Emerging Trends in Real Estate 2023

The commercial real estate sector has plenty of motivation to act on the enormous potential impact of unchecked climate change.

Owners and asset managers must undertake cost-effective physical improvements to protect their buildings. It’s very risky to tempt fate by assuming that an extreme weather event will not happen on your watch.

Insurance is not a substitute for building resilience. Preferring to protect buildings through insurance rather than upgrading them to better withstand extreme weather may be more expensive in the short term. Insurance can protect building owners against damage loss, but not against demographic or investor sentiment changes. Moreover, insurance coverage is becoming increasingly expensive in high-risk locations, and, in some cases, it’s difficult to obtain at any price.

Pressure for greater environmental, social and governance (ESG) investing disclosure by real estate owners and investors is also intensifying. While industry groups are calling for collective voluntary action, the growing number of regulations being considered at the federal, state and local levels indicate that governments are getting impatient about limited ESG progress.

Pressure for greater disclosure from institutional investors may be too strong for building owners to resist adapting ESG protocols, especially given the investors’ market size and the current capital demands. Even if investor demand increasingly pushes the market to more sustainable buildings, some investors believe that a downturn might slow ESG progress for a while.

Nevertheless, the US Securities and Exchange Commission is forging ahead, as evidenced in its May 2022 ESG disclosure regulations. They require greater disclosure and transparency, as well as enhanced consistency in reporting, in order to go beyond industry self-regulation.

Building owners and developers should leverage a host of new incentives from governments, including billions of dollars of incentives in the Inflation Reduction Act, to help buildings hit these aggressive climate goals. Such “carrots” are designed to help the industry meet the increasingly challenging set of environmental regulations.

Last year in Emerging Trends, we said “everyone wants in” — reflecting the deep and wide investor demand for real estate. This year, we found that many investors have moved to the sidelines — or to other types of assets, including equities and bonds. Lower expected returns on real estate are the primary cause, reversing the prior decade’s substantial capital inflow driven by compelling risk-adjusted returns.

Rising interest rates are eating into potential rates of return, making acquisition and construction debt more expensive, just when operating incomes seem destined to slide as the economy weakens. This dynamic of lower income and higher costs is breaking deals, as buyers either seek price breaks or pull out.

Today’s biggest headwind to getting deals done is uncertainty over where prices will settle. Buyers are concerned about overpaying. On the other hand, sellers don’t want to sell their assets short and then see them retraded at higher prices once the markets improve.

Meanwhile, the same interest rate increases that reduce leveraged returns also make real estate-linked bonds and other interest-bearing investments more compelling.

We expect capital availability to decline in the near term, though the denominator effect may not force sales as much as in typical downturns. For example, since many institutional investors have been under-allocated in commercial real estate, they will not need to rebalance by selling real estate assets.

Overall, the fundamental issue for many investors is how long the Fed will keep raising rates. Many investors and developers are willing to look beyond the short-term turbulence to focus on longer-term opportunities. As a result, there are few examples of motivated sellers in the market.

Housing is still too expensive. Though prices began to fall modestly in the summer, they are still near record levels nationally. For too many people, neither for-sale nor rental housing is affordable — and prices and rents have soared even further over the past year. Even if we experience an economic downturn, as many economists expect, that’s not projected to provide significant relief.

There are many reasons why housing remains unaffordable. The top fundamental reason: a chronic undersupply of properties, especially at affordable prices. The challenges to building new housing remain the same: restrictive zoning and building codes blocking or limiting new supply, among other roadblocks. Affordable housing developers also bemoan the fact that today’s increasingly complex deals now require more underwriting from more capital sources. Another hindrance is homebuilders’ cautious construction pacing, plus labor shortages in the construction sector, which haven’t returned to pre-Great Recession levels.

Though population growth slowed sharply during the pandemic, demand for rental housing is rising from the many young adults eager to start their own households after moving back in with their parents during COVID. Further boosting demand is the increasing number of younger adults choosing to live alone, perhaps a reaction to lockdown claustrophobia.

