No Match Found
Last year, the plan for the real estate industry was simple: Ride out current risks and reposition the business for a period of sustained growth and improved returns.
However, reality has set in for the industry leaders we interviewed for this year’s Emerging Trends in Real Estate. They no longer expect a U-turn to the way things were before the pandemic. Instead, they’ve accepted the possibility that a lot of people won’t be returning to the office after all, or at least not nearly as often. This has profound implications not only for office owners, managers and brokers, but also the nation’s downtowns and other property sectors that depend on a vibrant office market.
There’s also reluctant acceptance in the industry that interest rates will remain high for at least the next year and possibly even longer.
Even good news, such as investors being eager to acquire new assets, is tempered by bleak sector data. For example, despite available equity, transactions are down — and many in the industry point to instances where buyers and sellers simply can’t agree on pricing because the dearth of sales limits price clarity.
On a positive note, respondents to this year’s Emerging Trends survey believe the worst of inflation is behind us, which should give the Federal Reserve a reason to pause interest rate hikes.
“Despite the economic headwinds and the challenges obtaining credit, there are opportunities available for high-quality properties that meet the needs of today’s investors and tenants. Firms must learn to adapt their growth strategies to succeed in this period of higher-for-longer interest rates.”
More than three years since the start of the pandemic, the real estate industry professionals we interviewed for Emerging Trends largely have accepted that the sector will not be returning to the way it was before, as work and commuting behavior patterns have been tough to change — even with corporate demands and incentives to return to the office. Office buildings have also lost their appeal to investors, with sales transactions down more than twice as much as the other major property types.
There’s currently a bifurcated market in the office sector of haves and have nots, with a few properties in big cities that remain attractive to corporate America. Those properties are typically the newest, safest, healthiest buildings with the top amenities in the most-sought-after locations. Such premier facilities are attracting a disproportionate share of leasing interest. Moreover, office markets in many smaller, growing cities are not only surviving, but thriving even beyond pre-pandemic levels.
In the years ahead, companies with business models that support remote work will keep reducing their office footprint to save on rent. Going fully remote also may help companies win in the battle for talent, as companies that offer remote positions have access to a wider talent pool, which allows them to recruit better workers at more affordable wages. Such economics may be too compelling for them to reverse course and lease office space like before.
So what should office owners and cities do with the empty properties? While some in the industry have been calling for the repurposing of high-vacancy office buildings, the industry leaders we surveyed caution that not all office buildings can be economically converted — even with government subsidies. A better economic solution, they suggest, may be demolishing buildings and repurposing the land.
Despite the bleak forecasts, some industry leaders we interviewed haven’t given up on the future of office buildings. They want to learn from how the retail sector adapted and ultimately rebounded from the competition it faced over the past few decades from e-commerce, which emerged as a viable alternative to in-store shopping.
US household and corporation debt appears to be within the means of borrowers to repay, with scant signs of financial distress. That’s usually a positive sign for commercial real estate. However, rapidly rising federal debt could be more problematic, potentially “crowding out” private investment in the industry, leading to slower economic growth as well as higher interest rates — both of which would be long-term drags on construction, investment and returns.
Almost all of the industry experts we surveyed reported that debt (credit) became less available since the Fed began to hike interest rates in March 2022.
Originations have fallen among all primary debt sources, including banks, commercial mortgage-backed securities (CMBS) and life insurance companies, although private debt sources are sometimes stepping in to fill in gaps where others have reduced lending. Many survey participants also attributed 2023’s sales transaction decline partly on the reduced credit availability.
Not only is there less of it, credit has become more expensive and stringently underwritten. In lieu of credit, borrowers have been holding on to their existing debt, which is reflected in the increasing volume of outstanding CRE debt. This has enabled banks to grow their books of business despite making fewer new loans.
A clear theme of this year’s Emerging Trends is the fact that commercial real estate investors are becoming increasingly cautious in their outlook and more selective in their asset selection. We find that investors slowly are lining up to take advantage of undervalued assets and acquire new assets. For example, the Emerging Trends Barometer for 2024 registered its highest buy rating since 2010, likely reflecting recent and expected price declines, making this a more favorable entry point for acquisitions after a decade of relentless appreciation.
But even optimistic investors, who have been aggressively raising capital for distressed properties, are finding a limited number of promising opportunities to pursue. These investors have moved to the sidelines in anticipation that there will be more favorable opportunities down the road. Deal activity in the real estate industry will likely depend on how interest rates change, as the Fed’s higher-for-longer approach to interest rates is likely to slow economic growth.
