Commercial real estate is one segment of the market that is struggling in the current economic backdrop. Commercial real estate properties encompass all those used for business purposes, including offices, warehouses, distribution centers, data centers, or those made for investments, such as multifamily units.
Investors find commercial real estate investments appealing because of their cash flows and potential for capital appreciation. However, the sector struggles to gain footing amid the high interest rate environment, which creates financing issues.
Not only that, but shifting work habits and other pandemic-era changes have also impacted the industry. Here are the most notable trends that emerged in the industry in 2023 and where to go from here.
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1. High interest rates are wreaking havoc on the industry
Commercial real estate properties rely heavily on leverage and lending to finance properties. Financing wasn't a problem during the low interest rate environment after the Great Recession in 2008. However, the past couple of years have seen interest rates rocket higher, creating a problem for those in the industry.
That's because commercial real estate loans have much shorter terms than residential loans, generally between five and 10 years. These loans also have a large balloon payment at the end of the term, and many property owners opt to refinance the properties, creating an ongoing need to refinance.
Interest rates matter because of something called cap rates. Cap rates, short for capitalization rates, are commonly used to measure how profitable a commercial real estate investment is. The cap rate is the property's net operating income (NOI) divided by the purchase price. The resulting percentage is the expected annual return.
Interest rates affect cap rates because they lead to higher borrowing costs, which decrease the net operating income. As a result of the Federal Reserve's aggressive interest rate hiking campaign, borrowing costs for real estate companies have risen substantially. Today, investors require a higher cap rate to compensate for the increased expenses -- creating a gap between how much lenders are willing to lend and what investors are willing to take on.
2. Office properties are feeling the heat
Many things changed during the pandemic, including people's work habits. Businesses have transitioned many people to remote work where possible, and employees today continue to have work-from-home or hybrid work-from-home arrangements that decrease the need for office space.
According to data from the National Association of Realtors, office vacancy rates are a record-high 13.3%. Meanwhile, some specific pockets of office properties are really feeling the struggle, like in San Francisco, where vacancy rates are a staggering 35% -- the highest ever in the city's history.
According to CBRE Group, one of the world's largest commercial real estate companies, uncertainty about future hybrid work arrangements and the economy are causing many tenants to delay their decisions. CBRE expects these properties to recover in the longer term, but in the shorter term, uncertainty will continue to be a headwind for those in the space.
3. Industrial and data center properties are holding up well
Unlike office properties, industrial properties have held up pretty well. Industrial properties include warehouses, distribution centers, factories, and manufacturing facilities.
One reason these properties have held up is the growing demand for e-commerce, which has fueled the demand for warehouse and distribution centers. More businesses have gravitated toward e-commerce, which saw a rapid uptick in demand during the pandemic.
Strong trends are expected to continue, too. According to a report published by Mordor Intelligence, the global e-commerce market is projected to grow at around 15.8% annually through 2028, which should serve as a tailwind for more properties to accommodate this growth.
The rise in artificial intelligence technology has also created robust demand for data centers. According to the real estate company Jones Lang LaSalle, some big cities are struggling to keep pace with the growing demand for these properties, driving up prices despite the challenging economy and high interest rates.
The recovery won't happen overnight
As we move into 2024, companies in the industry will continue grappling with high interest rates and tight lending conditions, making any dealmaking difficult.
Investors can prepare by having capital ready to put to work if commercial real estate stocks dip much further from here. I'd keep an eye on buying opportunities in industrial real estate investment trusts.
