Challenging months ahead. That’s what two commercial real estate veterans say awaits the Kansas City CRE market.
Aaron Mesmer, principal with Kansas City, Missouri-based Block Real Estate Services, and Kenneth Block, principal and managing member of the firm, told Midwest Real Estate News that while the fundamentals of most commercial sectors remain strong, high interest rates and construction costs have slowed both development and sales activity in the Kansas City market.
When will development and sales activity pick up here? That depends largely on what the Federal Reserve Board does with interest rates, Block and Mesmer said.
“There has been a general slowdown in new construction because of the rising expenses of construction and the higher interest rates,” Mesmer said. “In general, there is some reluctance of buyers to make new deals until there is more certainty in the market. We have seen the number of transactions fall off from where it was a year ago.”
This doesn’t mean that the Kansas City commercial real estate market is in freefall mode. As both Block and Mesmer say, leasing activity remains high for most sectors. And if the Fed is near the end of its interest-rate hikes? That would be good news for this market.
“We are finding our footing a bit,” Mesmer said. “There are some opportunities out there for decent deals with reasonable returns. As a company, we are trying to get projects teed up and to the starting line for development.”
Development challenges
Block said that developers today face two challenges. Construction costs have risen, with the cost of labor and materials high today.
Then there are the higher interest rates bedeviling the commercial real estate industry. It’s made developing commercial properties, whether industrial, multifamily or retail, far more expensive.
“Team up inflation with higher interest rates, and it’s basically made doing projects really not that smart today,” Block said. “You can’t track where your costs are going when rates are rising. We’d get a price and then three weeks later, we’d get a new price. Because of this, we stopped all new projects this year.”
The good news? Most analysts are predicting that the Fed is at least near the top of where it will push its benchmark interest rate. There might be one or two more rate increases, but these won’t be major bumps.
And while Block is waiting for rate stability, the company is doing everything it can to get its projects ready to go. That way, when rates do settle and stability returns to the market, Block can jump quickly back to development work.
A sales slowdown
As in other markets, commercial real estate sales have slowed in the Kansas City region. That’s to be expected: Higher interest rates have convinced many sellers to hold onto their properties. And buyers aren’t happy with the prices that sellers are attaching to their commercial buildings.
“There was a lot of profit-making over the last several years,” Mesmer said. “There were many scenarios in which the sellers would sell but only if they could get a crazy number. They were getting that crazier number more often than you’d think.”
As Mesmer says, transaction volumes were higher than normal before interest rates began rising. They have been lower than normal for the last year. Mesmer predicts that transaction volume should normalize as interest rates stabilize.
This doesn’t mean that sales volumes will be as high as they were before the Fed began its series of rate hikes. Again, sales activity before the Fed’s moves was abnormally high. It won’t be easy for sales volume to match those highs.
“I don’t think anyone is saying that the Fed will raise rates another 400 basis points,” Mesmer said. “You can decide whether the Fed might raise its rate by 25 basis points or maybe another 50. But you won’t see that big increase again. When we see that stability, I think you’ll see more sellers willing to sell. For now, though, many are sitting on their properties and waiting to see what might happen.”
Some commercial sales will be forced by the structure of loan deals that were completed two or three years ago. As Mesmer says, the first of these big financing resets will happen in the third quarter of this year.
“The fundamentals are still good for most commercial real estate types, except for office,” Mesmer said. “Multifamily rents have gone up. Industrial rents have gone up. But when the interest rate goes from 3.5% to 6.5%, does that cause an issue with the lender? Or does it mean staying involved in a property and devoting much of what was once cash flow to debt? This will play out during the next six to 12 months. In some cases, the borrowers are strong and will have the capital to put more money in. In others, the borrowers will be kicked off the horse.”
An office bright spot
The office sector is struggling in the Kansas City market, much like it is across the country. But Block pointed to one strength of this sector: office space located in mixed-use developments.
Block said that mixed-use developments remain in demand. And that includes office space located in them.
“Office in true, modern mixed-use developments, with restaurants, retail and living accommodations, is performing well,” Block said. “The rents are strong for these spaces, and so is the demand. There is an interesting break with the haves and have-nots. The Class-B and C-plus office spaces are struggling quite a bit. Tenants don’t want to go into those spaces.”
Many of Kansas City’s older office buildings have been targeted for redevelopment, Block said, with many slated to become multifamily space or hotels.
Some of this has already happened in downtown Kansas City, Block said. Construction crews have transformed much of the class-C office space in the center of the city into apartment buildings or new hotels.
This has had a positive impact on Kansas City’s downtown, with Block saying that these repurposed projects have helped push down the office vacancy rate in the city’s urban core.
The challenge? Not all Class-C and -B office buildings can be converted affordably to other uses.
