A continued flight to quality office assets. A slowdown in demand for industrial properties. A multifamily sector that remains the darling of investors.
These are some of the highlights from Colliers‘ Global Investor Outlook, a look at investors’ sentiments regarding commercial real estate in 2023.
We recently spoke with Steig Seward, U.S. head of research for Colliers, about the report’s findings and the state of commercial real estate in 2023. Here is some of what he had to say.
Colliers’ report shows that investors, like tenants themselves, are interested in the highest-quality office properties today. Is that a trend that is still going strong?
Steig Seward: There has been a prolonged flight to quality in the office sector. Companies are engaged in a war for talent. HR departments are doing what they can to retain their top talent and attract new talent. Having office space that makes people want to come back to the office is a high preference for leadership teams and HR departments. Many companies are upgrading their addresses to help combat that talent drain.
Some of these companies might reduce their office footprint once they move. But they will pay a higher rent. If you net it out, their total operations costs remain the same, but they still get to upgrade their address and, hopefully, attract the best talent.
In the markets that we cover, newer, class-A office space is seeing the lowest vacancy rates.
Seward: These newer buildings are designed differently. There is a shift in these newer buildings toward more collaborative work environments and more meeting spaces as opposed to dedicated offices. Definitely, the floor plans and layouts of newer buildings are more conducive to that type of work. They also have higher-quality amenities, outside patios, concierge services and perks like that.
What will happen to those older office buildings, though, that lack the amenities that tenants today favor?
Seward: We conducted a study recently of top gateway markets. We found that 35% of all the buildings in those markets are older than 50 years. They are facing functional obsolescence because of time. Not all those office buildings can be converted into something else. They all can’t be converted into multifamily or hotels. Only a small percentage, maybe 10% or less, would be a good fit for conversion. It’s going to be interesting to see what happens with these buildings. I suspect that most of them over time will lose their tenant base. At some point, when the financial conditions are right, their owners will scrap the building and put up a highest- and best-use type of property instead of trying to reconfigure the whole building. That’s not good from an environmental standpoint, but it is a cheaper way to get to the end results.
What about the multifamily market? In Colliers’ global report, it says that investors today consider multifamily the top asset class for their dollars, with multifamily being seen as even more attractive than industrial.
Seward: Multifamily has been the darling of investors for quite some time. It used to be that office was king and multifamily was next, then industrial and retail. As things have turned, multifamily has been thrust into the spotlight. It is definitely where people want to invest. It is having its share of difficulties, too, with today’s interest rate environment. But if you talk to people out there, they all list multifamily as a key asset class that they are most interested in scooping up.
When it comes to multifamily, what are investors looking for?
Seward: It depends on the investor’s profile. You have some investors who are only interested in higher-amenitized Class-A properties. Others are perfectly content with investing in affordable housing. Investors play in different areas. Different investors favor downtown over suburban. It is not a universal movement in which all the investors are moving in the same direction.
Industrial has been a strong sector for a like time. Do you think, though, that investor demand for industrial assets has reached its peak?
Seward: Demand is starting to slow for industrial assets. The industrial market was on a rocket ship just after the pandemic started. There was all this demand for online shopping. It caused a ripple effect with retailers. They had to increase their warehouse space to handle all this merchandise. Industrial has been on an absolute tear the past two years. We are starting to see that demand is slowing a little bit. But it’s not like it has completely fallen off. Demand for industrial assets is still stronger than it has been historically. When you compare demand to what we saw in 2021, it’s not as strong. But 2021 was a record year when it comes to net absorption numbers. And 2022 was the second-best year for absorption on record. It’s natural to see demand trimming down a bit.
The last two years have been so strong for industrial that we might have gotten a bit spoiled, it seems.
Seward: It’s important to remember what an outlier 2021 was. But in 2022, we still saw almost 480 million square feet of net absorption in the industrial market across the country. That is still well above average. If we didn’t have 2021 as an outlier and just saw 2022, we’d say, ‘Wow. What an amazing year.’ But we were comparing 2022 to a phenomenal year.
The Colliers’ report also said that investors are still interested in last-mile distribution properties.
Seward: All the retailers and logistics providers see that the most important last step to the distribution chain is getting to that last mile. That can make or break delivery timelines. We are seeing more of these distribution centers popping up closer to those big population hubs. Companies can reduce their delivery times with these centers instead of relying on one or two giant super centers. We will see more of these last-mile facilities pop up. Companies are spreading their total square footage over more locations.
Overall, do investors still consider commercial real estate a good home for their dollars, even with the higher interest rates?
Seward: Real estate has always been considered a good hedge for inflation. Commercial real estate is still doing well. We are coming from a very low interest rate environment. Because the interest rates were so low, investors were still able to obtain a large, impressive margin. At the same time, rent growth was rising and vacancies were down. Now that the cost of capital is more expensive, that margin of profitability is beginning to shrink. A higher cost of capital is squeezing that profitability margin. You also have buyers who want a steep discount. Sellers, then, are holding onto their assets. Unless they are forced through some type of event, most of these sellers are going to hold their properties and ride this out. We have a disparity between buyers’ and sellers’ expectations at this time .
Does that mean we’ll see fewer transactions in 2023?
Seward: The first half of 2023 will be relatively quiet. Deals will get done, but not at the pace that we experienced last year. But once the markets get a better handle on what the interest rate environment will be, when we feel we are at that peak where the Fed is no longer going to be increasing its federal funds rate, that will establish a floor. Then the industry can begin to recover and everyone can factor in exactly what the cost of capital is going to be going forward.
