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 Q1 2023: Pervasive uncertainty amid rising interest rates

At the three-year mark since the onset of the pandemic, the commercial real estate market is still trying to find that “new normal.” With lending restrained, pricing uncertainty and concerns over a recession, the market is navigating unchartered waters as the economy continues to rebuild. Among the top trends to watch are:

• Uncertainty in the Financial Markets – Given the Fed’s aggressive increase in interest rates, deal flow has slowed
• Lending Pull Back, Future Risks — Bank failures have led to significant tightening of financial conditions and fear of more failures
• CRE Loan Maturities/Defaults — Growing fears of significant defaults, losses in office sector
• Property Pricing Adjustments — A bid-ask spread is keeping deal flow limited, but how will new pricing impact owners, occupiers and investors?

Here’s a look at market metrics from industry technology and investment leader LightBox. These metrics provide an early indicator of trends in the investment, broker, valuation, lending, and environmental due diligence segments.

Record high inflation and rising interest rates

Record high inflation and rapid increases in interest rates created significant headwinds at the start of 2023. Investment activity stalled. Then 1Q23 ended with a gut punch from unexpected bank failures and doomsday headlines about massive defaults in the office sector.

The market had to digest a rapid mix of developments, including fundamental shifts in demand for real estate, and the first bank failures since the Great Financial Crisis, among other issues. Amid the most aggressive tightening of financial conditions by the Fed since the 1980s, investors and lenders are challenged to pencil deals confidently — or forecast future valuations. While the near-term forecast is in flux, there still is an even mix of headwinds and tailwinds for the near term.

In early February, the Fed signaled that slowing inflation, along with other indicators, warranted a pull back in the pace of rate hikes. An expected 50 bps increase became a 25 bps increase in February, followed by the same in March. This was a welcome dose of optimism as the market digested news of Silicon Valley Bank and Signature Bank failing and concern grew over the possibility of an expanded banking crisis.

The LightBox Commercial Real Estate Activity Index shows a broader market decline in commercial properties listed for sale (blue line), a divergence from typical market conditions where the peak in listings coming to market in 2Q22 would lead to an uptick in the services that support deal closings (environmental due diligence and appraisals). But 2022—and the start of 2023—has been anything but normal. Other key takeaways include:

• Buyer profile shifts — While owners are listing properties for sale, the buyer universe is constrained and tends to be cash-only buyers, private capital or family funds rather than the typical investors. The buyer pool is still at historically low levels
• Transaction indicators fell — Confidentiality agreements, an indicator of how the size of the buyer pool is changing over time, fell from a high of 131 per deal last January to only 65 by year-end 2022 as buyers were shut out of the market by higher capital costs or chose to wait on the sidelines. In 1Q23, the average number of CAs per deal increased slightly to 72, still well below the high-water mark of a year ago. CA levels for the main asset classes (office, multifamily, industrial and retail) are likely higher or lower given the significant variations by asset class.
• Environmental due diligence and appraisal volumes decline – As measured by LightBox’s ScoreKeeper model (environmental) and C360/RIMS (appraisal) platforms, volumes declined in response to a slower transactions market, with environmental reports ending 1Q23 down 40% YOY and appraisal volume down 43% YOY.

December 2022

The commercial real estate (CRE) industry is in unchartered waters, given the current interest rate increases and related economic upheaval that is slowing deal flow and creating significant uncertainty. All eyes are on debt and equity financing at this critical time, given the impact on transaction activity. This LightBox blog examines CRE financing and dives into:

• The impact of rising interest rates on the cost of capital
• How investors and brokers are navigating shifting lending requirements
• The impact of higher cap rates
• What’s ahead for CRE investment

“Investors are navigating a challenging environment where lending requirements, property valuations and debt service coverage are under more intense scrutiny, ” says Tina Lichens, Senior Vice President of Broker Operations for LightBox. “As buyers and sellers reevaluate their positions heading into 2023, we expect to see a rebalancing of pricing expectations that will ultimately lead to renewed growth in investment activity.”

