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The Commercial Market: Then, Now and into 2022

6 Jan, 2022

By: Fred D. Burkhardt
Then, Now and into 2022
Early 2022 brings mixed news for the real estate market. A PwC US report prepared in conjunction with the Urban Land Institute entitled, “Emerging Trends in Real Estate 2022” has found that, regardless of the industry sector, uncertainty remains a key component. Property markets that were once counted as relatively predictable will continue to be uncertain. The good news, according to the report, is that decision-making confidence has improved since mid-2021. In fact, 75 percent of survey respondents reported feeling more confident making long-term strategic decisions. This figure stood at less than 50 percent in last year’s report.
 
Real Estate Certainty Decimated by COVID-19
Unsurprisingly, the global pandemic is at the root of the problem. Restrictions and lockdowns in 2020 and 2021 facilitated significant drops in revenue in the retail, office, and hospitality segments. Even here, the news hasn’t been all bad: data centers, e-commerce and housing industries reported record real estate highs. 
 
As the effect of the pandemic continues to fade in some parts of the country, it makes sense that companies and investors are eager to get back to their pre-pandemic activities. Nearly two years into the pandemic, with nearly 60 percent of the U.S. population vaccinated, pent up-demand has laid the groundwork for a return to some level of normalcy. 
 
From investors’ perspectives, real estate has emerged as a winner during the pandemic, and the housing industry has led the way. While the demand for housing remains high, the soaring prices might stagnate as soon as more people start listing their homes to meet the growing demand.
 
Many analysts who cover the commercial real estate market have predicted a positive year ahead. The National Association of Realtors (NAR) Economic and Commercial Real Estate Outlook 2021–2022 showed that American workers are slowly returning to offices, further revealing that demand for retail and industrial real estate space remains steady. While the vacancy rates in offices remained high in Q1 2021, not much change has been observed for shopping centers, industrial spaces, and multifamily units.
 
Factors Impacting the Market
Before looking to the future, it’s important to consider that few – if any — industries have seen a return to life as it was prior to the COVID-19 pandemic. But as the dust settles, the commercial real estate industry is looking at how to adapt to emerging trends and develop new standards. Some of these factors are covered in the following sections.
 
Working remotely. American workers like working from home, and companies are realizing that there is money to be saved with this trend. Telecommuting’s impact has been significant, as evidenced by the number of companies moving into smaller spaces or repurposing non-traditional spaces to accommodate the company’s changing needs.
 
The Zillow Economic Research & Pulsenomics” survey puts this shift in the relationship between the workforce and workplace into perspective. Ultimately, the impact of this shift will affect the real estate market recovery, which is expected to remain uneven throughout the first half of 2022. 
 
Access to capital. Looking back at the last 15 months, it becomes clear how different the market-changing event of COVID-19 was compared to prior market corrections. The debt capital markets have seen volatility, particularly in public markets like commercial mortgage-backed securities, mortgage REITS, and agencies such as Freddie Mac and Fannie Mae. Swings in risk premium spreads have been dramatic. The number of non-current loans reverting to current and viable loans on income-producing properties is being driven by performance and the impact of changes in e-commerce, travel, and office use and demand.
 
Mortgage REITs took significant hits early in the pandemic, but there has been some recovery driven by restructuring credit lines and paying down credit facilities that experienced margin calls. Debt funds issuing short-term transitional bridge and mezzanine loans have experienced stress, much of which came from financing costs. 
 
Private equity funds have raised significant capital for various real estate sectors, with $371.8 billion available as of the beginning of the third quarter of 2021. With public, institutional and private equity capital providing the market with a view of valuation and pricing, we still have not had an active transaction market. While transaction volume is slowly recovering, it’s still well below pre-COVID levels. Price discovery continues to be limited, and buyers and sellers are holding their ground on the bid-versus-ask for assets that are still viewed with uncertainty as owners look to vaccines and boosters to predict timing for a return to normal. The market has not seen the volume of expected distress sales, but there is plenty of capital ready to deploy.
 
Essentially, the market continues to be flush with debt capital liquidity, despite property type and market uncertainty. Looking into 2022, performance will dictate the amount of distress and losses, and risk management should dictate markets, property types, leverage, loan structure and pricing for mortgage debt. 
 
Sector by Sector Assessments
 
Industrial real estate. E-commerce-driven changes in consumer behavior – a drive to purchase online has led to a surge in demand for logistics real estate. It is estimated that leasing industrial space for inventory and data connectivity could reach 250 million square feet to accommodate this trend.
 
While inventory storing and management is essential for e-commerce giants, the booming industry is driving the demand for niche commercial real estate sectors like cold storage and data centers. Content and cloud services providers have been eager to acquire the facilities they need to meet high demand. 
Data centers provide the infrastructure that makes it possible to shop online or work or attend school from home. Interestingly, the growth of data centers is measured in power output and not square footage. Currently, 373 megawatts equivalent of industrial space is under construction compared to 134.9 megawatts in the first half of 2020.
 