Recent slowdowns in rent pricing growth and home price appreciation have done little to increase affordability. Millions of people have taken matters into their own hands and are moving to markets, including the Sun Belt, where they can afford to buy a house. That solved the issue for many early movers, but prices and rents have been rising much faster in many of these “Zoom towns,” reducing their affordability.

Demographics and the slowing economy could also help ease the housing imbalance, but there are no easy fixes. Some policy options would help: notably, lowering the many obstacles to housing construction, decreasing rising regulatory costs (stemming from fees and changes to building codes) and expediting approvals. Technology can play a bigger role in actually delivering homes by helping bring innovation and cost efficiencies to a sector that has been notoriously slow to change.

The government could also expand affordable housing production. However, Congress dropped the affordable housing components of the Bipartisan Infrastructure Law (originally part of the proposed Build Back Better Act), meaning that no additional federal help is on the way. In the end, perhaps the most effective solution is the most obvious: The industry must construct more housing that is affordable to more people.

Infrastructure spending remains a top trend, but this year, it's on a positive note. Whereas past emerging trends have addressed Washington’s inaction on infrastructure spending, this year the property sector should be encouraged, thanks to the Bipartisan Infrastructure Law. The $1 trillion bill provides $550 billion in new spending over five years and eclipses the $305 billion infrastructure bill that President Obama signed into law at the end of 2015. This program will be supplemented by additional infrastructure programs in the Inflation Reduction Act of 2022.

So where’s the money going? The main infrastructure bill encompasses a broad range of activities focused chiefly on transportation, including bridges and roads, rail and transit, ports and airports. However, it also provides funding for broadband internet, power, environmental remediation and resilience, among other programs. The Inflation Reduction Act adds spending for combating climate change and building energy security.

While every program promises to touch some part of the built environment, several have especially significant impacts for cities, along with the potential to advance economic and environmental justice by investing in traditionally underserved communities. The Reconnecting Communities Pilot provides $1 billion for projects that remove barriers to opportunity caused by legacy infrastructure. An additional $3 billion was included within the Inflation Reduction Act of 2022, which furthers this initiative.

Another program from the Bipartisan Infrastructure Law that has significant potential impact on communities and the commercial real estate (CRE) industry is the $65 billion designated to expand broadband access to the 30 million Americans living in areas without broadband infrastructure.

We noted in a prior trend that many hyper-growth markets have been unable to keep up with building critical infrastructure, particularly related to transportation. The infrastructure funding bill will provide almost $600 billion in transportation funding. More than half of that will be allocated to the highway system, the largest such investment since the Interstate Highway System began construction in the 1950s. Climate change is also addressed in the bill, which provides critical funding for building environmental resilience and expanding water availability.

Business leaders are closely monitoring the potential impact on the real estate industry of the metaverse — a digital platform that may profoundly change how businesses and consumers interact with products, services and each other.

Such real-world activities as conferences, trade shows, exhibitions, weddings, sporting events and other social gatherings could be enhanced with the metaverse. Thus far, no one is predicting that the metaverse will replace brick-and-mortar properties, but down the road, the platform could impact how we interact with physical locations.

One of the biggest areas the metaverse could impact is the workplace. The metaverse can enhance collaboration, complement the physical office and improve the overall workplace experience — which could be extremely beneficial given that more workers are demanding flexible work arrangements. The metaverse could also be useful in helping firms upskill their employees at a time when everyone is hunting for talent.

Metaverse properties, like any other type of real estate, can be bought, sold, purchased and leased. This could open up real estate investing to a new pool of investors, as buying virtual properties is much less expensive than purchasing physical properties.

Interest in the metaverse is hot — even though many of its concepts are years away from being solidified. Your company doesn’t need to be a metaverse leader today, but you should explore the potential implications to your organization.

Like any new technology, the metaverse has potential risks, including data privacy and cybersecurity risks. As firms pursue applications, you should conduct a thorough assessment of your organization’s vulnerabilities to the metaverse and how to manage those risks. For example, metaverse real estate buyers and sellers are unlicensed virtual brokers and property managers who are not required to obtain real estate licenses. Your company should vet potential partners and work with someone you trust as you outline a long-term plan.