While the first half of 2022 saw strong investment activity, interest rate increases pushed cap rates higher and caused a significant retraction in commercial real estate deal volume. As major money center banks retreated in the third quarter, the CBRE Lending Momentum Index, which tracks the pace of CBRE-originated commercial loan closings in the U.S., declined by 11% compared to the second quarter. This was nearly 5% below the level recorded in the third quarter of 2021.

Interest Rate Increases Shutting Down Buyers

The higher cost of capital has shut some buyers out of the market, and, as a result, third quarter investment was down 18% year-over-year and 16% below the second quarter.  In response to interest rate increase and changing conditions, 28% of environmental due diligence consultants have lender clients who halted or curtailed originations in the third quarter, according to LightBox’s latest survey data revealed. “For loans that are proceeding, lenders are exercising far more scrutiny on assumptions about occupancy, rents, and property values. In today’s uncertain environment,” according to Dianne Crocker, LightBox’s principal analyst, “the numbers have to make sense.”

A Look at Credit Losses and Delinquencies

Larger banks have been more prudent in anticipating potential credit losses, but the credit losses and delinquencies haven’t been seen yet, says Jon Winick, CEO of Clark Street Capital.  “Time will tell if they were ahead of the curve enough, anticipated problems that never occur, or had their heads in the sand.”

Given the backdrop of rising rates and the potential recession, credit risk and having a good handle on property values will be top of mind for lenders, says Raj Aidasani, Senior Director, CREFC. “Our market has yet to fully absorb the dramatic changes over the last year and, in addition, the standoff between buyers and sellers is expected to continue. Lower transaction activity translates to lower market price transparency, making the credit work lenders perform even more critical.”

Other key take aways:

• Underlying property performance remains strong for many asset classes, especially those that can raise rents to account for higher costs. Many companies and properties have experienced strong years given the momentum in 2021 and the start of 2022.
• Among the property sectors to watch are multifamily, which has seen record rent growth, and industrial, due to questions about whether demand drivers will remain as strong long-term.
• Debt capital is more difficult to find for office, hotel and retail properties, as lenders reduce their exposure to asset categories with higher risk.
• Many lenders are cautious about the office sector, given its lower occupancy levels due to return-to-work policies. Recent layoffs in the tech sector could add another layer of stress to some office properties.

Property Appraisal Volume Shrinks

Growing economic weakness has also prompted lenders to reassess their loan allocations as they attempt to balance portfolios that are seen as too heavily weighted for real estate. “We’ve seen a dramatic slowdown in appraisal activity this year, which provides an early indicator for loan activity,” says Candi Coleman, MAI, Head of Lender Strategy with LightBox. “The appraisal industry has been very busy for the past 18 months and now we’re in a holding pattern.”

The slowdown in lending also puts the spotlight on maturing loans and a potential risk crisis as cap rates and interest rates rise, says Coleman. “As a wave of loans sets to mature over the next 12 to 24 months, property owners will be faced with the potential for higher debt service and possible decreasing values.  That puts borrowers in a tight spot when looking to refinance their loans.”

Nov. 25, 2022– As the retail spend is tallied for Black Friday (and the overall retail sales stretch from Halloween to Cyber Monday), Business Insider looks at contrarian efforts to shun the hype and redirect the focus to supporting employees and charities. REI was among the first to take the big step in 2015, giving employees a paid day off and encouraging them to get outside and enjoy the day. See why IKEA, Patagonia, Google, and others bucked the trend for 2022.

Here’s a round up of Black Friday results and what’s ahead for the rest of the shopping season:

Black Friday Sets Record for 2022

An analysis by Adobe Analytics notes that online Black Friday sales in the U.S. hit a record-breaking $9.12 billion this year, despite shifting economic conditions and some consumers’ concerns about scaling back on expenses. This year’s sales were 2.3% higher than last year. Among the key growth sectors were electronics, smart home equipment, toys and exercise equipment.

On a cautionary note, CNN notes that consumers are tapping into their savings to pay for goods and boosting their credit card balances in the process. Check out this CNN story for more.

