While many property types fall under the “commercial” umbrella, the core four are industrial, multi-family, office, and retail. Commercial real estate (CRE) deal volume and pricing surged to a peak in March of 2022 in a low interest rate and higher liquidity environment. Since then a move toward increasingly higher interest rates and credit tightening have slowed deal volume and caused a drop in sales price per square foot across most sectors and markets.

The Commercial Property Price Index (CPPI) by Green Street is an all-property index of institutional quality assets and notes a decline of 16% from the previous peak, as of Sept. 7, 2023. They note that transaction volume has been increasing, but with interest rates still high and a rising yield on the 10-year Treasury bond, deal activity may slow again as prospective buyers lower their bids below what is acceptable to sellers.

A recent darling of the commercial real estate investor’s portfolio, industrial properties have been booming and are now normalizing. The rise of e-commerce during the pandemic was a catalyst for demand that led to increased rents, decreased vacancies, and many more projects in the construction pipeline.

Now, with the rise in interest rates as the Federal Reserve has changed its policy to fight inflation, industrial metrics have slowed but remain solid.

New construction has slowed as the costs to build have increased, but vacancies remain low and rental rates have generally continued to trend upward across markets, albeit at a slower pace than before. Demand for logistics and warehousing space has moderated as e-commerce normalizes, but manufacturing projects have risen in its wake because of recent reshoring initiatives. Still, companies seeking to move manufacturing and services back to the U.S. have challenges to overcome in the form of a weakened economy and federal regulations that inhibit their efforts to attract and retain a quality workforce.

Like all the other CRE sectors, total sales volume has slowed across markets with the increased cost of financing deals and lower liquidity. Still, the average sales price per square foot has remained elevated as owners have proven willing to hold their assets until buyers bid closer to the asking price. California markets held the highest share of total sales activity by dollar volume, though this is also partly because it holds a higher price per square foot than other markets in the nation.

Rental rates gained most in California’s Inland Empire, while the Midwestern metros lagged and the Southeast markets posted mixed results.

Vacancies in Nashville, Atlanta, Dallas-Fort Worth, and Baltimore posted below the national average.

Phoenix and Dallas take the lead for current industrial square footage under construction when expressed as a percentage of their market’s total stock—and Phoenix has far more in the pipeline still. When inflation normalizes and interest rates decline, industrial development will likely rise, though at a more modest pace than we have witnessed in the past few years.

Another top performer of the commercial real estate space, multi-family metrics surged over 2021 and 2022. As people stayed home for work, they prioritized larger spaces that accommodated home offices. Some spent much of their year in (or even moved to) other, more affordable states This in-migration caused many of the southern multi-family markets to post asking rental rate gains from 20% to 30% year-over-year—an untenable pace.

Overall, the sector is normalizing. Dampening factors include the increase in deliveries and persistently high inflation that erodes renters’ purchasing power. In his book, Evicted, Matthew Desmond noted “rent eats first,” an expression describing how housing costs are fixed and must be paid before all other expenses. Tenants stretch to meet the demand of rental rate increases by cutting costs where they can, but when it becomes untenable, it leads to unintended consequences like illegal overcrowding of units, higher vacancies, and increased homelessness, which in turn leads to a decline in property values in the area. So, while housing unaffordability has kept would-be homeowners in multi-family housing—a boon for the sector—this is moderated by the ongoing inflationary pressures.

Because shelter is a basic human need and single-family housing is out of reach for many, investors have been keen on the stability the multi-family sector provides as an income-generating asset. In recent years this has prompted many purchases of multi-family assets at extraordinarily low cap rates, including rates below their commercial mortgage constant. Such negative leverage (or even just lower, positive leverage) constrains the margin of error in the operations of the property, potentially resulting in negative cash flows and causing any shocks to the net operating income to be more acute.

A Berkadia report for the first half of 2023 notes that multi-family deliveries outpaced leasing activity, causing an increase in vacancy rates in the latter half of 2022. To contend with larger inventory, multi-family investors have moderated asking rent increases over the past year. The number of properties offering concessions increased marginally, though the value of those concessions declined.

Additionally, Berkadia reports that positive employment trends and wage growth, plus landlord concessions due to recent deliveries, have had the combined effect of promoting absorption in the first half of 2023—bringing them in line with pre-pandemic trends.

