the acute phases of the pandemic have sought escape. That said, with macroeconomic uncertainty, a recession looming, and the possibility of layoffs on the horizon, analysts expect travel spending will moderate in 2023. Even so, there are exciting developments within the hospitality space, including the rise of short-term rentals and growing acceptance of Airbnb among property owners. While PwC expects U.S. hotels to see RevPAR finish at record highs in 2022, it also projects hotel occupancy rates to hit 63.6% in 2023, which is slightly below the projection they released in May. As the economy recovers and consumers feel more secure in their expenditures, travel spend is expected to continue rebounding towards 2019 levels.
Niche assets. These include casinos and entertainment venues, production studios and digital infrastructure, among others. We’ve seen increasing demand among investors looking to gain access to these niche asset classes, and this has led to growing interest in specialty REITs and investment managers. These asset classes are supported by favorable long-term fundamentals and require experienced management teams to unlock their value. For instance, production studios are supported by strong macroeconomic tailwinds including increased content consumption, coupled with the convergence of technology companies and content production, which are driving unprecedented demand for studio and production space. Casino and entertainment venues – particularly those located in Las Vegas – benefit from the growing experiential economy and strong desire for travel coming out of the pandemic. We are also in the midst of a digital transformation that necessitates significant investment in advanced infrastructure, such as cell phone towers, EV charging stations and data centers, to accommodate growing use and demand. More capital is expected to flow into these asset classes as they mature.
Follow the entire ICR 2023 trends series on the ICR Insights blog.