And, here’s a look at the winners and losers, courtesy of Retail Dive.

Getty Images photo.

October 2022

Significant market headwinds, including a slowdown in economic momentum, rising interest rates, ongoing supply chain disruption, labor shortages and the threat of a recession are adversely impacting investor sentiment heading into the year-end. As financial markets react to the Fed’s ongoing efforts to tame inflation, many commercial real estate investors and lenders are recalibrating, stepping back or taking a more cautionary approach to investment activity. This sentiment strikes a notable contrast to the optimistic forecasts voiced at the beginning of 2022, when many industry experts expressed confidence in a strong growth trajectory for the year.

As the Fed continues its efforts to raise interest rates to tamp down inflation, there is growing concern about whether that approach will produce the desired results without triggering a recession. Investment and brokerage professionals surveyed for this report overwhelmingly voiced concern about an economic recession, with only 10% being unconcerned about a recession.

Office Market Upheaval as Hybrid Model Impacts Occupancy

The office market is in the midst of significant upheaval, as companies work through myriad return-to-work options. Some are walking a tightrope between requiring employees to return to the office and providing flexible solutions to support employee preferences. It’s a complicated exercise that is playing out across the country — and creating much turmoil in the office leasing and investment markets. In short — there is no “one size fits all” approach and the results will take a few years to materialize.

Key highlights from the Fall 2022 LightBox Sentiment Report:

Economic Outlook

• Nearly 70 percent of respondents were concerned or bearish about the CRE market for the balance of 2022; that sentiment dropped to 58 percent when projecting out to 2023.
• 90 percent were concerned for a recession.

Office Sector

• Office vacancies remain a concern, with the slow migration back to the office seen more in large urban metros. There are signs of positive momentum as large technology firms such as Google add high-amenity campuses in New York, Chicago, Austin and other markets.
• Office occupancy levels in mid-September averaged 48% across a list of to 10 markets tracked by office security firm Kastle. Austin had the highest (61%) followed by Houston (57%). San Jose had the lowest (40%) while New York was (47%).
• In 2022, price PSF dropped nationally and in Manhattan, Boston and The Bay Area, but increased in Seattle and L.A.

Industrial Sector

• Industrial rent growth is expected to be over 20% for the near future, given strong demand and limited supply in many markets.
• Multi-story industrial buildings and robotics are the wave of the future, as construction costs and labor shortages push back against e-commerce growth.

Q1 2022 Outlook: Industrial Investors Remain Bullish

Sales, Leasing, Construction to Continue at Robust Pace

The dramatic shift in consumer buying habits during the pandemic has fueled a massive leasing, construction and investment spree across the U.S. As tenants scramble for modern space to expand their e-commerce footprints, landlords are benefitting from rental rates reaching into the double digit levels in some markets. This is all good news for investors, who continue to pour capital into this favored asset class.

According to a LightBox-SIOR Investor Sentiment Report, investors remain bullish on this sector, despite challenges from port congestion, rising construction costs, and a shortage of labor across many points in the supply chain. Nearly 72% of investors surveyed are predicting significant growth in the industrial sector going into 2022, a sentiment echoed by other industry experts interviewed for the report.

Among the key fundamentals are:

• E-commerce sales grew by 40% over the past year and will continue to drive industrial space usage for the foreseeable future. 
• Vacancy rates are at record lows in many markets, including Los Angeles and the Inland Empire, where the strength of the ports and proximity to large population pools has helped push vacancy down to around 1%. Many other markets are seeing vacancies from 3% (Charleston, Sacramento and Las Vegas) to 4% (Nashville, Miami and St. Louis).
• Rents are expected to rise by 5% to 7% or more in 2022. Occupier demand, led by retailers and logistics providers, will push rents higher; they could reach double digits in many markets. Asset pricing could increase the same or more. Among the top markets for year-over-year rent growth in 2021 are Northern New Jersey (33.3%), Inland Empire (28.3%), Philadelphia (25.9%) and Nashville (20.3%).
• Net absorption remains strong and was tracked at 231 million square feet at mid-year 2021. This activity is notable given the 152 million square feet of new space completed during the same time period and 420 million square feet currently in the pipeline. Among the top markets for construction are Dallas Fort-Worth, Atlanta, and Chicago.
• Supply chain disruption, rising construction costs and material and labor shortages are key headwinds for industrial real estate. Over the past year, the industry has experienced an unprecedented level of port congestion, supply and labor shortages, and increases in the cost of steel, lumber and plywood and other materials. Given the robust level of industrial demand, however, those headwinds are not expected to dampen investor enthusiasm for this sector.

