By Stephen Swett
The past year continued to be challenging for commercial real estate (CRE). While some sectors showed strong fundamentals, the economy continues to influence CRE. As we look forward to 2024, we take a look at REITs, home prices, regulatory risks, ESG and more.
The past year has been a challenge for commercial real estate overall, and the public REITs underperformed, posting a 6 percent return through November vs. a 20 percent for the S&P 500. After valuations had soared amid very low interest rates, the Fed’s pivot to a hawkish stance beginning in late 2021 has led to an increase in its target Fed Funds rate to a range of 5.25 to 5.5 percent, a full 500 basis points higher than the target range two years ago. While inflation has decelerated, costs for many items are significantly higher than before, which has strained the consumer, resulting in shrinking basket sizes at grocery stores. Amid this backdrop, the yield curve inverted, and risk of recession remains uncertain. While fewer economists are predicting a 2024 recession now than earlier this year, the Conference Board still predicts a modest recession in the first half of 2024.
For commercial real estate, valuations have been negatively impacted, but price discovery has been elusive as transaction markets have been frozen as bid-ask spreads have gapped out. U.S. REITs have seen implied cap. rates rise nearly 200 basis points in the past year, which would signal a 25-30 percent decline in value. With mortgage maturities estimated at more than $500 billion in both 2024 and 2025, the ability to refinance these loans – particularly in the office sector – may be challenging, resulting in rising foreclosures and forced selling. Overall, however, a stable economy and potential for interest rate decreases as inflation continues to cool, would be very supportive of commercial real estate performance in the coming year.
Home values have continued to be sticky even as headwinds appear significant. Home prices are up nearly 50 percent over the past five years – significantly outpacing wage growth – and mortgage rates have increased from 2.7 percent at the start of 2021 to 7 percent today. As a result, over the past year, existing home sales have fallen by about 15 percent, and are approaching the lows reached during the Great Global Financial Crisis. On the other side, inventory of homes for sale has dropped significantly as in-place homeowners are less willing to part with locked-in low mortgage rates.
Nationally, home prices have only fallen over a sustained period only once in 60 years of data (2006-2009 during the global financial crisis), but Redfin currently predicts a modest reduction in 2024. If rates continue to decline, homeowners will see a shrinking in the benefit of their existing mortgages, so inventory for sale would likely rise. However, with housing affordability at its lowest level since 1986, according to the National Association of Realtors, it’s difficult to see how a more significant drop in prices can be avoided as markets normalize. In any event, we expect continued demand for rental housing – multifamily and single family – to remain very strong throughout 2024, albeit with moderated rental rate increases.
With inflation still lingering, landlords are aggressively managing 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 three years has masked some of these inflationary pressures, but as rental increases slow, rising expenses, which represent 30 to 40 percent 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.
Since the pandemic, sectors such as Industrial, Multifamily, Single-Family Rental, and Strip Retail are likely to see their strong recent fundamentals continue into 2024. Industrial has been one of the sectors that has benefited most from underlying shifts in the economy that were amplified in COVID. Online retail shopping has elevated the need for high-quality and well-located warehouse properties to facilitate efficient delivery of goods. While supply has increased rapidly and rent growth has decelerated, the underlying demand should continue to grow over time, ultimately absorbing excess demand. Multifamily and Single-Family Rental demand remains strong, magnified by the sharp drop in home ownership affordability; as with industrial, Multifamily supply is up – particularly in the sunbelt and some urban areas – but demand should remain elevated with supporting demographic trends. Strip Retail has benefited from a lack of new supply and retailer demand for the best space, which has driven accelerating leasing spreads and higher occupancy.
As 2024 approaches, remote working has become an issue. There’s an unmistakable desire among employees for greater work flexibility, but many employers are committed to increasing in-presence work to ensure productivity and enhance collaboration. In any case, a recent survey by AlphaWise shows little expectation that hybrid work will return to pre-pandemic levels, but current operating levels of hybrid work have stabilized, suggesting less demand for office real estate and more technology investment. Office demand is expected to decline by 10 percent over the next three years. Urban areas are projected to be hardest hit, with cities such as New York, San Francisco, and Chicago seeing office demand shrink due to outmigration to outlying suburban areas and other regions, and we will likely see tenants continue to downsize or vacate. To appeal to employees to return to work, companies greatly prefer class A or newer, high-quality buildings with plenty of amenities such as health or wellness facility, smart work areas, or other services, despite higher rents. Overall, occupancy rates and rents are both expected to continue to decline in 2024, which could further hurt office valuations which are already down about 20-25 percent since the pandemic.
Commercial real estate has always faced regulatory risks such as restrictive zoning, tighter building codes, and rent control. Currently, there are a variety of rising risks facing real estate landlords. Given recent construction activity at record levels, local zoning and permitting is getting more restrictive, and busy permitting departments are taking longer to review and approval applications. Building codes are also becoming more invasive. For example, California and New York City are pursuing bans of gas stoves and emissions limitations; while these potential bans are local now, they are likely to spread. Rent control has been a threat to residential real estate for decades, but after recent spike in rental rates, the risks are rising. Currently, Oregon and California are the only states with statewide rent control laws. Five other states — New York, New Jersey, Maine, Maryland, and Minnesota — have localities in which some form of residential rent control is in effect, as does Washington, D.C. Housing advocates in Massachusetts are pushing for a ballot initiative in 2024 for a statewide rent control policy. In an adjacent risk, Congressional Democrats are pushing to limit corporate ownership and rental of single-family homes in the U.S., an issue that could also be taken up at local or state levels if the federal effort fails.
For public REITs, ESG pressures have been pushing companies for years to enhance their disclosures and proactively incorporate “E, S and G” in all of their business decisions. Moving forward, all building owners will see these pressures grow, as federal, state and local mandates will force adoption of ESG strategies at the building level. Environmental factors such as carbon and greenhouse emissions, climate and weather risks, and renewable energy have been front and center. Additionally, the social impact of products and services, human capital and human rights, and data privacy and security require a more focused effort on corporate responsibility, social equality, and diversity. While the investment community continues to see the importance of these issues, additional regulations in the future, with potentially high compliance costs or fees for noncompliance, will further raise the financial risks of not addressing ESG.
For more 2024 trends in sectors from energy and investor access to healthcare, visit the ICR Insights blog.