“Does the building work for that renovation?” Block asked. “You have to look at how the building is sized. You have to look at its core and the distance from the core to its outside walls to make sure it’s a good fit for residential units. Some buildings don’t fit correctly. They have too much core area, too much wasted space.
“Some of these buildings are in the right locations, but some are in the wrong locations. Those that are in the wrong locations will be removed and some new product will be built. Those in the right locations are going to be repositioned if the economics make sense.”
Suburban office spaces with their large parking lots provide enticing development opportunities, too, Mesmer said.
With more people working from home, suburban office parks that once needed four parking spots for every 1,000 square feet might now need one-and-a-quarter to one-and-a-half spots for the same amount of office space. This means that a portion of their parking lots can be used to house new developments.
Mesmer points to a suburban office development in Overland Park, Kansas. This building boasts a large parking lot. But because it no longer needs as many parking spaces, the owner is turning a portion of the lot into a Dunkin’ Donuts.
The flight to quality
Block says that the flight to quality is real in the Kansas City office market. When office users do move into new space, they are increasingly leasing a smaller amount of space. That space, though, is higher quality.
This way, office users get a better quality of space while spending about the same amount of money.
“We have been fortunate in that the buildings that we build are always Class-A-plus with first-class locations,” Block said. “We have attracted a great group of tenants to our office space. The quality of the space and the amenities a space offers are so important. What you must do to attract workers today is different than what you had to do 10, 15 or 20 years ago.”
The office sector remains in limbo largely because so many employees are still working from home. Some major companies are now requiring that their workers return to the office, at least on a hybrid basis.
But these moves have yet to result in a lower vacancy rate or more activity in the office sector.
Block, though, said that this will gradually change as more workers return to the office.
“Employers are finding that they are not getting the level of quality work out of employees when they are not in the office,” Block said. “They are not getting the synergy between employees. And don’t forget, part of the payment that employers make to their employees is for their commute to the office. That has been figured into the employees’ pay. If employees are not commuting, the employer might say it needs to pay them less. They are not spending the time or money or gas to commute into work. That is starting to happen now. It is a very fluid office market today.”
The fundamental strength of other sectors
While the office sector continues to struggle, other commercial sectors remain solid, such as multifamily and industrial.
Demand remains high for apartment and industrial space throughout the Kansas City region and the entire country.
Mesmer, though, said that he has seen a slowdown in rent growth in some multifamily markets. Fortunately, the Kansas City market has bucked that trend, he said.
“Kansas City developers were more reluctant to build a lot of product at once,” Mesmer said. “We have had fewer units delivered relative to our peer cities. Our rent growth is strong because of this lack of supply. In other markets, we are seeing a slowdown in rent growth. And that slowdown does have an impact on the number of transactions in this sector.”
The underlying fundamentals of the multifamily market remain strong, though, Mesmer said. That’s largely because the country is still undersupplied when it comes to housing.
“We think that the multifamily fundamentals will remain strong for some time,” Mesmer said.
The commercial industrial market has remained strong for several years, too. Demand remains exceedingly high for industrial space throughout the Kansas City market, Block said.
That doesn’t mean that even this sector doesn’t face challenges today.
Block pointed to the high costs of construction. As he says, the cost of building a simple industrial property has risen more than 30% during the last two years. What might have cost $60 a square foot to build now costs $80.
At the same time, interest rates that were in the low 3% are now in the high 6% range or at 7%. That makes the cost of borrowing money higher.
This means that developers have to charge higher rents for new buildings. Blocks says that industrial buildings that might have rented for under $4 a square foot are suddenly charging $6.40 a square foot.
“In the short term, industrial development activity has slowed in our market,” Block said. “Some buildings have been completed recently. But there is not a lot of new development taking place now. There is still good activity in the smaller, light distribution market. But that product is also filling up. It’s a weird market.”
Another challenge? Many banks are not providing the financing that developers need today, with many sitting out until the economy stabilizes, Block said.
“A lot of banks are very cautious,” Block said. “If you come in with a deal at this point, they wonder what you are doing. ‘Don’t you realize that the marketplace is terrible?’ Everybody is looking at less money today. Some of the big commercial brokerage companies are cutting back on people right, left and in-between. If you are doing 20% or 30% less business, you are clearly in a position where you don’t have the capacity to get the income you need. You have to cut expenses.”
Again, though, that doesn’t mean that there isn’t optimism in today’s market. Just look at Block Real Estate Services. As Ken Block says, the company has probably 20 multifamily projects that it will be ready to develop once the economy improves and interest rates stabilize.
“We want to be ready,” Block said. “But we won’t start developing these projects until the exact clear moment that the market is settling down. When that happens is unclear now.”