“As e-commerce continues to transform our economy, investors are looking for every opportunity to gain entry or expand their positions in the industrial sector,” says Tina Lichens, COO, LightBox. “Industrial is attracting significant amounts of domestic and foreign capital and is well-positioned to withstand supply chain disruption or other volatility that might occur.”

September 2021

Chicago’s commercial real estate industry is faring well at this stage in the pandemic recovery, but there are headwinds that investors should consider, according to a 2021 Mid-Year Chicago Sentiment Report from The Real Estate Center at DePaul University. Nearly 60% of CRE professionals are optimistic, if not bullish, about Chicago commercial real estate for the next 18 months. There are concerns, however, related to government effectiveness and property tax uncertainty at the local, county and state levels.

COVID-19 Impact on Real Estate

Chicago Commercial Real Estate Report Findings

See this Connect Media story for more.

July 2021

As the summer shopping and travel season gets into full swing, the commercial real estate industry is closely watching the flow of revenue into the hard hit retail and hospitality sectors. According to a Q2 2021 Investor Sentiment Report from LightBox, investors and their advisors are seeing promising indicators. This is translating to aggressive pricing for top tier assets in both sectors and predictions of a spike in investment in the second half of 2021 and into 2022.

There remains a lingering sense of caution, however, and a look toward Labor Day when retail and lodging receipts will be tabulated; back-to-work and school plans will be underway; and there likely will be greater clarity concerning vaccination rates and variants. Aggregated, this is keeping significant capital on the sidelines and moving many investors into top tier, low risk assets.

Retail Challenges as Ecommerce Surges

The retail sector is navigating the challenges of ecommerce growth and physical store declines; it also is evaluating new concepts and experiential strategies. Centennial Properties, for example, is moving ahead with plans to transform former Sears stores in suburban Chicago into mixed-use projects  — with 303-unit luxury apartments and Main Street retail at Hawthorn Mall in Vernon Hills, IL and a 304-unit luxury apartment project at Fox Valley Mall in Aurora, IL. The focus is on planning the development as an entire campus and creating a master vision to establish the destination and integrate all elements together.

“The pandemic is creating a seismic change in how people spend money and how they entertain themselves. It’s up to us to recreate a retail environment that essentially has been the same for 30 to 40 years,” said Steven Levin, Founder and Chief Executive Officer of Centennial Real Estate, based in Dallas, TX. “The challenge is that you have to look at the property as an entire campus. And, creating a master vision to establish the destination is more difficult in an established mall. It is imperative to own the real estate, not just the parcel; otherwise, it is hard to integrate as a well-designed project.”

Hotel Investment Slows

The report also notes that the hotel sector is embracing the surge from almost unparalleled “emerging from the pandemic” Spring and Summer travel activity. Yet industry experts are more than anxiously awaiting the return of the all-important business and convention travelers. And, there is a general consensus that a broader recovery will require an expansion beyond the ultra-safe assets into the wider pool of middle and lower tiered properties.

“The commercial real estate industry is skillfully navigating a complex set of challenges while at the same time seeing many positive signs of recovery and renewal at mid-year 2021,” said Tina Lichens, Senior Vice President, Broker Operations, LightBox. “The retail and hospitality sectors are poised for continued growth and transformation yet are also the most vulnerable to continued upsets as the market stabilizes and investors make decisions about which asset classes can deliver strong long-term returns.”

