The numbers for the first half of 2021 show that market activity has resumed, and commercial real estate is recovering ground lost during the COVID-19 pandemic. There was a significant decline in sales and leasing activity at the outset of the pandemic in 2020 and although there has been a subsequent spike in construction costs, CRE markets are faring better than expected.
Coldwell Banker Commercial’s (CBC) Mid-Year 2021 report reveals that market activity has returned and there are some clear winners and losers. CBC sees strength in the industrial, self-storage and net-leased markets as the year has progressed, while the hospitality, retail and office leasing markets continue to cause concern.
Dan Spiegel, Managing Director of Coldwell Banker Commercial, says, “The pandemic exacerbated changes already taking place in the economy, such as e-commerce, ghost kitchens and millennial home buyers, which drove commercial real estate activity in 2020. Prices fell far less than after the 2008 financial crisis and are already rising again. Buyers/sellers and landlords/tenants are adjusting to the ‘new normal’ and transactions are closing — with some new concerns about the future.”
Fear of inflation
A primary concern among investors is a fear that the recent sharp rise in inflation will not prove transitory but become a long-term issue. Economic expansion continues to depend on interest rates and fiscal stimulus, but eventually a strong, sustainable economy will be contingent on whether employers can find labor. Despite the Fed’s insistence that rising costs are temporary — resulting from supply shortages and rapid reopening brought on by the pandemic — many CPG companies, like Kimberly-Clark, P&G, Coca-Cola, have already elected to pass increased costs onto customers.
Landlords and tenants in the commercial real estate space have adopted approaches that clearly show they expect inflation will last, too. Leases with CPI clauses and rent escalations of 4-5%, versus the typical 2-3%, are readily being signed. Coldwell Banker Commercial professionals in a few leading markets are also seeing slight moderation in developer tempo from the beginning of the year due to soaring material costs.
Spiegel says, “Amid all this market uncertainty, one thing is clear — both buyers and sellers have been acting quickly to get deals done before terms change.”
Cap Rate Compression Continues
Record amounts of money that’s been sitting on the sideline is now returning to the market, but investors are finding that there is very little product available. While low interest rates drove the decline in cap rates during the pandemic, rather than operating fundamentals, there remains sufficient room for compression as frustrated buyers are now open to purchasing properties at much lower cap rates than they would have ever considered prior to the pandemic. Interestingly, the markets didn’t experience a wave of distressed properties materializing from the pandemic. Spiegel says, “Sellers still have the upper hand, forcing buyers to pay premiums on both opportunistic and long-term investments. This new surge of price increases could likely add to inflation.”
Risk Tolerance Grows
Typically, investors turn to real estate as an investment alternative that provides higher returns and a hedge against inflation, when stock markets reach record highs. Yet, as the economic recovery gains steam, investors are showing greater appetite for risk. The search for yield in a very low cap rate environment is pushing investors to new markets, with many preferring secondary markets over primary. Sunbelt states continue to be the most appealing, offering yields that can be 75 to 100 basis points higher than many gateway cities.
There’s also a renewed interest in highly-delinquent properties like B and C malls as well as small office space. Robust demand remains for multifamily, logistics and storage, medical office, QSR and grocery-anchored retail assets.
Uncertain 1031 Exchange Market
The 1031 exchange program faces an uncertain future and that has emerged as a key factor investors must now consider. This transaction tool become enormously popular during the pandemic, and it has created another surge in demand for replacement properties, as well as a significant sense of urgency to close deals quickly.
Spiegel says, “Adverse changes or elimination from the current tax code could lead to billions in lost property value for many small investors and potentially freeze capital.”
Assets under $10 million are seeing strong interest, with buyers focusing on properties that can close quickly — such as warehouses, distribution facilities and single-tenant retail stores leased to essential businesses with long lease terms. Exchange investors who prefer more passive investments are avoiding apartment buildings, multi-tenant retail centers and properties that require more day-to-day management.
Office Sector Shifts
The pandemic has caused major shifts in the office sector, with big corporations shying away from typical 7- to 10-year renewals as they figure out how they want to use the space. While businesses found that they can be productive with employees working from home, 70% of CEOs want teams to return to the office, according to staffing firm LaSalle Network. More than half of office workers, however, would prefer to be remote at least part of the time — vaccinated or not — and say they would leave their job if it didn’t offer a hybrid solution.
With so much uncertainty in the market, most occupiers are looking for short-term lease obligations, mainly in the one- to three-year range with options. Spiegel says, “There is no standard approach right now, as many companies are evaluating what roles need to come in and what configurations best suit two to three days in-office a week. With no solid return plans in place, the next 9 to 12 months will likely see vacancy rates rise significantly.”
There is expected to be a permanent reduction in high-rise office space needs over the next year, as more companies adopt hybrid models and look for cost savings. Office demand experienced its worst loss in the first quarter of 2021, totaling 45 million square feet, following a 75-million-square-foot decline in 2020. Factors cited in this reduction is the fact that tenants, other than big tech, continue to downsize. While Amazon, Facebook, Apple and Google all added space, most larger corporate office users like JPMorgan, PwC, Salesforce, Target and Gap have been scaling back, causing vacancies to go up by 4% to 5% in gateway markets.
Spiegel says, “We believe that vacancy rates will rise even more over the next year as companies make final return-to-office decisions over the next six to nine months. As these scenarios unfold, a large amount of sublease space will come online and further flood the market, which is currently up 67% from the start of 2020.” It is also expected that rents will drop to unprecedented levels, offering tenants tremendous opportunity to secure everything from high-quality CBD assets at bargain prices to fully furnished space. The shift to remote work could devastate building owners and big cities if it lasts.
“We expect activity to be greatest in industrial, multifamily, land and suburban office over the next year,” concludes Spiegel. “Despite being the most sought-after sector in 2020, demand for cold storage and last-mile delivery remains incredibly strong because of the ongoing preference for online shopping; this momentum will push rents higher and cap rates lower for some time.”
CBC also also believes demand for suburban living will increase as more companies shift to remote work, which should fuel new opportunities for build-to-rent developments, modular homebuilding and affordable housing. The self-storage space is expected to remain strong as local stores and businesses open to meet demand in the suburbs. Finally, as vaccinations become the norm, CBC expects student housing to see a spike this fall as high school graduates from both 2020 and 2021 enter college — putting potential pressure on residence halls, which will likely increase off-campus housing demand.
Read the full CBC Mid-Year 2021 report here.
Coldwell Bankers Commercial, Agents, are available to help you navigate commercial real estate within Billings, MT.