While the demand for dry warehouses has increased, the growth in online food sales, including perishables and refrigerated foods, has encouraged e-commerce giants to lease cold storage units to streamline operations for the fresh grocery delivery business. Since cold storage is a niche and maturing sector with high risk-reward possibilities, a growing number of investors are looking for long-term leases, reliable tenants, and even joint ventures with cold-chain operators in urban cores. Even though the initial investment is high, especially for cold storage units with specific requirements, they tend to yield higher rents than dry storage warehouses. 
 
Retail sector. The reopening of many brick-and-mortar stores brought hope to the retail sector, but long-term growth appears shaky as retailers are finding it difficult to overcome barriers to shipping and logistics. While physical stores might provide the much-needed engagement consumers want, business foreclosures and bankruptcies are expected to continue to rise. 
 
With few exceptions, malls and urban retail facilities are facing low occupancy and rental income. Mall owners are suffering, striving to devise new strategies like conversion to industrial space or adaptive reuse of their properties with multifamily units or hotels depending on localized demand. 
Though investors might be hesitant to invest in the retail sector until life returns to something resembling normal, the demand for high-quality grocery-anchored centers with strong sales and long-term tenants remains stable.
 
Office spaces. The return of employees to offices combined with the pace of vaccination provides some indicators of the shape of the recovery of the office space market. It’s probable that many companies will allow employees to work from home indefinitely, but those workers who return to workplaces might demand more personal space for social distancing, which could end the era of densely populated offices. 
 
This may drive demand for more space per employee, inducing employers to seek larger but cheaper office spaces in the suburbs. Although a CBRE analysis showed that remote working could reduce the overall requirement of office space by 15 percent, office-based employment is likely to increase over time. The 2021 NAR outlook report found that 70 percent of reporting companies are leasing or moving into real estate with smaller square footage to address the remote work trend.
 
Recent statistics found that 52 percent of global employees work remotely at least once per week, and 68 percent work remotely at least once per month. With this move to hybrid work, the commercial real estate outlook shows that office spaces may not necessarily be filled by the same employees every day. As companies move to a more agile hybrid approach, they no longer need to have enough space to house most of their workforce.  The NAR’s commercial real estate outlook showed that 70 percent of respondents are leasing or moving into office space with less square footage due to hybrid schedules. 
 
Working with less space, however, requires more strategic planning. To make the most of their new reality, more business leaders are investing in corporate real estate technology solutions to help them plan and optimize their use of space. They’re also investing in mobile technology that makes it easy for employees to reserve space when they need it.
 
Though office occupancy is falling as companies cut costs or employees work remotely, the NAR reports an overall increase of five percent in asking rents from 2020. The commercial real estate outlook for areas with high vacancy rates — such as in metropolitan areas including New York City or San Francisco — shows rental rates are still down, while rates in smaller cities with lower commercial vacancies — such as Fort Myers and Naples, Florida — are up more than 10 percent. Rather than reducing rent as companies return to the office, commercial real estate landlords are starting to make more rental concessions, including flexible or short-term leasing terms, free parking, allowing subleasing to help businesses offset costs and offering allowances for tenants to make building improvements
 
Fifty-seven percent of those surveyed by the NAR’s report said they are seeing more short-term leases of less than two years compared to pre-pandemic levels.
 
Multifamily units. With variations based on location, the multifamily industry saw a decline in rents and value due to the migration of many American workers to the suburbs. This primarily affected urban apartments in major metro areas. Conversely, markets that witnessed overall growth saw rents rise during the pandemic. 
 
Analysts have predicted that multifamily apartments are on their way to full recovery. Investments in this sector are expected to reach $148 billion by the close of 2021, a 33 percent increase compared to $111 billion in 2020, and sustainable growth through 2022. 
 
Build-to-rent (BTR) projects scheduled to be delivered in 2021 or 2022 might work for some investors as well. BTR is a relatively new real estate model that involves building homes inside a professionally managed community similar to traditional gated societies with premium amenities.
 
Conclusion
Though the pandemic has spared no regions of the country, its impact on U.S. property markets diverges significantly from the last economic recovery. Some sectors, like industrial properties, have barely paused due to a surge in online spending-spurred tenant demand. The same is true for multifamily properties, with tenant demand still increasing and rents back to record levels throughout much of the country.
Despite this surge, the pandemic accelerated the retail property sector’s long slide, with store closings and vacancies rising. The only exceptions are grocery-anchored centers, dollar stores and home improvement retailers, all of which are seeing growth. The office sector is in the middle of a major reset, with vastly different outcomes based on location and whether a building has flexible layouts and better ventilation systems. Even so, vacancies are expected to keep rising.
 
The pandemic has magnified an ongoing shift away from expensive downtown markets and toward smaller, more affordable ones. As a result, businesses need to stay nimble. Uncertainty can be a curse, or an opportunity. T&ID
 
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