While only the beginning of the year, the commercial real estate industry is already beginning to see new trends take shape. To get more clear insight on what the investment market might look like going through 2023, The Registry recently spoke with Kevin Shannon, Newmark’s Co-Head of U.S. Capital Markets. Shannon has been with Newmark since 2015 and has sold more than $65 billion worth of real estate, according to information from the company. During the conversation, Shannon shared his thoughts with The Registry about the current state of the investment market and what it might look like moving through the rest of the year.
Over the past several years, companies have changed their needs for office space across the West Coast. How has that impacted office investments in 2022?
Work from home and the pandemic has negatively impacted demand for office space which has also negatively impacted investor underwriting in the office sector. Vacancy rates for gateway West Coast office markets, like Los Angeles and San Francisco, are at all time highs currently. Forecast absorption, tenant retention and rental rate growth have all been reduced as a result.
This is especially true for commodity office product as tenants have used this downturn to upgrade to best-in-class brand new or renovated Class A office product. Institutional investment capital currently lacks conviction generally in the office sector given the lack of visibility relative to the timing and pace of the recovery in market fundamentals. Dramatically reduced office investment activity in the second half of 2022 and the first half of 2023 has and will be dominated by family office investors taking advantage of discounted pricing opportunities.
What about other sectors of commercial real estate- industrial, multifamily, etc. What trends should we expect to see there in 2023?
All real estate assets including recent sector darlings like industrial, multifamily and life science have been significantly affected by the rapid increase in the cost of capital. The unprecedented pace of the Fed’s recent rate increases has dramatically changed debt. Fannie Mae debt for multifamily as an example was in the high 2s a year ago and today is in the mid 5s. Cash on cash returns have been impacted for all real estate sectors, which has resulted in lower valuations across the board primarily driven by higher debt costs and the use of higher exit cap rates. The leasing fundamentals though for most industrial, multifamily and life science markets are still solid even though the cost of capital has adversely impacted valuations.
What surprised you the most over the last 12 to 18 months? Do you think that trend will continue into 2023 and beyond?
The pace of the Fed’s rate increases in 2023 was unlike anything we have seen before. The rapid rise in rates shocked the capital markets environment and investment capital is still adjusting. Strategies for real estate debt, government bonds and corporate debt are perceived as more attractive given current yields and the economic volatility than real estate equity by many institutional investors right now.
As you look at the market dynamics in 2023, what do you think will be the most significant things that will define the industry in the coming year?
I think everyone in capital markets knows pricing for all asset classes is off. I think for office, the data points that demonstrate where current valuations are will occur in the first half of 2023. Appraisals will be adjusted once these data points are printed which will cause stress on a lot of capital stacks for office product. The best trophy office product won’t be as stressed and less impacted from a valuation perspective because they are typically held with little or no leverage, but the vast majority of office product aren’t core trophy quality. Office debt maturities should increase by approximately 39 percent in 2023 compared to 2022, and nearly half of that will be for floating rate debt maturities. Poor office fundamentals in most markets and much higher debt costs will lead to some distressed sales and many owners will be looking for recap partners at greatly adjusted valuations.
Is that worrisome? Why or why not?
Real estate has always been cyclical and we are clearly in another down cycle. We have always recovered and will again from this down cycle. Rates will come back down, in my opinion, in one to three quarters after the Fed pivots later this year.
What opportunities do you see in the coming year, and how are you and your firm preparing for the year ahead?
There will be far more distressed sale opportunities in 2023 which has resulted in an increased focus by our team on lenders and operators with debt maturities. There is a ton of institutional dry powder for opportunistic and value add strategies which is on the sideline right now waiting for a market bottom. Fear turns to greed quickly given the vast amount of data transparency in our industry. Family office investors aren’t trying to time the market bottom like institutional capital and are making some great investment acquisitions right now with limited competition.
A year from now, what do you think we’ll be talking about?
We will be talking about our real estate recovery next year. We have seen retail fundamentals bounce back post pandemic and I do think sectors like multifamily and industrial will bounce back quicker than the office sector. Office will bounce back too. I believe next year we will also be talking about the surge in conversions for more commodity office product as well as improved return to office stats. Most employers clearly want their employees back in the office and the leverage will shift to employers this year as the Fed’s policies continue to slow our economy. Both of these trends will contribute to a continued office recovery.