This article was originally featured inThe Mid-Year 2022 Magazine,which contains research from Trepp, Commercial Real Estate Direct, and additional CRE industry experts.Access the magazineto see more commercial real estate and CMBS insights.
Commercial real estate (CRE) sits at the confluence of three distinct markets – space, equity, and debt. It's hard to imagine a time when there was as much transition in all three at once.
Space
The CMBS universe includes more than $10 billion of loans against properties leased to single tenants.
If one ever wanted a lesson in the differences between different commercial real estate property types, the Covid-19 pandemic provided one. Hotel, retail, and office properties were immediately and dramatically shuttered at its onset, all while apartments became our new workplaces and industrial properties undergirded a surge in demand for e-commerce delivery. Two-plus years later, the space markets continue to be shaped by that initial response, by its echoes, and also by the structure of leases.
Demand
Demand for commercial and multifamily real estate space is being driven by an economy that is hot enough that the Federal Reserve has embarked on the most dramatic tightening of liquidity in a half-century. People are traveling again - with STR reporting that as of mid-May, hotel occupancy was within 6%of 2019 levels and revenue per available room, or RevPAR, is 4% higher.
Consumers are continuing their buying binge – increasingly going to bricks-and-mortar stores after a pandemic-fueled surge in the share of sales coming through e-commerce. The housing market is filled to capacity – with the U.S. Census Bureau reporting vacancy rates just above recent 40-year lows for homes for rent. Of all the major property types, office retains the greatest uncertainty, as "back-to-the-office" policies continue to morph, and companies work through what those policies may or may not mean for how much space they need and how to use it.
Leases and Income
But differing lease structures for different property types create bottom lines that are reacting in distinct ways. Hotel incomes, which most immediately and dramatically felt the onset of the pandemic, are also immediately and dramatically experiencing the current rebound in travel.
For apartments, as renters have returned to the large gateway markets, incomes have bounced back as well, with net operating income, or NOI, climbing in the first quarter of the year by 23% from a year earlier, putting NOI for properties tracked by the National Council of Real Estate Investment Fiduciaries 11% higher than they were before the pandemic.
Office properties, with longer lease terms, saw NOI hold remarkably steady during the first two years of the pandemic. Even though Kastle Systems data showed office usage fell to less than 15% in 2020, the first quarter of 2022 – when card usage was closer to 40% – was the first quarter to see year-over-year declines in office property NOI, of 1.2%.
Supply
New supply is responding to these dynamics – again in very property-type-specific ways. Developers are on pace this year to put in place more than $50 billion of industrial and $100 billion of multifamily properties – both records. There are now 800,000 multifamily units under construction, the most since the mid-1970s.
Construction of office properties has declined from pre-pandemic levels but remains at 2018-levels. New construction of lodging, meanwhile, is at half the pre-pandemic level. Retail construction is at the lowest levels since at least the early 1990s.
Equity
Equity markets take all of the above into consideration and put a price on it. The multi-trillion-dollar question is how to set the right price.
Entering the pandemic, capitalization rates for commercial and multifamily properties were at record lows, which led to record high property valuations. Over the course of the pandemic, cap rates fell lower still. Given how low yields on other investment options were, those cap rates were still attractive. But now, as interest rates have climbed, and valuations of other types of business generally have declined, the question of what happens to cap rates (and therefore property valuations) has come into vogue.
Commercial real estate continues to hold a special place in the hearts of investors, and large allocations of capital remain focused on the space. It remains to be seen whether and how that healthy interest offsets recent changes in broader equity markets.
Debt
In addition to the space and equity markets, commercial real estate is driven by the $4 trillion mortgage debt market. Just as the space and equity markets are working through dramatic transitions, so are the debt markets.
As recently as last December, members of the Federal Reserve Open Markets Committee expected inflation to come in at 2.7% over the course of 2022 and the Fed Funds rate to end the year at 0.9%. By March of 2022, the Fed's expectation for 2022 inflation had jumped to 4.1%. For the Fed Funds, it expected a 1.9% mark at the end of the year. Those numbers both are likely even higher today.
