Some Office Values Could Show Full-Year Declines of Up to 15% in 2022
Downward pressure weighed heavily on valuations in the fourth quarter, according to SitusAMC Insights’ Current Valuation Insights analysis, particularly for office properties in central business districts.
At the beginning of fourth quarter, appraisal community consensus was that commercial real estate (CRE) valuation erosion would be in the 3% to 5% range. However, with the investment environment changing rapidly, declines greater than 5% (or more depending on the starting point) may be more reasonable. Our 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.
Office Woes Continue
The office sector will be the main driver of value declines in the fourth quarter, with the highest level of investment rate change. Office cap rate expansion is expected to be about 30 bps QoQ and discount rates about 25 bps higher (or higher for properties with leasing concerns). SitusAMC anticipates value declines that may approach 10% by the end of fourth quarter following about a 2% decline in third quarter. Values will likely be down 10% to 15% YoY, and likely more severe for CBD office than suburban office.
The Sunbelt markets continue to have the highest occupancy and perform best. Boston is also a winner, and the micro-markets of Century City in Los Angeles and Hudson Yards in New York City are seeing good leasing activity. Office demand has waned in the broader New York City market and San Francisco.
Leasing activity is showing a flight to quality. Occupiers are seeking Classes A+ and A++ buildings offering high-end amenities, locations near mass transit and ESG initiatives to lure workers back to the office. However, outside of Class A+, there is a massive amount of functional obsolescence.
Office leases are being analyzed on a net effective rent basis, as landlords are increasingly having to offer free rent and significantly higher tenant improvement (TI) allowances to get deals signed. Spec programs are becoming more popular as TI build-outs can command higher rent premiums and allow tenants to move in sooner, without concerns over supply chain issues.
Considering the headwinds for the sector, questions arise regarding the assumptions for stabilized occupancy: not just how long it will take a property to reach stabilized occupancy, but whether the threshold for what is considered stabilized should be revised downward, reflecting the challenging office environment. SitusAMC has not generally seen a trend of stabilized occupancy reductions in fourth-quarter valuations, but will continue to monitor the situation.
Few office transactions are occurring. Investors are often taking properties off market due to very little buyer interest. Properties often get few or no offers and strike prices are not hit. The sales that do occur may be distressed or offer assumable debt. Many Class B and C properties may be going back to the bank and undergoing short sales.
SitusAMC is seeing a slowdown in demand for life science among tenants and investment rates moving up. In New York, San Francisco and Washington, D.C., life science properties have been hit particularly hard. Class A assets that have recently seen aggressive pricing are experiencing a noticeable slowdown.
Optimism in Retail
Retail has a relatively positive outlook, with value minimal declines of 1% to 2%. Most of the segment’s write-downs occurred early in the pandemic, and the sector has been repriced to a level that makes it relatively attractive to investors from a fundamentals and rate-of-return perspective. The sector is not immune from debt market headwinds, however. There is some upward pressure on investment rates, though negative leverage is less of a concern in retail than other property types. Transactions are pointing to a flight to quality and assets catering to essential retail. Investors are particularly keen on assets with assumable debt, which can offer a higher rate of return in the current investment environment.
High-end retail is performing well. Class A malls are experiencing strong tenant sales and positive re-leasing spreads, resulting in relatively strong cash flows moving forward. There is some disconnect between appraisers on grocery-anchored retail with some holding investment rates firm and some increasing rates by about 25 bps. The biggest issue facing the industry is labor, with many retailers struggling to maintain operating hours.
Industrial Performance Falters
Fourth-quarter value declines are expected to be in the 5% range (more for those that were flat to up in third quarter). Market participants are becoming more willing to accept write-downs as rising interest rates continue to influence capital market assumptions. Rental rates are still strong, but the pace of growth has slowed as tenant demand moderates. There is a growing concern from a rate of return perspective that short-term NOI growth will not be able to support the tremendously low cap rates. This is particularly true for assets that have a wide variance between contract rents and market rents.
Industrial investments that are leased long-term (bond-like) at significantly below-market rent are being hit hardest from a valuation perspective, regardless of the quality or credit of the tenant. The buyer pool for these assets has dwindled as debt capital has become more expensive. Write-downs will likely be in the 5% to 8% range and there may still be room for further expansion on investment rates. There is greater investor interest in assets that are leased for a shorter amount of time and have the ability to get to market-rate rents quickly, but investment rates are increasing for these properties as well: The going-in rates on stabilized properties may be 100 bps higher than a couple of quarters ago. Value-add investments are experiencing a similar magnitude of rate expansion.
Similar to other property types, there is also a flight to quality. Big credit tenants are a bellwether during times of economic uncertainty. Another bright spot is gateway markets, where large supply and demand imbalances exist.
Value Declines Emerge in Apartments
The third quarter appears to have been an inflection point for apartments, with values plateauing after several quarters of strong growth. Third quarter also saw some increase in investment rates, especially discount rate expansion, but strong fundamentals and dynamic rent growth mostly offset any declines in value. However, the continued rise in the cost of financing through the fourth quarter is leading to negative leverage situations, and values are under pressure. SitusAMC is seeing increases in both the discount and terminal rates in the fourth quarter. Even with value declines in the 3% to 5% range in the quarter, aggregate asset prices for garden apartments – the darling of the investment community – are up about 50% from 4Q 2019.
From a fundamental perspective, positive tailwinds support the apartment sector, and apartments have generally maintained their position as a safe-haven investment. Limited housing supply, strong employment and single-family affordability issues bode well for rent growth in 2023. Rent growth is expected to slow from its recent record-breaking pace, but starting market-rent increases could still be in the 5% to 10% range over the next year. However, SitusAMC is seeing some pullback in rent growth assumptions for 2024 and 2025, with the possibility of a recession and increasing affordability concerns.
Rising expenses are becoming a concern for the apartment segment with aggregate expense increases potentially up 5% to 7% in 2023. This will have a direct impact on NOI and leading to the value pressures associated with the apartment sector. Development costs, up about 25% from a year ago, are eating into investment returns and expected to crimp new supply.