As we move halfway through 2024, commercial real estate (CRE) headwinds are not particularly strong in any one sector. Inflation is above the Fed's 2% target, and some believe interest rates will remain at current levels indefinitely. Moderate changes in the bond market have caused the yield curve to flatten slightly, but this does not necessarily indicate a clear change in direction.
CRE trends likely to emerge and gain momentum in the second half of 2024 include:
Busy office
Roughly 75% of the U.S. workforce continues to work in the office at least part of the time. The shift to return to the office (RTO) continues to steadily increase and is one of the hottest trends in CRE. A robust labor market and employers prioritizing office-based employees when considering new hire salaries are also helping to drive the vibrancy of the office environment.
Much of the discussion about high vacancy rates stems from employees' continued reluctance to return to the office, but that's only part of the story. The pandemic also forced the rapid integration of technologies that allow employees around the world to interact seamlessly, forever changing how teams work in and outside the office. As a result, there was a noticeable desire for more quality office space, but numbers have declined significantly.
Trophy properties (Class A office space) and newer buildings are responding positively to demand, enjoying stable vacancy rates and, in some cases, record rents. This leasing activity reinforces the consistent performance of high-quality office properties in well-located locations, according to Mark DeLuca, KBS CEO and Eastern Region President.
“Businesses are drawn to these amenity-rich buildings as a way to attract top talent and stay competitive,” DeLuca says.
While this “flight to quality” trend may result in initial revenue losses for some portfolios as traditional leases expire and tenants seek new locations with more attractive amenities, investors willing to take the risk of renovating or repurposing older assets in high-demand suburban areas or conveniently located downtown areas could see long-term gains.
Retail resilience
Consumer confidence is fueling a booming economy, which is great news for most retailers. While consumers continue to prefer online purchases, their buying habits have not replaced in-store shopping, and retailers are accordingly blending the online and in-store experiences. Additionally, many retail property owners are investing in renovations to make the in-store shopping experience more appealing, integrating food, beverage and entertainment to drive foot traffic, and continuing to support online shoppers with functional services such as in-store pickup and return drop-off.
Due to a lack of new construction over the past few years, relocating retailers will find existing market space somewhat scarce. Suburban shopping staples such as strip malls and neighborhood shopping centers anchored by grocery store tenants are also expected to remain stable through 2024. Mall-based retailers are the exception, as many are closing underperforming stores and relocating to smaller, open-air centers preferred by their target demographics.
Renovations and modifications
There is more than twice as much available office space today than there was at this time a year ago, and this is predicted to continue. Again, this is largely due to a quality vs. quantity issue, with today's occupiers needing less space but wanting a quality working environment.
As employers look to lure staff back to the office with easy commutes and quality office space, suburban properties as well as city centre locations with good access to public transport are experiencing new popularity.
There is a stalemate between sellers who are optimistic about asset value and buyers who are prepared to wait until the right time to purchase. Investors who have been on the sidelines due to rising interest rates may be in a favorable position as traditional sources of financing continue to be pulled in the wake of rising vacancies and falling property values. There are also concerns about continued CRE loan defaults and the $1.5 trillion in U.S. CRE debt coming due by the end of 2025. It remains to be seen how that will impact CRE and the broader market.
Increase in detached rental properties
High mortgage rates are keeping many middle-class individuals and families out of the home buying market. According to a recent report from CoreLogic, rents for single-family homes increased 3.4% year over year in March. This increase is likely to shrink as more supply comes to the market. In the past four quarters, construction has started on 80,000 rental homes, up nearly 16% from the four quarters prior. However, increased supply is likely to sustain demand for single-family rentals unless mortgage rates fall significantly or home prices decline.
The future of single-family homes and apartment complexes is somewhat more complicated. Single-family home rents fell year-over-year for the first time in 14 years due to an increase in apartment supply in some markets. Apartment complex rents saw a modest increase in the first quarter of 2024, which is lower than rents typically seen at this time of year, but this could be due in part to the amount of new units that have recently entered the market, with even more units under construction. In fact, 2023 saw more new apartments coming onto the market than in over 35 years.
For portfolios evaluating converting unused office space into affordable housing, some jurisdictions offer financial incentives to offset the costs of conversion. However, the process is not as simple as it may seem: Factors such as the building's age, size, configuration and location suggest that only 3-5% of buildings are eligible for conversion.
Data Centres
Connectivity will be key, driving the need for more data centers and cell towers to manage growing workloads. One of the fastest growing areas of energy demand is generative AI data centers, which require large amounts of energy to train and generate answers to queries. Industrial-focused CRE portfolios may be estimating long-term benefits from renovating older office space to accommodate the construction of new facilities. While workforce demand for more and faster technology is still likely to grow, construction and energy costs will also be higher, potentially offsetting any initial benefits.
The rise of reshoring and nearshoring hubs
E-commerce has accelerated consumer delivery expectations, with same-day or near-same-day delivery becoming the common standard. Additionally, adjustments in supply chain logistics are redirecting goods flows and expanding fulfillment center operations in cities along the East Coast and in the Golden Triangle region, such as Memphis, Tennessee; Wichita, Kansas; and Huntsville, Alabama.
Construction activity is expected to surge post-pandemic, peaking at 283 million square feet in 2022, followed closely by 2023. As demand stabilizes, new construction has slowed, with completions declining from approximately 58 million square feet in Q4 2023 to just 20.3 million square feet in Q1 2024. Data centers and similar opportunities may remain available, with affordability and access to logistics infrastructure being key determining factors.
Green Integration
Sustainability measures are a fundamental component of new builds and renovations, and recent rulings from the U.S. Securities and Exchange Commission (SEC) requiring CRE investors to consider the carbon footprint of their real estate portfolios, combined with tenant preferences for green buildings, are likely to add ESG considerations to the decision-making process.
Determining how green you can be requires a thorough cost-benefit analysis, which should also include financial incentives available through tax benefits and long-term utility bill savings, as well as the competitive advantage that LEED or GRESB certification can provide in current or future markets.
KBS has been recognized for its sustainability by receiving a Green Star in the 2023 GRESB Real Estate Assessment. This is the first year that KBS has participated in the GRESB Assessment. The company plans to participate annually, demonstrating its ongoing commitment to ESG transparency and performance improvement. Tenant perception is also a factor, with green buildings often being able to command higher rents.
KBS is committed to furthering its industry leadership through ESG and is actively committed to maintaining the health of its offices. Last year, KBS set a goal to reduce greenhouse gas emissions by 5% by 2025, including both emissions under its direct control and on-site emissions generated by tenants in properties we manage.
CRE Outlook 2024: A “blend” of trends
The continued evolution of work dynamics, consumer buying behavior, mortgage rates, and technological advancements (including the expansion of AI into CRE) are creating unique, interconnected dynamics. Skillfully assessing these trends and combining them with traditional risk assessments can result in transformative strategies that take CRE in exciting new directions.
For more information, visit KBS.com/Insights.