High inflation, rising interest rates, continued supply chain disruption, housing supply shortages and shifting workplace policies all contributed to a tumultuous year in commercial real estate in 2022. Looking ahead to 2023, these factors remain in play, with concerns about a possible recession adding to uncertainty and turbulence in the market.
“This is certainly not the first time that market pressures have created significant challenges in commercial real estate,” said Mike Thomas, head of PNC Real Estate. “However, it’s important to remember that the industry is in a very different place than it was during the 2008 financial crisis. There are strategic approaches that may provide some stability in the current economic environment, but businesses and investors may have to be willing to innovate and pivot.”
A careful portfolio evaluation is an important first step for real estate owners and operators looking to protect the health of their investments and developments. This evaluation should include proactive reviews of financials, including upcoming debt maturities to ensure there is time for analysis of third-party reports and real-time action.
Owners and operators should also take into account the rapid rise in interest rates and how loan amounts will likely be lower than those based on the same cash flows from a year ago. More so, the higher interest rates may also impact appraisal capital rates, which could result in lower property values, putting additional pressures on loan proceeds. Keeping investors in the loop about these market conditions is also integral to this evaluation process.
In addition to evaluating portfolios as a whole, there are specific considerations to keep in mind as several distinct commercial real estate sectors weather ongoing and anticipated economic conditions.
Although some companies are gradually starting to bring more employees back into the office, occupancy levels in top U.S. office markets remain a fraction of what they were prior to the COVID-19 pandemic.
The future of work arrangements continues to evolve, and commercial office space along with it. Owners of office space may face financing challenges given lower occupancy rates and a higher interest rate environment. Although Class A office space will likely remain attractive to tenants who are looking for office space, the location and its offered amenities will be more important than ever. For instance, businesses may need to consider how the relocation and suburb movement trends that occurred during the COVID-19 pandemic have impacted their workforce’s proximity to the office.
More so, the ongoing viability of the office market may in large part depend on a willingness to explore strategic repurposing of office spaces into productive alternate uses, such as multifamily housing.
One commercial real estate sector that has shown surprising resilience is retail. The brick-and-mortar retail industry faced challenges prior to COVID-19, leading to expectations that the outlook would only worsen with pandemic restrictions and the consequent rise of e-commerce. Ongoing operational pressures due to supply chain issues and record-high inflation have added to concerns about the future of retail spaces.
Despite these setbacks, however, many retailers have rebounded and even expanded. Consumers’ growing demand for experiences has led to increased foot traffic in well-located, well-tenanted and well-managed properties. While some retail locations may continue to struggle, those are likely to be retail locations that are typically unanchored and poorly tenanted.
Leasing activity in the industrial and logistics sector was strong in 2022, but this may change as companies face economic headwinds in 2023. Although facilities continue to add new inventory, it is not enough to keep pace with the demand from strong e-commerce growth and the need for online distribution networks. However, any slowdown in this sector is likely to balance out disruptions that occurred as a result of COVID-19 and start to return warehouse and industrial space operations to pre-pandemic levels.
Macroeconomic conditions, combined with lingering effects from the pandemic, are having a significant impact on the housing industry. Housing supply for single-family homes remains flat as developers face supply chain disruptions, labor shortages and higher construction costs resulting from inflation. Short- and long-term interest rates also remain high, causing housing costs to increase dramatically for both sales and rentals. At the same time, higher borrowing costs add to development budgets, while increased long-term interest rates make purchasing single-family homes more expensive and reduce permanent loan proceeds available to fund multifamily development.
In the face of these countervailing forces, however, there are currently more apartments under construction than at any time since the mid-1980s. While this supply will enter a market with a weakening economy, which could drive rents lower, it remains unclear how the lack of affordable housing for purchase may bolster apartment demand.
Navigating the Challenges
With economic headwinds likely to continue to swirl, the outlook ahead appears uncertain for many commercial real estate sectors. Businesses may find some stability, however, by maintaining close ties with financial partners that are well-positioned to help throughout economic cycles.
“In times of volatility, it’s important to execute on what you are able to control,” said Thomas. “Working with an advisor who can help identify those areas, as well as help develop innovative strategies in response to challenges, will be very important in this economic environment.”
Ready to Help
PNC can work with you to develop strategies to help you manage issues related to market volatility and commercial real estate. For more information, reach out to your PNC Relationship Manager, or click here to learn more.