Both Dallas-Fort Worth and Phoenix are leading in the construction of new units, while some of the top markets for inventory growth (by percent of existing inventory) included Huntsville, Alabama; Nashville, Tennessee; Pensacola and Jacksonville, Florida; Charlotte, North Carolina; and Boise, Idaho.

Office has been a bleak sector limned with potential. The story of the office sector is one of dichotomy: with large or obsolete spaces on the one hand and smaller or amenity-laden spaces on the other.

During the high liquidity of 2021 and 2022, Class A space was bolstered by the low interest rate and saw the continued development of and demand for new, flexible spaces and enviable amenities. Sales prices increased across assets in 2021 and 2022, with Class A office space no exception. In the higher interest rate environment of 2023, prices have since declined, with a particularly steep decline for Class A space.

Nationally, office vacancies continue to rise, asking rents decline, and total sales volume has slowed dramatically. Vacancies have continued to surge in tech-centric western markets like Seattle and San Francisco while rental rates in southern markets like Miami, Austin, and Washington D.C., have posted higher than the national average. Of the national markets, Manhattan retained the highest asking rental rates, while also netting the largest number of sales and the highest average sales price.

Though many companies have mandated a return-to-office policy, they have experienced resistance from the workforce, and many are still analyzing how much office space they need. Tenants are assessing not just the total square feet but are also considering the layout, green spaces, and other amenities that boost the desirability of the space while prioritizing layouts that allow for the most productivity. These will likely need to include a variety of meeting spaces, but also enclosed spaces that allow for privacy, concentration, and video calls.

In the wake of the pandemic and in a higher interest rate and lower liquidity environment, the dichotomy has grown between the best assets and average ones.

While the current environment offers little incentive to invest in these buildings, a report by JPMorgan Chase notes how office properties with otherwise solid demand drivers could benefit from renovations to systems and amenities that align them more closely to the Class A assets. Combined with a strategic move away from office-only neighborhoods in favor of mixed-use ones, these renovations could drive demand and yield favorable returns on investment for those who have the capital. If buildings are suitable for adaptive reuse and their location and demand make such a reuse project feasible, these types of projects will ease the glut of obsolescent inventory on the market and improve overall metrics for the sector.

There has been little creation of office-using jobs from May through July, though August showed some growth, with Dallas leading the way.

While office projects are in the pipeline for many markets, only a small percentage of these have broken ground in the last year, indicating they are generally a holdover of prior demand, not an indicator of current demand trends.

A surprise to many, the retail sector—once beleaguered by oversupply and burgeoning e-commerce—is still holding on to generally positive market fundamentals. New construction has been on a decline for years now, and this, combined with an uptick in demolitions has provoked a decrease in vacant available space and an increase in rental rates.

CoStar reports show that pre-pandemic bankruptcies have eliminated weaker players in the industry and that as a result, 2022 saw fewer bankruptcies than in previous years.

Like the office sector, retail space has continued to experience a dichotomy, with smaller, grocery-anchored strip centers in densely populated areas or open-air malls outperforming the larger indoor malls that have become prime targets for adaptive reuse. These larger malls have often undergone conversion to multi-family or office space, or in some cases even industrial—taking a bite out of the retail space stagnating on the market.

In cases where a conversion to a different property use is not feasible, some larger malls have undergone a conversion in the type of retail activity they are supporting—moving from goods to experiential retail and services.

Potential headwinds for the sector include the inflationary pressures and student loan repayment resumption that may put a crimp in consumer spending, though consumer spending reports have consistently yielded higher-than-expected figures, which have continued to bolster the sector.

On the whole, retail is normalizing from the pandemic-induced boom in e-commerce and the pent-up demand for in-person shopping and experiences. Like the other CRE sectors, sales volume has declined due to the higher interest rates, but retail remains one of the only sectors in which investors can secure positive leverage, even in the current interest rate environment.

For each of these core sectors (and all the other specialty property types not covered here) it is especially important to know the value of your particular investment property and the characteristics of its unique market. To get insights customized to your property or portfolio—including market rent analyses and feasibility studies—reach out to your local Valbridge Property Advisors office today.