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Investor Preference for Industrial Sector Plummets in 2Q 2022

Strong rent growth drove apartment and industrial property values higher in the second quarter, according to Current Valuation Insights, a SitusAMC report leveraging the perspective of our current appraisal and valuation management work. But despite the growth, investor sentiment toward the industrial sector is plummeting.

As we round the halfway mark of 2022, dynamics are shifting in the commercial real estate (CRE) investment environment. Preliminary data from SitusAMC Insight’s second quarter 2022 institutional investor survey shows changing preferences among property segments. 

Industrial Falls From Favor, Retail Rebounds

Compared to the previous quarter, the percentage of investors selecting industrial as the best property type in the next 12 months plummeted from 47% to 11%. Respondents cited major concerns that the sector is overpriced. Apartment was the most favored segment among investors; 56% of investors ranked apartment as the best sector, up from 21% last quarter. Skyrocketing mortgage rates are putting a crimp in single-family affordability resulting in strong demand conditions for apartments. Several investors also remarked that apartments were the best inflation hedge among the property types.

Meanwhile, retail appears to be making a comeback, with investor preference for the sector climbing to 33% from just 11% last quarter, citing opportunity for yield plays. Investor sentiment on office, on the other hand, is extremely bearish; no investors selected it as the top property type, down from 16% in first quarter. 

Space Market Fundamentals Boost Apartment Values

SitusAMC is seeing these sentiment shifts play out in our client work. Market rents and rent growth drove value in the apartment sector in the second quarter. Fundamentals and sales activity remain strong, but there are fewer investors at the table when the bidding reaches the best and final round. Investment rates are not decreasing across the board, but are specific to the assets and the submarket.

For the first time in several quarters, low-rise apartments outperformed garden apartments. Suburban is still surpassing urban, but some urban locations show signs of growth. 

Gateway markets such as New York lagged but are improving. Chicago is making progress in rent growth, which is translating into some value improvement. San Francisco is starting to produce positive indicators as well, and Boston and Seattle are experiencing growth momentum. In addition, apartments are becoming less affordable in gateway metros, according to SitusAMC Insight’s proprietary multifamily affordability index. 

Industrial Rent Growth Stays Strong

After so many quarters of seemingly unstoppable growth, the industrial sector is starting to display initial signs of a slowdown, even though fundamentals remain strong. Rents are still growing in most markets and investors are still anticipating widespread above-inflationary rent growth, and are underwriting to these assumptions. But it is unrealistic to expect another quarter of 8% to 12% rent growth. Meanwhile, the buyer pool for industrial properties has been shrinking since the beginning of the year and some larger portfolios are not being financed or traded. 

Assets sporting below-market rent leases with three to five years remaining are still very appetizing to investors, especially in the explosive growth markets of Southern California and Northern New Jersey. However, investors are often requiring a 25- to 50-basis point increase in the discount rate for below-market rent leases with greater than five years remaining. 

Office Values Hold Steady Amid Changes in Tenant Space Usage

Office values remained relatively flat in the second quarter, with most of the increases in values derived from contractual rent increases. Overall office values are skewed, however, by strong growth in life science.

Near-term market rent growth has steadily increased over the past year and is nearing the standard 3%. The strongest growth markets continue to be in the Sun Belt markets and the suburban office subtype, which are doing better than gateway markets and CBD; but rents are increasing in those areas as well. 

Early renewals are approaching 10%, the highest level since 2015, though this is partly due to leases that expired during the pandemic and were renewed on a short-term basis. Many tenants are downsizing. Daily office occupancy is mired around 40%, and it might not exceed 60% in the long term. There has been a flight to quality properties as employers try to attract top talent during a tight labor market. 

Retail Valuations Show Signs of Life

Retail benefitted from strong consumer spending in the first quarter. However, strong retail sales are unlikely to continue as inflation erodes consumers’ disposable income and narrows spending to everyday necessities such as gasoline and food. Retail outlets that provide essential goods, such as neighborhood and community centers with grocery anchors, will likely maintain steady income streams. Malls could be hurt by the decline in non-essential spending.

The second quarter saw a small increase in retail valuations. Leasing activity picked up as well, as short-term mid-pandemic leases expired and were renewed. A couple of large deals involving grocery-anchored centers have signaled very strong cap rates, in the low- to mid-4% range, in strong markets such as San Diego and Miami. However, these rates were negotiated at the beginning of the year when the debt markets had not yet changed. Some SitusAMC clients are repricing their assets down slightly because of the debt market environment. 

Uptick in Leisure Travel Benefits Hotel Performance

General hotel sentiment has been improving slowly and steadily since last year, primarily driven by an increase in leisure travel; business travel has not returned to pre-COVID-19 levels. Hotels that rely on leisure travel are surpassing pre-pandemic performance, especially the luxury segment, where some are at 20% to 30% over pre-pandemic ADRs. CBD hotels, which are highly dependent on conference travel, are struggling despite some emerging growth in ADR and occupancy. Chicago CBD is performing poorly. CBD hotels in NYC are performing better, but assets are selling for low prices.

Hotel trades are rising. Investors note the upside potential as travel rebounds thanks to pent-up demand. Hotels in California and coastal Florida are performing well, with some explosive sales on a price-per-room basis – $1.5 million to $2 million per room for some luxury assets in California. 

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July 2022