For real estate investors, understanding the relationship between economic conditions and the real estate cycle is vital. Factors like supply and demand, rental rates, investor sentiment, and the cost of borrowing are directly impacted by the current state of the economy. In this Market Analysis, we will explore how the economy influences the commercial real estate cycle, which in turn, influence the future returns an asset can generate. By gaining insights into these dynamics, investors and industry professionals can make informed decisions, and leverage the prevailing economic conditions for success in the commercial real estate market.
The economy slowed in the first quarter of 2023 as a result of the Federal Reserve's continued interest rate increases. This strategy was intended to reduce inflation, which has slightly decreased, but still remains stubbornly elevated. Additional rate increases are still possible.
One result of the tighter monetary policy was a major slowdown in new construction projects and real estate transactions, much of it due to the increased difficulty in securing funding. As a result, some are predicting a transitory recession that will cause consumer confidence to drop. Despite this, the employment picture remains strong.
With all these variables, coupled with an uncertain future, it has become increasingly difficult for a real estate investor to anticipate the market. However, since returns are based on the future performance of assets, understanding the market cycle is more important than ever.
Dr. Glenn Mueller's Real Estate Cycles Analysis from the University of Denver - Burns School of Real Estate & Construction Management is highly regarded for commercial real estate forecasting. Published quarterly, it provides extensive data on major commercial real estate markets nationwide. Based on nearly 300 models tracking occupancy and rental rates, it covers 54 Metropolitan Statistical Areas (MSAs). This analysis serves as the industry standard, offering insights into current asset performance and future projections in relation to supply and demand. It is a valuable tool for understanding the impact of the economy on rental rates at local, regional, and national levels.
The real estate market is known for its cyclical nature, with periods of growth followed by decline, and vice versa. This analysis highlights the relationship between supply and demand.
When demand for real estate increases, the supply rises until a balance is achieved. Conversely, a lack of supply drives rental growth until equilibrium is reached. However, as demand is met, new supply enters the market at an accelerating pace, often exceeding the equilibrium point. This leads to an oversupply phase, ultimately resulting in a recession.
Dr. Mueller's real estate cycle model divides the graph into 16 points, roughly representing a 15-year cycle. The length of the cycle can vary, with longer cycles like the one between 1980 and 2000 or shorter cycles like those in the 1970s. By referencing the graph, investors aiming to time the market perfectly would consider building or acquiring properties near the end of a recession (position #6 on the graph), such as around 2013. On the other hand, selling or diversifying would have been opportune around positions #11 or #12, perhaps in 2007.
It's important to note that while each commercial sector (office, industrial, retail, and multifamily) generally reflects the overall health of the economy, certain sectors lag behind others and reach their peaks at different times. Additionally, individual metro markets have their own unique characteristics and localized cycles for each sector.
The following is a general overview for first quarter of 2023:
Office building occupancy rates fell by 0.3% in the first quarter of this year. However, the quarter-over-quarter increase in rental rates was 0.1%, and the annual increase was 1.0%.
Industrial sector occupancy rates decreased by 0.3%. In contrast, rentals had a high annual growth of 10.4% and a solid quarterly growth of 2.2%.
Apartment market occupancy rates decreased by 0.3%. However, rents rose 1.0% for the quarter, and 2.7% annually despite this reduction.
Retail occupancy remained constant, while rents increased annually by 3.9% and quarterly by 0.8%.
Occupancy data for the hotel industry was not made public. However, there was a notable annual gain of 19.1% and a quarterly increase of 6.0% in the average revenue per available room, as the sector continues to recover from the effects of the pandemic (RevPAR).
Here are more in-depth analyses in each category:
Office Real Estate:
During the first quarter of 2023, the national average office occupancy level decreased by 0.3%, a 0.7% drop from the same period the previous year. The occupancy rate, which is at 87%, is lower than it was during the Great Recession. Although the number of jobs requiring an office has increased by 6%, the amount of leased office space is still 2% below pre-pandemic levels, but the amount of subleased space is now twice as common. Additionally, compared to 2022, the growth rate of office positions has drastically decreased in the first quarter of this year.
