CRE Market Sees Downshift in 1Q 2023
Office vacancies rose, apartment growth cooled and the industrial sector continued to soften in the first quarter of 2023 amid a downshift in the commercial real estate market, according to SitusAMC’s Current Valuation Insights quarterly analysis. This report leverages the boots-on-the-ground perspective of SitusAMC’s appraisal and valuation management teams, offering investors real-time market and property-type insights ahead of many traditional CRE data sources.
Preliminary 1Q 2023 valuations peg retail as relatively flat, while industrial and self-storage valuations are expected to be down about 1% to 3%. Apartment is expected to have valuation declines between 3% and 4%. Office valuations look to have posted around a 3% to 5.5% decline as of mid-February, but the segment is likely to take further hits throughout the rest of the first quarter given continued structural challenges. In fact, some troubled office assets are getting put back to the lender; some mezzanine and senior notes are being sold because the senior holder no longer wants the asset back in certain situations. It is important to note that quarterly value change is relative to adjustments made in 2022, so some funds may be in store for larger corrections to adjust to market realities.
Office Usage Plateaus at 50%
The first quarter will prove to have been another tough one for office, as the segment faces structural shifts in demand and now cyclical headwinds. With recent news of layoffs, particularly in the office-intense tech sector, we are seeing an offloading of space, adding more inventory to the sublease market.
Office usage rose recently, but appears to have plateaued around a weekly average of 50%, according to data from Kastle. Most employees are coming into the office on Tuesday or Wednesday, when office usage jumps north of the 50% mark, so by default, about 40% of the week is not well-occupied. A good corroborating indicator of this is New York City parking rates, with garages spiking their rates in the middle of the week to coincide with the increase in office usage, and much lower rates on the weekdays on either side of the weekend. This usage pattern has a domino effect on restaurants and shop owners in office districts. However, office values should be examined in context of the highest day’s usage. Even if few workers come into the office on Mondays or Fridays, companies still need enough space to accommodate the mid-week spike in usage.
Actual vacancy rates continue to increase. If tenants are renewing, they are downsizing, and also seeking top quality space. With the recent significant capital market adjustments along with the sector headwinds, transaction activity has been slow. The limited activity that has taken place has seen a wide increase in cap rates.
So far in the first quarter, draft values for the office sector are down on average 3.5% to 5%+. However, the disparity between valuations this quarter has been extremely significant, with some unique performers experiencing relatively flat values, while others are down more than 20%. Most office assets are seeing rate adjustments again this quarter. But the degree of declines is market-specific, with tech-heavy metros seeing the worst falloff, led by San Francisco and other California markets, followed by the Pacific Northwest. Alternatively, Sunbelt markets in the Southeast are seeing much smaller declines.
In addition to rate expansion, we are seeing more assumption adjustments, especially decreases to stabilized occupancy. There have also been increases in absorption and downtime assumptions, reductions to renewable probabilities, and slight increases to free rent and tenant improvements (TI)s. Examinations of both structural and general occupancy, as well as de-risking of the cash flows, will be critical in 2023.
Last quarter saw value declines for life science, but this quarter they have pivoted and are relatively flat, with no rate adjustments. Current risks for the sector include a lack of venture capital funding and poor tenant credit quality. However, stabilized assets are not having leasing or credit-quality issues. This highlights the importance of not painting a broad brush stroke across the whole office sector – there are haves and have nots. Top-quality office with high-end amenities is going to perform well, but commodity office is challenged.
Industrial Continues to Soften
Broadly, industrial equity values are flat to -5% range, averaging about -2%. There is still a big divergence between long-term leased and short-term leased assets.
Capital markets assumptions, on average, are for a 5% exit rate and a 6.5% discount rate (higher for long WALT bondable cash flows), indicating there is potential room to run. We are not seeing a broad expansion in rates as investors believe they took their medicine in the fourth quarter of 2022. There is still a search for pricing, with a large spread between buyers and sellers.
We are seeing positive market rent growth where fundamentals are strong, particularly in the gateway markets. There is solid demand in Southern California and New Jersey from big, brand-name tenants, especially for less commoditized, big box warehouse product. There is incredible demand in South Florida and Savannah, GA, where even the large amount of supply coming online is not enough. This is leading to some big jumps in leasing rates, which ties back into the divergence between the short-term and the long-term lease investments. Still, market rent growth is muted compared to last quarter.