Among the key findings of the Q2 2021 Retail and Hotel Investor Sentiment Report are:

Retail

• Omnichannel retail will drive retail growth — as consumers drive a need for quick and efficient ways to shop online, in-store, or through technology.
• Bricks and mortar retail is expected to grow in 2021 — given consumers’ desire to return to in-store shopping and socialization. Some predict a tipping point where ecommerce expansion slows and in-store retail expands.
• The retail investor profile has shifted. Private investors, high net worth individuals and non- traded REITs are the primary deal makers, with institutional capital waiting on the sidelines.
• Grocery anchored and lifestyle centers remain at the top of the list for investors. Those with good population density, high-income levels and some evidence of supply constraint are particularly in demand and are commanding lower cap rates. Strong shopping center assets are being bid up very aggressively, with pricing that is similar to pre-pandemic levels.

Hotel

• Resort and leisure travel is back but business and convention travel is key to a strong recovery.
• All eyes are on Labor Day as a critical timeframe for understanding which hotel properties and investors can be called survivors.
• Sales are expected to spike significantly in the second half of 2021, potentially reaching pre- pandemic levels in 2022 and 2023. Many buyers will focus first on properties that can benefit from leisure travel, particularly those in driving distance of large population pools.
• Hotel distress statistics are potentially misleading. More hotels than any other property type are in the distress pipeline, through a transfer to special servicers. Yet looking ahead, the stat does not evoke widespread concern, as many believe that lenders have little desire to take over low performing assets.

May 2021

Industrial Construction Continues to Rise in Midwest

The Midwest industrial engine continues to grow, with construction moving at a strong pace despite an unprecedented increase in materials pricing that is straining the development sector. This activity is occurring in many large markets as well as growing secondary markets, such as several in the Midwest, stretching from Nashville to Indianapolis to Kansas City.

According to a May 2021 Market Report from Avison Young, Nashville has 10 msf of new industrial space under construction and has had more than 1.4 msf of new product delivered in each of the past three quarters.

“We continue to see industrial development increasing in many Midwest markets, as companies expand e-commerce and logistics operations in strong regional distribution hubs,” said Erik Foster, Avison Young Principal and leader of the firm’s National Industrial Capital Markets Group.

Nashville Construction Overview

The Nashville market is witnessing its largest growth cycle on record, with expansion coming at an exponential pace, according to Avison Young research. Motivated by steady tenant demand and tight market conditions, developers remain bullish on Nashville, with over half of the projects underway being built on a speculative basis. Even as new speculative construction adds inventory to the market, all submarkets continue to record sub-5% vacancies.

Soaring demand for warehouse and logistics space across the market has largely kept up with a record amount of supply coming up over the past few years. The Nashville industrial market recorded over 1.6 msf in YTD net absorption at the end of the first quarter.

Indianapolis Grows Its Logistics Hub

Indianapolis’ industrial market has nearly 12 msf currently under construction, consistent with the level of new construction underway for the last 15 months. Larger tenants have recently shown an interest in Indianapolis because of its central location and lower tax structure, but much of its recent construction has been driven by speculative projects. Large speculative projects under development range from the 1 msf building in I-70 West Commerce Park by Sunbeam Development to the 767,000 sf building in Whiteland Exchange, I-65 and Whiteland Road, by Jones Development.

Other Midwest markets experiencing industrial growth include Kansas City, which has 7.9 msf under construction; Cincinnati, where 6.1 msf is under construction; Louisville, which has 5.2 msf underway; and Minneapolis, which has 2.5 msf under construction.

Construction Prices: Steel, Lumber See Sharp Increases

The Avison Young report notes that skyrocketing costs on steel, plywood and other building materials are not enough to significantly slow the industrial pipeline, which currently exceeds 300 million square feet (msf) nationally.

This strong activity continues despite a 12.8% increase in the overall cost of construction input items from April 2020 to February 2021. While many broad material categories have increases below 10%, key individual materials have seen sharp increases — including lumber and plywood, which rose 62%; copper and brass mill shapes (37%); and steel (20%), according to the Associated General Contractors of America (AGC) trade association.