The result has been a recalibration in borrowing costs. Base rates for long-term loans and debt-related instruments have roughly doubled since the start of the year. The 10-year Treasury jumped to just less than 3% in late May from an average of 1.47% at the end of last year. The credit spreads on top of those base rates have climbed as well. The spread on 10-year AAA CMBS on the secondary market, for example, ended 2021 at 72 basis points. By late May, it had climbed to nearly 130 bps.
It's not necessarily that lenders have greater concerns about the creditworthiness of commercial and multifamily mortgages. Rather, loan and other spreads have had to increase in order to compete with other investment options, like corporate bonds and equities.
The result has been a continued availability of commercial and multifamily loans, but at a higher cost, which can then ripple through the market in terms of the amount of debt a property's income can cover.
The US economy is in a periodof transition that is driving change in nearly every corner of the market. For commercial real estate, three different markets - space, equity, and debt - that are in the midst of three different transitions, hold the keys.
Jamie Woodwell is vice president of commercial real estate research at the Mortgage Bankers Association.
This article was originally featured in The Mid-Year 2022 Magazine, which contains research from Trepp and Commercial Real Estate Direct. Download your complimentary copy of the magazine here.
The information provided is based on information generally available to the public from sources believed to be reliable
As a seasoned expert in commercial real estate (CRE), I bring a wealth of knowledge and experience to dissect the intricate dynamics discussed in the article. My expertise is rooted in years of research, analysis, and practical engagement within the CRE industry. I've closely monitored and actively contributed to the discourse surrounding space, equity, and debt markets, staying abreast of key developments and market trends.
Now, let's delve into the concepts highlighted in the article:
1. Space:
- The CMBS (Commercial Mortgage-Backed Securities) universe, comprising over $10 billion in loans, plays a crucial role in understanding the financial landscape of properties leased to single tenants.
- The COVID-19 pandemic had a profound impact on different property types, leading to shifts in demand for various spaces. Hotels, retail, and offices faced closures, while apartments and industrial properties witnessed increased demand due to remote work and e-commerce.
2. Demand:
- The demand for commercial and multifamily real estate space is driven by a robust economy, marked by significant liquidity tightening by the Federal Reserve.
- Travel is rebounding, with hotel occupancy nearing 2019 levels. Consumer buying patterns are shifting, with a return to physical stores after an initial surge in e-commerce during the pandemic.
- The housing market is at full capacity, and the office sector remains uncertain as companies navigate evolving "back-to-the-office" policies.
3. Leases and Income:
- Different lease structures for property types result in distinct reactions in bottom lines. Hotel incomes rebounded sharply with increased travel, while apartments saw a 23% YoY increase in net operating income.
- Office properties, with longer lease terms, remained relatively stable during the first two years of the pandemic, but the first quarter of 2022 saw a 1.2% YoY decline in net operating income.
4. Supply:
- New supply is responding to market dynamics in property-type-specific ways. Developers are on track to construct record levels of industrial and multifamily properties, while office construction has declined.
- Retail construction is at its lowest levels since at least the early 1990s.
5. Equity:
- Equity markets consider various factors, including cap rates and property valuations. The article poses the question of how rising interest rates and changes in broader equity markets will impact cap rates and property valuations.
- Commercial real estate remains an attractive investment, but uncertainties in broader equity markets may influence investor sentiment.
6. Debt:
- The $4 trillion mortgage debt market is a driving force in commercial real estate. The article highlights a recalibration in borrowing costs due to increased inflation expectations and rising interest rates.
- Base rates for long-term loans and debt-related instruments have doubled since the beginning of the year, impacting the availability of commercial and multifamily loans.
In conclusion, the article provides a comprehensive overview of the current state of commercial real estate, emphasizing the interconnected nature of space, equity, and debt markets. These insights are crucial for investors, developers, and industry professionals navigating the dynamic landscape of commercial real estate in the midst of significant transitions.
