“Overall, the outlook for commercial real estate next year is subdued in terms of capital and space market performance, with some rebalancing continuing across all sectors,” said Ermengarde Jabir, senior economist at Moody's Analytics.
Commercial real estate trends by asset class
Uncertainty around interest rates and offices remains the biggest concern, but performance has varied across other asset classes.
Continued obstacles for office: According to Moody's Analytics, the national office vacancy rate hit 19.2% in the third quarter of 2023. That's up from the second quarter and nearing an all-time high of 19.3%. “Despite these headwinds for office, outdated offices do exist and will continue to exist, but it's important to remember that offices themselves are not outdated,” Jabir said. As more office occupiers seek quality, some older and less desirable Class B and C offices may face obsolescence. As a result, opportunities may arise to convert office space in CBDs to apartments and data centers. Signs of softening in industry: Industrial continues to perform well, especially in refrigerated properties. Reshoring and nearshoring efforts in manufacturing could provide an additional boost to the sector. However, the asset class may be easing as post-pandemic inventory demand decreases and renters refrain from expanding. “While industrial real estate is starting to show signs of softening, the long-term outlook for the sector remains bright,” Jabir said. “Moody's Analytics CRE projects that annual rent growth for warehouses and distribution facilities will remain consistent at about 5% to 6% per year over the 10-year forecast period, indicating that the sector has reached a new plateau.” Neighborhood Retail Succeeds: Many view retail as synonymous with Class B and C shopping malls, which have been underperforming for years. But retail also includes neighborhood shopping centers in densely populated urban and suburban areas. E-commerce continues to grow, but only accounts for about 15% of total retail, leaving plenty of room for brick-and-mortar operators. “Retail will emerge as a mainstay in 2024,” Jabir said. “The asset class is expected to perform steadily, with neighborhood and community shopping center vacancies remaining unchanged and rents growing modestly and positively.” Multifamily Strong: Multifamily continues to perform well. Although rent growth is slowing, vacancy rates remain around 5% through 2023. Current high interest rates will likely keep mortgage rates rising, priced out would-be homebuyers and sustain demand for apartment complexes. The only notable concern is the lack of demand for luxury apartments. Luxury apartments may be easy to build, but they're not necessarily easy to get into. As a result, many luxury apartment complexes are lowering rents and offering concessions to attract tenants.
Industry Challenges
One of the biggest concerns in commercial real estate is rising interest rates and costs.
The interest rate drama continues
The bond market was volatile in the first half of the fourth quarter of 2023, with the 5-year Treasury yield fluctuating in a range above 0.50%, as investors frequently reset their expectations about the Federal Reserve's future policy, sometimes two or three times a week.
More recently, the Fed's chances of raising rates further have declined; many expect one or more rate cuts will be necessary in 2024. But the Fed is unlikely to be too swayed by sudden changes in the numbers; it wants to see clear trends established before changing course.
It's important to note that while the Fed acts directly on short-term interest rates like the Prime Rate and SOFR, it does not act directly on Treasury bills or other fixed interest rates, which are driven by market forces like inflation expectations, meaning the future of fixed rate loans is subject to influences other than the Fed.
Rising costs
Rising inflation is driving up the costs of construction materials and labor. Combined with the increasing frequency and intensity of natural disasters, this is resulting in higher insurance premiums and payouts.
Commercial property insurance is not just expensive, it is often not comprehensive and difficult to access. The National Multifamily Housing Council’s (NMHC) 2023 State of Multifamily Risk Survey and Report found that 56.8% of respondent insurers added new policy limits to mitigate risk, and 60.6% were forced to increase deductibles to maintain affordability.
To combat rising costs, owner-operators can also increase rents and reduce operating expenses by streamlining payables and receivables processes through financial services.
Future Opportunities in Commercial Real Estate
Despite the obstacles ahead, 2024 offers several opportunities for commercial real estate investors.
Optimizing Cash: Amid market uncertainty, cash is king. The ability to quickly purchase assets under stress cannot be overemphasized. Having quick access to cash often results in better terms. Commercial real estate businesses can better take advantage of opportunities by investing in financial services and rent payment solutions, especially when interest rates fall. Affordable Housing: The lack of affordable housing is one of the biggest issues facing the nation. The industry has already found innovative ways to increase housing supply, such as modular construction, adaptive reuse, and historic tax credit equity. But a push is also needed to update zoning and address NIMBY-ism. Real Estate Tech: Real Estate Tech is diverse, continually evolving, and full of opportunity. Whether it's installing smart thermostats or offering digital rent payment options, commercial real estate owners and investors can use real estate tech to make more informed decisions, operate their buildings more efficiently, and gain a competitive advantage. Energy-efficient upgrades: As energy prices rise, these updates are more important than ever. For example, switching to solar power and recycling grey water can help owners and investors save on utility bills and attract environmentally conscious tenants. Similarly, cities often consider how much energy an apartment building will use before granting permits, so energy-saving measures can save valuable time in the development process.
Bottom line: Commercial real estate looks bleak in 2024, but it's important to keep a close eye on it. With many asset classes slowing down, investors need to ensure they have the liquidity to jump on opportunities when they arise – and there will be.