Falling values? Fewer transactions? A slowdown in new construction starts? These are all likely in the commercial real estate sector in 2023, according to Anthony Graziano, chief executive officer of Integra Realty Resources, a Denver, Colorado-based commercial research and consulting firm with offices across the country.
Integra recently released its Viewpoint 2023 report, an in-depth look at what it expects to see in commercial real estate this year. The takeaway? Expect a year of change, with commercial real estate values normalizing.
In other words, expect CRE values to fall this year from the peaks they hit in 2021 and 2022.
Graziano shared his thoughts on the U.S. commercial real estate market and its future with Midwest Real Estate News. Here is some of what he had to say:
Integra Realty Resources cites Amazon’s decision to pull back on the number of new warehouses it is building. Is this a sign that the industrial market might have finally hit a peak?
Anthony Graziano: I don’t know that we can call it a peak yet. The fundamentals are still good for the long term. But in terms of value and pricing, we have probably seen industrial’s peak. I don’t think we’ll see industrial values keep rising this year. There is still a large speculative supply out there. Then there’s the pullback from Amazon. I think that is giving investors pause.
We do expect industrial demand to begin to slow down this year. That will put pressure on pricing in 2023. The costs of construction are up. Interest rates are up. As we are heading into a recessionary climate, we will see pullbacks in spending. That will have an impact on the industrial market.
I’m sure that will concern CRE professionals. The industrial market has been so strong for so long.
Graziano: There are still markets with opportunities for industrial development and investment. In markets that have a limited amount of land and where demand is still high, you might still see strong industrial values. It’s all driven by demand. At the end of the day, how sustainable is the demand that we’ve seen for industrial? If you look at most of these markets, industrial product is trading at two times what it was two years ago. That is not sustainable. We can’t continue that trajectory.
You mentioned rising construction costs. Is there any relief on the horizon from these rising costs?
Graziano: I do think relief is coming. It might take a bit longer to work through the cycle, though. It will take a turn of projects that are planned but don’t get started to cause construction costs to fall. The difficulty now is that developers are telling construction contractors that they are going to start their projects. Construction contractors are still bidding as if everything is going to start. The reality is, not all of these projects are going to start. Contractors won’t have as much work. That will bring construction costs down. Everyone is still working as if the pipeline of new projects is full. When that pipeline empties out, the suppliers of construction materials will have to offer more competitive prices.
I think that we will start to see that this year. There won’t be as much new construction out there. That will make costs more competitive. It will probably take the better part of this year to see construction costs come down. We are already starting to see materials costs come down in the residential sector. There are going to be projects planned for this year, but whether construction is started is what matters when it comes to costs. The market conditions of coming out of the ground are challenging. We have a flagging of demand, rising interest rates, high inflation and rising costs. Those four things are not conducive for projects coming out of the ground. Once the demand for construction weakens, the industry will have to adjust. Contractors will have to be more competitive to win work. The costs will come down. That will make projects more feasible to start.
What about the office market? That sector is struggling across our markets. What do you see happening in the office sector this year?
Graziano: The preference of most workers is to keep working from home. Unemployment is so low, employees have the power to demand a hybrid or work-from-home scenario. Once unemployment creeps up, the employers will get back more power. They will bring back more of a full-time in-the-office model. They can start telling workers that they must come in full time if they want a position. We’ll see more migration back to the office as unemployment starts to rise.
But the rise in work-from-home is just one element in this. The other question? What are we using the office for? What is the purpose of the office? In most suburban offices at this point, they have the amenities and location that will attract people back to the office. That is what office investors are looking at: Is the office building in the right location? Does it have the right amenities? Is it offering the right environment to encourage workers to come back? That’s where there has been a flight to Class-A assets with the right amenities. Those are the prime office assets to own.
Do you see any positives for the office sector this year?
Graziano: Coming out of COVID, office and retail were the least-favored asset classes for investors. Because of this, we didn’t see a dramatic run-up in pricing for office and retail. The good news is that we already normalized pricing for these assets. They didn’t have any huge price run-ups that need to be corrected. As the market rolls out this year, we are going to see office and retail transactions.
Will we see many conversions of outdated office space, perhaps into multifamily?
Graziano: It depends on the office building. If you are looking at a small building with narrow footprints in New York City, where land is valuable, that is an OK candidate for a conversion to multifamily. But for most obsolete buildings in most cities in the United States, buildings with large footprints and tons of exterior glass, conversion is not feasible. It is very expensive to convert office buildings to residential. Making the economics work is difficult. That is not the solution to what we are going to do about office space. Multifamily demand is starting to slacken.
For those buildings that aren’t good candidates for conversion, some will find an alternate re-use. They might become studio space or some type of entertainment space. But the real answer is that we don’t know what is going to happen with those office buildings. There is no good answer. They are obsolete. Eventually, they will get torn down and redeveloped. There is a point where no matter how big a building is, it makes sense to rip down the building and start over.
In the Viewpoint 2023 report, Integra references some alternatives to what we typically view as traditional real estate investments. This includes build-to-rent residential homes. There is increasing demand for build-to-rent single-family properties, isn’t there?
Graziano: The build-to-rent phenomenon is interesting. There is a lot of pressure in the housing market, including cancellations on new construction. The build-to-rent product is filling an important niche in the marketplace. The build-to-rent market is red hot. A lot of the people who want to live in a build-to-rent home are doing it for lifestyle reasons. They might be taking a job, say, in Dallas. But they don’t know how long they’ll have this job or how long they’ll be in Dallas. It doesn’t make sense to buy a home if you are not going to be there more than two or three years. This market type is a good fit for people who don’t want to make a long-term housing commitment.
Here’s a big question: Where do you see commercial real estate values trending this year?
Graziano: Real estate values have to normalize, which means they have to come down. They are now at a peak. They probably reached that peak by the end of 2021 or certainly by the middle of 2022. And now with the adjustments in the economy, with recessionary pressures impacting demand and inflationary pressures driving interest rates up, we should see most values come down in 2023.
Those sellers who are not in a position where they are forced to sell this year probably won’t. It’s more logical for sellers to hold onto their properties. That will result in fewer transactions and buyers. The properties that do sell will sell for values that will be lower than what we’ve seen recently. Buyers won’t stretch to make a deal. The sellers will try to hold out. But at some point, they will have to lower their price.