2023 has been a particularly challenging year for investing in the commercial real estate (CRE) business. The market is grappling with various factors, including struggling existing portfolios, rising concerns about the future, and the influence of high interest rates on CRE lending. To better understand the CRE investment landscape and what’s on the horizon, we analyzed current trends to provide insights on the 2024 market outlook for investors.
Economic Outlook for 2024
Looking at the broader economic outlook, 2024 is expected to be challenging for commercial real estate due to high interest rates and the possibility of a recession. Inflation, although easing, is still running at more than 7%, and it is anticipated that the Federal Reserve will again raise interest rates until a significant reduction in inflation is observed. This higher cost of capital, coupled with weakening fundamentals, will generally continue to negatively impact asset values.
Even with the possibility of a recession, corporate finances are in good shape, and employers are likely to avoid excessive layoffs to retain skilled labor in a tight market. Average household debt is also relatively low compared to previous recessions in the US’s economic history, suggesting a moderate downturn. In the second half of 2023, inflation is projected to be significantly lower, leading to plateauing and eventual decreasing interest rates and the beginning of a new cycle that will extend into the 2030s. Even more notably, there are signs of increasing lending activity heading into 2024, so we explored what is driving these changes and the outlook for multifamily, office, industrial, and retail properties to gauge investment feasibility in the current market.
Slower Leasing Velocity and Uncertainty
During the second quarter of 2023, leasing velocity in commercial real estate experienced a slowdown in certain sectors. The uncertainty surrounding the total impact of earlier bank failures created a sense of unease in the market, and the reliance on small banks for capital in the CRE sector makes it vulnerable to any pullback in lending from these institutions. This situation has led to speculation about the future direction of commercial real estate.
One of the main reasons for the slower leasing velocity is the economic downturn that was caused by the global pandemic. Many businesses have evaluated their space needs to adapt to workplace strategies, resulting in leasing less space and a decrease in demand for commercial space. With more companies adopting remote or hybrid work policies, there is a growing concern about the long-term impact on office space demand in particular. Fortunately, we have not seen this same reduced demand in space needs and leasing activity in our R&D, Lab, and Flex properties, which are heavily reliant on employees working on-site.
This uncertainty around the future of office space demand, however, is causing hesitation among potential tenants and investors in the CRE market to make long-term lease commitments, which may be further exacerbated by geopolitical factors as we head into 2024, an election year. Trade tensions, political instability, and changes in government policies can all impact investor confidence and decision-making. Ambiguity around these factors can result in a cautious approach from investors, leading to a slowdown in leasing activity.
Overall, the commercial real estate market is expected to continue to face a nuance of challenges in 2024. As businesses navigate through economic downturns, changing work patterns, and geopolitical factors, it is important for industry professionals to closely monitor market trends and adapt their strategies accordingly. By staying informed and proactive, stakeholders in the commercial real estate sector can effectively navigate through these challenging times and position themselves for future growth. It is also a time of opportunity though, and Ciminelli continues to pursue investment opportunities that provide the opportunity for value appreciation through a strategic business plan.
Increasing Commercial Real Estate Lending Activity
Despite the concerns and uncertainties, data shows that commercial real estate lending activity is increasing on a weekly basis. This positive trend indicates that there is still confidence in the market despite the challenges it faces. One factor contributing to the uptick in commercial real estate lending activity is the growing popularity of alternative lending options. Traditional banks and financial institutions are facing competition from non-bank lenders and private equity firms that offer more flexible financing solutions. These alternative lenders often have a higher risk tolerance and are willing to fund projects that may not meet the strict criteria of traditional lenders. As a result, borrowers have more options when it comes to securing financing for their commercial real estate ventures. However, it is crucial to monitor lending activity closely, as delinquency rates for commercial loans are expected to rise in the second half of 2023.
Multifamily Properties: Demand-Supply Mismatch and Slowed Rent Growth
Nationally, the multifamily sector has seen an increase in vacancy rates due to the completion of additional units in recent years. The net absorption of apartments in the last 12 months was half of what it was the previous year, while more units were delivered during the same timeframe. This demand-supply mismatch has resulted in a higher vacancy rate of 6.9%, up from 5.3% a year ago. Consequently, rent growth has dropped to 1.1%, below the pre-pandemic level. However, the multifamily sector is expected to remain strong in 2024, compared to other CRE sectors, due to favorable demographics, a strong job market, and low housing affordability caused by higher mortgage rates. This is especially true locally, in Western New York, where the multifamily sector has remained stable compared to the national average.
Office Properties: Challenges and Transformation
Despite more people returning to their offices, the office sector continues to face challenges. The national office vacancy rate reached a record high of 13.1% at the end of the first half of the year. Tenants have also reduced the average square footage per person to lower occupancy costs, leading to lower demand for office space. With the rise of alternative work solutions, it will be interesting to see the office sector transform to adapt to the changing work arrangements and needs. It is anticipated office vacancy rates will remain high in 2024, which may position them well for conversion opportunities.
Industrial Properties: Slowed Down but Still Strong
The industrial sector of commercial real estate has experienced a slowdown from its record-high performance during the pandemic. Net absorption at the end of the first half of the year was nearly 40% lower compared to the previous year. Additionally, more industrial spaces were delivered to the market, resulting in a higher vacancy rate of 4.7%. Despite these challenges, rent growth for industrial spaces eased to 8.9%, but it still outpaced pre-pandemic levels. The industrial sector remains stronger than before the pandemic.
Retail Properties: Challenged but Resilient
The traditional retail sector has been facing challenges for the past decade due to the rise of e-commerce, and the pandemic further impacted its activity. However, the retail sector has managed to bounce back over the last few years. The vacancy rate has remained unchanged for the last three quarters at 4.2%, which is the lowest among all commercial real estate sectors. With inflation easing and interest rates stabilizing, the demand for retail space is expected to remain robust in 2024.
The commercial real estate market in 2023 faces challenges but also opportunities. Slower leasing velocity, uncertainties, and the impact of bank failures are factors that require careful monitoring. However, despite these challenges, there are positive trends, such as increasing lending activity, which indicate resilience in the market.
Overall, despite the challenges, the commercial real estate market in 2024 presents opportunities for growth and adaptation. Ciminelli will continue to seek out investments where it can leverage its robust full-service real estate platform and expertise to execute on value-add opportunities. It is crucial for stakeholders to stay informed, monitor market trends, and make strategic decisions to navigate this dynamic landscape successfully.