Construction across many U.S. markets is expected to keep a strong pace into 2021, as developers try to meet demand from major retail fulfillment centers to food grade cold storage facilities. Consumer expectations are setting the standards for speed and diverse inventory from e-commerce, and those expectations are unlikely to diminish as delivery conveniences have now become commonplace.

Feb. 28, 2021

As the COVID-19 vaccine distribution ramps up (and a third vaccine is approved), there is progress being made — and also glitches in the supply chain delivery that are leaving states, municipalities, and, ultimately, residents, without the necessary vaccines. Here’s a look at how the supply chain is faring and what some commercial real estate experts have to say about the how to improve distribution.

According to the “Shots in Arms” update from the NPR COVID Vaccine Tracker, the top state by percentage of population receiving at least one dose is Alaska, with 22.3%, up from the 15.1% shown in the graphic above. New Mexico (21%) and South Dakota (20.2%) are the second and third states, respectively. This compares with late January when Alaska was still at the top, but West Virginia and Connecticut were second and third.

At the end of February, there were 96.4 million vaccines distributed, with 75.2 million doses administered, according to the Centers for Disease Control and Prevention (CDC). This totals 14.6% of the U.S. population vaccinated with at least one dose. (The two first vaccines approved each require two shots over several weeks.)

COVID-19 Vaccine Update: Solving Supply Chain Challenges

As the federal government moves to increase vaccine distribution, logistics and commercial real estate experts talked with Bisnow about the importance of involving businesses such as Amazon, Target and FedEx that have mastered supply chain issues and last-mile delivery. Given their expertise in moving products quickly to multiple destination points, could they have an impact on vaccine delivery?

Amazon Distribution is Not the Only Solution

Supply chain and analytics experts caution against thinking we can just plug in Amazon and create a more efficient system, however. According to this Modern Distribution Management story by Jonathan Byrnes of MIT and John Wass, formerly of Staples, the problem revolves around trying to push through a massive distribution effort within our existing fragmented system. Changes to the current distribution flow should include integrating more supply chain professionals into the public health process and using overlapping management, likely through the Defense Production Act, to improve end-to-end organization and results.

Among the solutions they present are more extensive advance planning to match patients, vaccines and locations and rewards, such as free transportation or cash, for vaccine compliance and perhaps negative rewards (limited access to restaurants, schools, and transportation) for those who refuse.

They also suggest adding a robust public relations campaign that reaches the population at multiple demographic touch points. Millennials would be more responsive than older Baby Boomers to social media outreach, for example. Success stories from early adopters would be amplified to reach residents in varying communities.

COVID-19 Cases: Still too High

In a late February CBS News COVID-19 vaccine update, Dr. Anthony Fauci, warns against being too complacent about the virus. While cases are stabilizing or slowing in many locations, a plateau of around 70,000 new cases per day is still a concern. “That’s exactly the thing that happened during previous surges,” he said. “As it peaked and started to come down, people withdrew some of the intensity of the public health measures and it kind of stabilized at a very high level. That’s very dangerous.”

October 2020

Prologis Report: Retail to Industrial Real Estate Not a Sure Bet

Wondering whether that empty retail anchor store would work as an ecommerce site? While industrial real estate is booming and bricks-and-mortar retailers are on the downslide, conversions are not always a sure bet. According to a recent Prologis report, retail-to-industrial real estate conversions will likely account for less than 1% of all retail space across the country over the next decade. This is because there are economic, political (municipal opposition and other factors), physical, and legal challenges.

According to the Prologis report:

• The COVID-19 crisis fueled five years of evolution in the retail sector — in less than five months. The massive demand for consumer goods, groceries and other household items forced the industrial sector to respond quickly. This accelerated the adoption of ecommerce (to wider audiences and many new users) and pushed companies to focus on their “just-in-case” inventory.
• Online spending is driving significant demand for logistics space, which is seeing correlating rental rate increases.
• Online sales have skyrocketed and are on pace to reach $340 billion globally in 2020.

See this Bisnow story for more details.