An extra difficulty is presented by the 67 million square feet of new office space that will be available in 1Q23, the most since 2009. Asking rental prices marginally increased by 0.1% from the prior quarter, an increase of 1.0%. However, the majority of class A buildings with less than 10 years of age and contemporary, adaptable designs showed these gains. Effective rents have decreased as a result of concessions. Notably, to emphasize their influence on the weighted national average, the 11 biggest office markets—which account for 50% of the total monitored square footage—are highlighted in strong italic style.
Industrial Real Estate:
Industrial occupancy rates fell by 0.3% in the first quarter of this year, compared to the same time last year, and by 0.2% overall. The completion of a sizable quantity of new development and a pause in leasing activities are to blame for this decline. After the holiday season, the first quarter is usually the least active as preparations are made for the following year. The slowing rate of absorption has caused developers to exercise caution, which has caused a decline in new building starts in 1Q23.
In addition, new investments are now less financially viable due to rising interest rates. Despite these difficulties, rent growth has remained robust, exceeding inflation by a wide margin and hitting 2.2% in the first quarter of this year. It has also maintained an exceptional average of 10.4% year over year.
The 12 largest industrial markets, which account for 50% of the total monitored square footage, are listed in bold italics to emphasize their impact on the weighted national average.
Apartment Real Estate:
The national average apartment occupancy rate fell by 0.3% in the first quarter of this year, a 0.7% fall from the same period last year. The unstable economic environment and potential for a recession, which hampered household formation and slowed demand for apartments, can be blamed for this fall. Therefore, the absorption rate in 1Q23 was barely half of what was seen in the years prior to the pandemic. However, because of their slower supply increase than the Sunbelt regions, the Northeast and Midwest markets did very well. Despite the fact that new supply is predicted to rise significantly in 2023 and reach levels unseen since the 1980s, we predict that new demand growth will be moderate throughout the year.
Despite difficulties with occupancy, the average national asking rent for apartments rose by 1.0% in the first quarter of this year, bringing the overall rent increase to 2.7%.
The top 10 multifamily markets, which account for 50% of the total monitored square footage in multifamily units, are underlined in bold italic style to emphasize their impact on the weighted national average.
Retail Real Estate:
Retail occupancies reached another high point in 1Q23 and increased 0.3% year over year, demonstrating market stability. Finding suitable space was challenging for tenants looking to expand, especially in outparcels and mid-size boxes. The biggest demand was seen in mixed-use buildings featuring ground-level and single-tenant retail spaces.
With 51 million square feet absorbed over the past year, slightly more than the 49 million square feet of new supply, the retail sector notable reached a significant milestone in 1Q23, marking the ninth consecutive quarter of positive net absorption. In the last five years, there has been a 35% decline in new construction compared to pre-pandemic levels, and over 1444 million square feet of retail space has been destroyed. These elements have helped the retail sector's net absorption to remain positive.
Retail asking rents increased on average nationally in the third quarter by 0.8% and yearly by 3.9%.
The 14 largest retail markets, which account for 50% of the total monitored square footage, are listed in bold italics to emphasize their influence on the weighted national average.
In conclusion, the current state of the commercial real estate cycle presents a varied landscape across different sectors and markets.
Starting with the industrial and retail sectors, we find that they are mostly balanced and operating at an equilibrium point. However, it is worth noting that a few cities have already entered the hyper-supply phase. This indicates a potential oversaturation of industrial and retail spaces in those specific locations, which could impact rental rates and occupancy levels.
Alternatively, the apartment sector is already experiencing the hypersupply phase in most markets. This suggests an over-abundance of available rental units, which could lead to increased competition among property owners and potentially lower rental rates. Investors should approach this sector with caution and carefully evaluate the supply-demand dynamics in each specific market.
The office market presents a more volatile situation, with fluctuations observed in many markets. However, amid these uncertainties, Central Florida stands out as a potential investment opportunity. The region shows promising potential for office space development and growth, making it an attractive option for investors looking to capitalize on the market's upswing. As always, thorough market research and due diligence are crucial before making any investment decisions.
If you'd like to explore potential acquisition or disposition opportunities in the commercial real estate market, our team of expert advisors at Sperry Commercial - Flint Brokers & Associates is ready to assist you. With their in-depth knowledge and experience, they can provide valuable insights and guidance to help you navigate the current market conditions, and achieve your investment goals.
For the complete report, click the link below.