Commercial Real Estate
2023 commercial real estate outlook
With a recession growing more likely, the industry may face a tough year ahead.
The 2023 commercial real estate outlook indicates there may be challenges ahead. Retail is at a crossroads, and the future of office space is unclear. Plus, supply chain issues persist, and inflation is near 40-year highs, prompting the Fed to steadily increase interest rates. But there are a few bright spots in the commercial real estate forecast. Multifamily properties continue to perform well, and the hot streak for industrial properties remains.
As we head into the new year, keep an eye on these 2023 commercial real estate trends and opportunities.
How macroeconomic forces could impact commercial real estate
National and international geopolitical issues and market volatility combined with high inflation and interest rate hikes place the U.S. economy in uncharted territory. It’s important to look at each of these macroeconomic factors:
- Geopolitical issues: The war in Ukraine and sanctions on Russia have had major global economic implications. While European countries may feel the greatest effects, the U.S. is still experiencing the conflict’s impact. Most notably, the resulting sanctions and supply chain issues have driven up food, shelter and energy prices.
- Record-high inflation: As of October 2022, the U.S. inflation rate was 7.75%. Inflation hasn’t been this high since the 1980s. Rent was up 7.5% from 2021 as of October 2022. The owners’ equivalent rent of residences was up 6.9% from the year before. These rising costs not only affect affordable and workforce housing, but also market rate housing. Many tech giants, for example, are concerned that their entry-level employees can’t afford housing anywhere near Silicon Valley.
- Rising interest rates: As of the November Federal Open Market Committee meeting, the target federal funds range is 3.75% to 4.0%—a level last seen in 2008. The Fed anticipates more increases into 2023, which could negatively impact commercial real estate owners. There may be an upside for multifamily owners and investors, as higher interest rates may cause potential homeowners to remain renters for longer.
Together, these factors may lead to a mild to moderate recession in 2023. The pandemic’s economic impact largely mimicked that of a natural disaster on a national scale, but the economy bounced back over several quarters. A 2023 recession would likely be a more traditional one. Full recovery would take place over years, not months, and impact all asset classes.
Multifamily is currently the highest performing of all asset classes. “As of the third quarter of 2022, multifamily vacancies are at 4.4%—a five-year low,” said Victor Calanog, Head of Commercial Real Estate Economics at Moody’s Analytics.
Multifamily owners and investors aren’t immune to cost increases. But they can adjust rents annually—sometimes even monthly—to account for market changes.
Demand for affordable and workforce housing far outweighs supply. Regardless of the markets and economy, commercial real estate should focus on finding creative ways to increase affordable housing, which could include:
- Modular construction and adaptive reuse of buildings
- Mixed-income properties
- The use of Historic Tax Credit
- Unique capital solutions
As e-commerce increases, so does the need for warehouses and industrial space. “E-commerce’s need to get products into consumers’ hands sooner is what’s driving a lot of innovation,” Calanog said. “All the way from investments in last-mile distribution complexes to drones.” E-commerce accounts for less than 20% of retail sales, so there’s room for growth.
“E-commerce will likely serve as a tailwind for the logistics industry—and industrial warehouse and distribution properties—for at least 10 years,” Calanog said. “The industry has begun to respond and deliver record amounts of new warehouses. Ultimately, whether or not industrial performance metrics fare well will depend on the mix of supply and demand.”
Industrial may be challenged by its longer leases, which generally only account for 2%–3% inflation.
The retail property forecast largely depends on location and retail category. For example, people still want to shop at a grocery store for certain items, pick up prescriptions, get a haircut or grab coffee. Neighborhood shopping centers in well-populated residential areas continue to perform well.
After decades of trying to revive B- and C-class malls for sales tax purposes, some cities are redeveloping these spaces. That doesn’t mean losing sales tax entirely, as buildings can be converted into mixed-use properties that include apartments along with restaurants, movie theaters and experiential retail locations.
Retail in city centers has been slow to bounce back. “Urban retail tends to boast higher rent levels than other retail,” Calanog said. “But it has continued to be weighed down because fewer people are working in downtown offices.”
The future of office buildings remains up in the air. It is, however, important to note that none of the regions across the U.S. have seen vacancy rates dip below their pre-pandemic Q4 2019 levels, according to Moody’s Analytics.
In some cases, the right location with the right amenities—think optimizing floorplans for collaboration, offering private outdoor space and adding onsite services such as childcare and catering—may bring employees back to the office.
“Looking ahead, we are not in the ‘office is dead’ camp, but we think cash flow growth will be challenged in the office sector,” said Anthony Paolone, Senior Analyst and Co-Head of U.S. Real Estate Stock Research at JPMorgan Chase.
The combination of the war in Ukraine, market volatility, high inflation and interest rate hikes could make 2023 a challenging year.
“Our forecasts suggest that unless the Fed changes course, 2023 will be characterized by slower GDP growth as monetary policy continues to tighten and global economies adapt to inflation,” Calanog said. “That translates to less credit and lending activity, and continued volatility for asset pricing.”
But there’s nothing new about commercial real estate’s cyclical nature. Property owners and investors with fortress balance sheets understand how to take advantage of those ups and downs. There may be overleveraged building owners during an economic downturn. That presents prepared owners and investors with an opportunity to grow their portfolio at a lower cost.
Originally published by Commercial Observer on December 2, 2022.
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