CRE Investors Sit Tight But Shift Sector Focus: ValTrends 2Q 2023

Investors have retreated from commercial real estate (CRE) and equities since June 2022, when the Federal Reserve began raising interest rates aggressively. While most investors are still sitting tight amid capital markets uncertainty, sector preferences are shifting, according to the latest quarterly ValTrends report, "Pockets of Opportunity." Peter Muoio, PhD, Head of SitusAMC Insights, and Jen Rasmussen, PhD, Vice President, SitusAMC Insights, discussed key findings of the 2Q 2023 report at the ValTrends webinar on September 11, 2023. 

"So many dramatic things have happened that have effectively frozen up much of commercial real estate," Muoio said. "The interesting juxtaposition is that for many segments, the space market conditions and the operating fundamentals haven't changed. But the capital markets have changed -- and that's changed everything." 

Record Number of Investors Prefer to Hold  

For the second consecutive quarter, 91% of investors surveyed chose to hold, while only 3% say they would buy and 6% would sell. "That's more dramatic than we saw in the Global Financial Crisis, when 'hold' rose to 48% of market participants," Muoio said. 

Though the preference for CRE remains at historically low levels, investors did show a bit more optimism about certain asset classes. For example, the retail sector, which has been buffeted in recent years by overbuilding, online shopping and the Covid-19 pandemic, was named by 36% of respondents as the best property type, tying with apartments. That's up from just 11% and 21%, respectively, for those two sectors just one year ago. "There's definitely rotation going on in terms of what investors are thinking about," Muoio said. 

Retail See Improvements in Demand, Occupancy  

Significant price appreciation and cap rate compression in the apartment and industrial sectors are driving investors toward retail. "Retail values took their hit in the early part of the pandemic," Rasmussen said, adding that the sector has the lowest projected value decline of all property types examined. "By 2024, retail returns are expected to reach a seven-year high." 

Interest in the sector is also tracking with improvements in demand and occupancy. Second-quarter rent growth hit the highest level since the onset of the Covid-19 pandemic, a trend that could continue for a few years amid muted construction. 

But strained consumer finances could pose challenges, Rasmussen warned. Consumer spending rose a robust 0.8% in July, but credit card debt also reached a record high and delinquencies continued to climb. Student loan borrowers tended to take on more debt during the recent moratorium. "Now that these payments are resuming, we may see some danger ahead for consumer spending," Rasmussen said, adding that one in five student loan borrowers face payments of $500 or more per month. 

Office Continues to Struggle  

Woes continued for the office sector, which 91% of investors named the worst property type. "How, when and where people work is still in flux, and so demand is still in flux," Muoio said, adding that tech layoffs have amplified the problem, and transaction volume remains weak. The few geographic bright spots include Orlando, Fort Lauderdale and Kansas City, which have benefitted from softer construction projections. The sector's downturn has led to significant cap rate increases. 

In addition, investors are concerned about the substantial debt maturities in the higher interest-rate environment, especially for CBD office, and worry that rents are inadequate, Rasmussen noted. "While we have increasing cap rates, it likely will not support refinancing without loss of equity," she said. "A lot of these office properties are going to struggle to meet your typical debt service ratios when these loans come due. Perhaps there's an opportunity in terms of distressed properties in the future. But we had an investor say this is not the segment for traditional investments. This is this is a case-by-case scenario." 

A flight to quality has led to a bifurcation in performance between the best-in-class assets, which are still seeing strong income returns, and older properties. Suburban properties continue to outperform downtowns, but both sub-types are still in the red. 

Near-Term Rent Growth Slows for Apartment and Industrial  

Multifamily will be challenged by slowing rent growth and rising vacancies as more supply comes online over the next 18 months. "The good news is that it looks to be a short-term phenomenon," Muoio said. "Supply will settle back down, demand will increase and vacancies revert back to very low levels -- by 2028, they'll be as low or below the extreme lows we had seen in the mid-teens."  

Industrial is still going strong, with manufacturing activity growth in June and July, just slightly below the record set before the start of the GFC. "That bodes well for future tenant demand," Rasmussen said. In addition, second-quarter warehouse occupancy hovered at a record high, though net absorption and rent growth slowed. However, rents are still up about 40% from the pre-pandemic period.  

"Owners are going to continue to reap the benefit of significant rent growth as leases expire," Rasmussen said, so fundamentals will likely remain solid despite increasing supply in certain markets, including Cleveland and Los Angeles. 

In addition, alternative property types are attracting more interest by investors. They include the health care sub-segments, such as medical office, which is benefitting from an aging population and soaring health care spending. Other pockets of opportunity include senior housing, student housing, affordable housing, self-storage, and to a lesser extent, data centers.   

The ValTrends report, “Pockets of Opportunity," offers a comprehensive look at SitusAMC's proprietary insights on valuation trends and space market fundamentals, as well as exclusive survey data on investor appetites for CRE versus bonds, equities and cash. Download the free, 28-page report here. View the ValTrends Quarterly webinar presentation here. Learn more about SitusAMC’s research and data offerings on our website.