Because of a short-term increase in supply, some tenants are starting to have a little more bargaining power with some of the intangibles, including free rent and TI dollars. However, the rise in supply is expected to be temporary, given rising costs and disruptions to financing.
Cautious Optimism for Retail
First-quarter retail trends are similar to the previous quarter, with valuations relatively flat. Some funds have even been able to eke out a little appreciation coming from the initial cash flow. Part of the reason that retail is performing better than some of the other property types is that it already took its value hits earlier in the pandemic, so there is less froth to deflate. Because of the price resets, the segment is stabilized and better positioned to withstand valuation headwinds.
In addition, strong leasing and good fundamentals are propping up the sector; 2022 tenant sales were relatively strong, though they slowed at the end of the year. The mall market continues to be a story of the have and have-nots, with strong leasing in the A++ mall category, but certainly not in the Class B or below categories.
However, retail faces areas of risk. A potential indicator of reduced consumer spending is that Americans are using their credit cards more. Layoffs at tech companies might spell trouble for upper-end consumer spending. The power center or bigger box retail is also an area of risk, due to some major closures, including Bed Bath and Beyond and Tuesday Morning.
There have been few, if any, significant A++ mall sales over the past few years. One challenge is deal size, with few buyers wanting to take on such a large piece of retail all at once. Large check sizes can complicate deals, even with favorable financing terms, because of the complexity of the capital stack. As a result, there may be more partial interest sales, below 50%. These sales would be particularly attractive to international capital, which is often looking for deals, particularly passive investments, with less than 50% interest for tax purposes.
Apartment Rent Growth Cools
Valuations have been flat to down in the first quarter for most assets. However, the declines are not of the same magnitude as in the prior quarter. From a capital markets perspective, there has generally been a further expansion of rates, though it is asset- and market-specific. Most of the assets with increases to rates this quarter are those that saw the greatest amount of compression throughout COVID-19, and those with negative leverage to some degree.
One of the bigger drivers of rate expansion this quarter is expense increases. Given the higher inflationary environment, line items, such as payroll, insurance and utilities, are on the rise. This affects the bottom line and will ultimately hit values as well.
Generally, the Class A assets in the best markets are seeing going-in caps in the low- to mid- 4% range. More middle of the road markets are seeing rates in the mid-4% range and lower-tier, tertiary markets are seeing a high 4% to low 5% range.
The segment is also experiencing rent deceleration. A year ago, there might have been 10% to 20% trade-outs from previous leases. Most markets across the country had double-digit rent increases and this has considerably narrowed. There are still positive trade-outs from a year ago, but mostly in the single digits. From a valuation standpoint, there is a big focus on narrowing the market to contract rent spread. It is important to be mindful of supply coming online in the near-term. Markets with little supply are in a better position for inflationary rent growth.
Seasonality has returned in many markets. Last year, rents continued to increase even through the winter months. Now, asset managers and market researchers are expecting a mellowing of rents in the winter, with a return in the spring and summer.
Sunbelt fundamentals remain solid, with investor appetite strong in Charlotte, Raleigh, Miami and Orlando. Investors seem to be getting more selective in their underwriting, dialing back last year’s enormous rent growth assumptions to more normalized levels.
Self-Storage Garners More Institutional Interest
Self-storage is maturing as an asset class, comprising a larger share of our client portfolios and a larger percent of allocation to the NCREIF index, given the run-up in values during the pandemic. However, Class A in good markets took a big write-down last quarter, and there has been some value erosion again in first quarter, between 1.5% and 2%, mainly due to rate movement.
Investors often buy one-off deals and then aggregate to leverage operational efficiencies to create value at a portfolio level. However, there have been some situations in which clients have brought large portfolios to market and the deals were too big to transact because of the check size, so they had to be broken apart.
There are certainly differences in cap rates between single deals and portfolios, especially portfolios that can show a history of rent growth. Caution should be taken when applying standard portfolio premiums, as they must be supported by the underlying asset characteristics. There has already been a notable dip in portfolio premiums, in some cases dissolving completely as it has already been baked into cap rates.
Self-storage can be counter-cyclical, which has propped it up through the pandemic economic cycle. The biggest risk to the sector is the ease of which supply can be added, sometimes only taking a few months to come online.
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