Previously published on February 22, 2023 in
By Milton Ezrati, Chief Economist at Vested
COVID-19 has cast a long economic shadow, most especially in commercial real estate. While rising interest rates have had a consistently negative impact on activity and pricing, the pandemic’s aftermath has had a mixed effect—helping in some areas, such as warehousing, and hurting in others, such as retail and office space. These patterns will likely linger.
The effect of rising interest rates is straightforward. The Federal Reserve has raised short-term interest rates from near zero last spring to just about 4.5 percent. The costs of financing a real estate project have risen almost in tandem.
Of course, no single rate governs commercial real estate projects, but with mortgage rates almost doubling during this time, it’s safe to say that the costs of projects have risen significantly, discouraging ventures of every kind and driving developers away from debt and toward equity financing—a preference that has brought pension funds, private equity, and hedge funds into the area. And since the Federal Reserve has made clear that it intends to drive up interest rates further, these pressures and trends will likely persist.
COVID-19’s legacy is more complex. The initial recovery from pandemic lockdowns and quarantines created a surge in all real estate activity, raising prices, rents, and sales. From the first quarter of 2020 to early 2022, prices in commercial real estate generally rose more than 80 percent. Sales rose nearly 30 percent in 2021 alone.
But by the end of 2022, the boom was losing momentum. During the second half of last year, overall commercial real estate prices fell more than 40 percent, leaving the whole year down 13 percent. No doubt, the rise in financing costs was the major cause of the turn, but the softening also revealed the differential impact of COVID-19’s legacy.
Warehousing and logistics generally have been clear winners. Even before the pandemic, the startling growth of e-commerce was dramatically raising the need for warehousing space. The pandemic’s lockdowns greatly accelerated that trend, one that shows no signs of abating even now that economies have reopened.
At the end of last year, warehouse vacancy rates stood at a low of 3.2 percent. Pricing in this area, even late in 2022, was up in every region of the country, especially the northeast. The underlying pricing and sales trends are so strong that even a recession in 2023 isn’t likely to reverse them entirely.
Multifamily housing has also led. The rising cost of financing may have pushed development expenses, but rising interest rates have also driven families that might have bought in the past into rental units of one kind or another. Demand had outstripped supply so significantly that the median rent rose almost 8 percent in 2021 and much more in major cities.
It appears, however, that development has begun to catch supply up to demand. Median rent rose a relatively modest 5 percent in 2022. On this basis, gains for 2023, though likely positive, will be even more modest.
If the bloom is coming off the rose of multifamily development, it still looks far more attractive than the retail area. In city centers, though many workers have returned to their offices, the foot traffic so many retailers rely on is still well below pre-pandemic levels. That and the continuing trend toward e-commerce have kept retail real estate on its back foot.
Malls have closed, and many are being repurposed for residential purposes and office space. With so little building and so much property off the market, things have begun to stabilize. Retail rents are rising again, though at a slower rate than inflation—3.8 percent in the past year. That stabilization may persist, but it’s hard to see any significant gains in 2023, especially given the likelihood of a recession.
Office building is probably the most problematic area. Construction costs have risen some 14 percent in the past year, hardly an encouragement, and most developers will likely remain skeptical until work-from-home trends become clearer. Vacancy rates, already high at almost 13 percent nationally, continue to climb in every major market.
Some suggest that some 10 to 20 percent of existing office space will have to be restructured in the coming years. Pricing accordingly remains weak. Indicative of the hesitation dogging the sector, commitments to long-term leases have fallen steeply.
The picture can only be described as a “mixed bag,” to use an old-fashioned expression. Though the rise in financing costs will act as a general drag in the sector in 2023, as will a recession, some areas will deal with COVID-19’s legacy a lot better than others with warehousing in the lead and office building, once the darling of the sector, bringing up the rear.