After yet another record-breaking summer, 2023 is trending to be among the hottest years ever recorded. In addition, the number of billion-dollar loss climate events continues to rise.1
Property owners and managers now find themselves subject to growing government regulation and ESG (environment, social and government) mandates. In addition, city governments in some CRE markets have enacted regulations in recent years mandating regular energy audits and requiring commercial buildings to implement energy-saving measures.
Property owners are also increasingly worried about their insurance costs, which have increased — in some instances, greatly — in recent years. Insurance premium increases are typically passed on to tenants, but there’s concern among some professionals we interviewed that tenants in this market may balk or the costs might limit future rent increases. And that’s all contingent on property owners even finding coverage, as many insurers have stopped offering plans in areas prone to extreme climate events such as California and Florida.
Aside from rising insurance costs, the increasing correlation between real estate assets and sustainability performance is another key reason why the industry should plan its next moves with sustainability in mind. Over the years, CRE investors and fund managers have faced complex and difficult choices in considering how exactly to move forward with sustainability. Now, decarbonization and energy efficiency, indoor environmental quality, climate resilience and related issues are becoming increasingly urgent as extreme climate events mount and the risks and costs to owners rise. Going forward, investors will likely be more risk-averse and will perform expanded due diligence to understand the risks and potentially alter their investments.
1Source: National Centers for Environmental Information
In last year’s Emerging Trends, we noted that housing affordability had fallen to its lowest level in over 30 years, as both for-sale and rental housing costs soared to record levels. This year, it’s even worse, especially for homebuyers. Rents are also higher, although they’re rising more slowly in some markets.
The industry’s focus on housing affordability will likely remain in this era of higher-for-longer interest rates. A troubling combination of rising home prices and rapid increases in borrowing costs has put home purchases further out of reach for more people.
The current housing affordability crisis, however, has been more favorable for renters of late as rent growth nationally is flat or minimal, after peaking in early 2022. This is the result of healthy additions to supply, including apartment construction, which is on pace to add over 460,000 units in the US this year, on top of over 700,000 units since the start of the pandemic.
As we’ve explored previously, the solution to the nation’s housing crisis is to build more of it, preferably at all price points. But the reality is we do not build enough units affordable to lower-income tenants especially — so not all new supply will necessarily improve affordability.
Advancements in artificial intelligence (AI), including generative AI, are showing promise in the real estate industry. For one thing, AI is starting to enhance the property search and analysis process. It’s reshaping how real estate investors analyze potential investment opportunities, improve customer experience, help streamline due diligence and improve fraud detection in real estate transactions, among other activities.
In addition, some investors we interviewed for Emerging Trends point to the potential for AI to generate a new source of demand for office space, particularly in traditional tech markets like San Francisco, where much of the venture capital and AI employment is based.
That said, although AI has been used in real estate for years, many of the technology’s capabilities and functionality are still largely unknown to the leaders we interviewed. In addition to a lack of understanding, interviewees cited AI misinformation as a key barrier to adoption.
To help combat misinformation and other risks, leaders should thoroughly research the topic and learn how to make responsible AI part of their larger AI strategy. Firms must also consider data privacy and security, particularly for systems that rely on large data sets, as protecting personal and sensitive information is critical.
Hundreds of potential AI use cases can be found across a real estate firm’s operations, finance, sales and marketing, IT and HR functions, among others. However, if you’re starting with this use case or that one, then you’re likely overlooking what makes AI such a big deal.
We have seen that pilots of individual use cases often miss the bigger value and impact of generative AI. There’s a better way, however. By linking sources of value to common AI patterns rather than individual use cases, firms can deliver outcomes with greater speed and reusability, which results in faster outcomes.
Since undergoing some fundamental shifts in the immediate aftermath of the pandemic, market preferences have surprisingly not radically changed in the past two years. Respondents still see the best opportunities in the so-called “smile” markets situated along an arc in the southern third of the country.
The number of Sun Belt markets among the Top 10 has increased. At the same time, the number of Top 10 markets in cold-weather climates in the Northeast and Midwest remain at one (Boston). Three of the Top 10 markets from the 2023 report dropped out this year — Tampa/St. Petersburg, Miami and Charlotte — but all stayed in the Top 20.
“We think it will take until 2024 for an uptick in transaction volume, but it will come. It won’t necessarily hinge on a lowering of interest rates by the Fed. It could happen before then as people get used to the new higher rates and start to transact again.”