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Commercial real estate investors and developers are suffering from a bout of whiplash. The last year has been disorienting, with runaway inflation, a rapid increase in interest rates, and most recently, destabilization in the regional banking sector. The abrupt change in market fundamentals has justifiably spurred rampant uncertainty, and as a result, many investors and developers have stepped to the sidelines.
The commercial real estate industry is transitioning from an unprecedented period of extended growth. The last business cycle was unusually long, extending well beyond the typical 10-year run. Now, a new normal is emerging. Fundamentals are certainly different, but different isn’t always bad or negative. It’s important to reframe and measure the current market fundamentals against historical standards, not the atypical standards that emerged in the last business cycle.
Upon closer inspection, key development and investment metrics still support a positive outlook for commercial real estate investment.
Positive Rent Growth
Rents are the cornerstone of real estate development. After all, without income and cash flow, there is no profit. Over the last two years, many commercial assets—multifamily, industrial, self-storage, data centers, etc.—have benefitted from excessive double-digit rent growth, and it has been a heyday for investors. That rapid growth, of course, had an expiration date, and rents have toppled from their peak pace of growth; however, they haven’t fallen into the red.
Nearly every commercial asset class continues to see positive rent growth. Multifamily rents increased 6.2% last year; industrial assets saw a 6.9% rent bump in 2022; multi-tenant retail rents have increased more than 6%; self-storage rents are up 2.6% for the year; and even in the office market, which has seen the most significant upset in demand, rents have only fallen 1.5%, remaining relatively flat. By any standard, these are healthy growth numbers, and positive rent growth is always a positive sign for real estate investment.
Healthy Demand Dynamics
Rent growth is an indicator of strong underlying demand, and that remains true today. Some developers look at leasing velocity above rent growth because it is an indicator of real demand, and it is easier to discern new leasing activity against new construction trends. The current leasing velocity trends are equally as compelling as the positive rent growth.
Multifamily and industrial leasing leads commercial activity, unsurprisingly. These two asset classes have dominated investment activity for the last decade, and there continues to be strong demand for each. The national industrial vacancy rate stands at a low 3.9%, while the multifamily vacancy rate is below 5%. Moreover, there remains a severe housing shortage, with the National Multifamily Housing Council estimating that the country is short 4.3 million housing units to meet current demand.
Demand dynamics in other asset classes are equally as encouraging. Retail leasing is up to 76 million square feet this year, the highest since 2019, and self-storage has maintained a 92% occupancy rate for the last decade, despite record new construction. Office is the only asset class to see receding demand due to work-from-home trends.
Strong Job Creation
Developers are rarely looking at current market fundamentals. Instead, they are looking into a crystal ball to predict the strength of a market when a project delivers, which is typically two or three years in the future. Jobs are a key component of that equation. Job growth signifies a positive economic trajectory. Today, headlines around job growth are gloomy—driven largely by tech company cutbacks, but beyond the tech industry, employment is strong. Every jobs report this year has outperformed expectations.
In January, the nation added an impressive 517,000 jobs, well-exceeding estimates. In February, businesses added 326,000 jobs to the economy, and in March, 236,000 jobs were added to the market. While the pace of jobs has slowed even this year, job creation is healthy by any measure, and more importantly, the country isn’t losing jobs. Under the shadow of increasing interest rates, inflation, and destabilization in the banking sector, this job growth illustrates a unique resiliency in of the economy—a great sign for new real estate development.
Unwavering Consumer Spending
Inflation is a serious concern for developers, both because it negatively impacts construction costs and labor as well as the financial elasticity of consumers. The Fed is aggressively attacking inflation by increasing interest rates, but consumer confidence has not been deterred. At the end of last year, consumer spending dipped nominally, down only .1% in December, exceeding expectations.
This year, consumer spending has rebounded, and in February, the index increased by 1.8%, the highest since March 2021. The increase in consumer came alongside a nearly 1% jump in wages. Consumer spending is an important signifier of economic health. It represents two-thirds of GDP. Developers use this metric as an indicator of progression, and once again, current activity is an encouraging sign of stability and opportunity for real estate development.
Higher, But Not High, Interest Rates
Interest rates are the top concern for real estate investors and developers. In a single year, mortgage rates have more than doubled, and they will likely continue to grow in 2023. Fed Chair Jerome Powell has been clear that the days of zero or near-zero interest rates are over. For anyone who has entered the real estate market in the last 15 years, interest rates above 4% will feel like a shock, but industry veterans will likely remember a time when standard interest rates were much higher than they are today. In 2000, interest rates were in the 8% range, and at the beginning of the 1990s, interest rates exceeded 10%. Since the Great Recession, interest rates have trended downward, and for the last decade, an interest rate in the 3% range has become a standard.
The rise in interest rates should be seen as a return to historical norms. This will certainly require an adjustment in pricing and cap rates to offset the higher cost of capital. Owners have resisted a pricing correction, but experts expect that will happen over the next six to eight months. As the market readjusts to the higher cost of capital, interest rates will simply become a metric in the underwriting process.
The last 12 months have been transformational for the real estate industry. While change can breed uncertainty, investors should be confident in the stability of these core metrics. These trends can be hard to see, but data and analytics technologies can help track metrics and illuminate trends. Through automation, software programs like Northspyre are helping developers better understand these changing market fundamentals and develop proactive strategies to respond. A new normal is emerging in real estate, and it is time to embrace it.
Tag(s): Real Estate Development
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