US Regional Real Estate 2023

Overview

The US commercial real estate industry contended with inflation, rising interest rates, credit contraction and a slower-growing economy as 2022 drew to a close. The impact of shifting office use habits is being felt in the real estate economy beyond office occupancy, and an unsettled banking environment has further tightened the availability of credit, while on the expense side, the phase-in of federal and state climate and emissions regulations have necessitated investment in new technology and retrofits. While COVID-era logistics logjams and materials shortages have moderated, the costs to develop and improve real estate continue to grow due to increasingly stringent underwriting standards, high and still growing interest rates and a still-strong labor market.

Even as the real estate economy cooled at the end of 2022, it was still a banner year for the real estate industry. Investor interest was particularly strong in the multifamily and industrial sectors. Despite what CBRE calculated as a USD671 billion drop in real estate transaction volume in 2022, down 17% from 2021, JLL notes that global real estate investment activity in 2022 was still at USD1.03 trillion. Recent bank failures have further constrained credit in the first quarter of 2023, and interest rates have continued their relentless increases, though we are likely nearing the end of the increasing rate environment. 

Most economists agree that a recession is imminent, but there appears to be an emerging consensus that the slowdown will be relatively mild and brief. There also seems to be growing consensus that the expected recession will be unusual in that it will not be accompanied by a large drop in employment by historic standards. The Conference Board predicts the unemployment rate will reach about 4.5% in 2023, up from 3.5% as of September 2022, an easing but far from an erasure of labor shortages. Uncertainty remains the key theme in 2023 as concerns persist around the direction of interest rates, the early signs of a banking crisis, sticky inflation and Russia’s war on Ukraine.

The Industrial Sector

In 2022, demand for warehouse and industrial space remained strong, fueled by, among other factors, the persistence of online shopping and the onshoring of manufacturing. Since 2020, industrial demand has outpaced supply, resulting in record-low vacancies and higher rents, but as the year unfolded in 2022, and continuing into 2023, investor interest has been muted by higher interest and capitalization rates. CBRE reported a record 661 million square feet of industrial space was under construction in the third quarter of 2022, up from 448.9 million square feet in 2021, which itself was a record-setting year. With construction delays clearing, new completions of industrial properties are expected to break records in 2023. Longer term, however, the current pullback in new construction starts could cause industrial completions to fall to an estimated 250 million square feet in 2024, further diminishing first-generation space options, according to CBRE, but potentially increasing demand for existing industrial assets.

Industrial leasing activity is forecast to moderate in the coming months as inflation cools consumer demand and excess inventory accumulates. While rent growth is bound to slow from its blistering pace in 2022, barring a serious recession, rents are expected to remain high amid historically low vacancies if the economy avoids a serious recession. In general, new properties are being built larger to capitalize on strong occupier demand. Properties encompassing more than 500,000 square feet account for 20% of projects under construction, versus only 5% of existing inventory, according to JLL.

Despite a slowdown in e-commerce sales growth off the blistering pace of the COVID years, e-commerce remains well above pre-pandemic levels, representing around 19.5% of total retail sales as of the second quarter of 2022, according to CBRE. As consumers buy more products online, retailers likely will need more space for order fulfilment and storage, further driving up demand for regional and last-mile distribution facilities. This demand is likely to be heavily concentrated in markets with strong population growth and favorable demographic trends, like Nashville, Salt Lake City, Las Vegas, Phoenix and Central Florida.

US import patterns could change amid geopolitical tensions with China, bringing an increase in cargo volumes through East Coast ports. This could stimulate demand for industrial space near ports like Savannah, Charleston and Baltimore, while the recent increase in onshoring of manufacturing operations could benefit Phoenix, the major Texas markets, Atlanta, Cincinnati, Greenville-Spartanburg and North Florida, according to CBRE. Higher fuel costs and tight labor markets could spur demand for distribution space near US transportation hubs with good infrastructure and favorable labor markets, such as Louisville, Memphis, Indianapolis and Kansas City.

Other contributing factors to the sector’s resilience include the expansion of automated technology and robotics, which require modern building design and amenities, and regulatory and ESG-driven investor pressure to improve the energy efficiency and sustainability of warehouses and logistics centers. The conditions are present for the industrial sector to experience another year of low vacancies, solid rent growth and continued investor demand.

The Office Sector

The pandemic may have fundamentally changed the way offices are used, with white-collar workers moving to an at-home or hybrid schedule rather than commuting daily. Recently, though, many firms have been bringing their workforces back to the office, leaving uncertainty around the permanence and depth of out-of-office trends. One of the consequences of the shift away from synchronous work is a deepening divide between fully modern or modernized new Class A buildings and other office properties. Modern, well designed, sustainable buildings that offer flexible workspace and high-quality amenities are in highest demand, while older buildings generally are more vulnerable to a slowdown in leasing activity. As federal and local climate and emissions standards are implemented, a larger and larger segment of the office occupier base will be required to occupy energy and emission-efficient spaces, further depressing demand for un-modernized office product. If a recession takes hold as expected, office-based employment could decline, but because many office occupiers have faced a tight labor market over the past several years, layoffs are expected to be less severe than in previous downturns. Given what seems to be a recent trend in firms seeking to increase office utilization and attendance, along with the need to occupy efficient, modern facilities, demand for the very top tier of office products should remain strong in 2023, but demand likely will continue to decline for the remainder of the office market. 

CBRE estimates that 38 million square feet of new office construction will be completed in 2023, down 27% from the five-year average. There is plenty of inventory in the overall market, but not enough of the modern efficient space for which demand is strongest. The next months are expected to see brisk leasing and healthy rent levels across Class A properties in popular Sun Belt markets and life sciences hubs like Boston. Although investment activity in life sciences properties has slowed from its record pace in 2020 and 2021, the outlook for the subsector remains strong, with overall vacancies low and rents above pre-pandemic levels.

2023 and beyond likely will see the owners of Class B and C buildings struggle to backfill space, adding downward pressure to rents. Faced with lower valuations, reduced investor and tenant demand, and higher interest and operating costs, an increasing number of non-institutional office assets could experience financial difficulties and become distressed or insolvent over the coming year. Much has been written about the conversion of Class B and C office assets to residential to meet housing shortages nationwide. That, however, is a capital-intensive process that requires entitlements and zoning changes in many jurisdictions – a years-long process that is unlikely to provide relief to office owners under current stress.

The Hospitality Sector

The US hospitality sector has rebounded from the near-complete stop of the pandemic years. With travel patterns largely back to normal but many hotels shuttered permanently post-pandemic, in 2022 revenue per available room (RevPAR) hit 108% of pre-pandemic levels and hotel gross operating profits reached their highest levels since 2019, according to CBRE.

Researchers predict a strong summer travel season as more international tourists visit the US from major markets in Asia and Europe due to easing travel restrictions and a weakening US dollar. An expected rise in airfares should encourage many US travelers to vacation closer to home rather than travel internationally. Drive-to leisure markets and corporate-oriented markets with strong leisure appeal are expected to continue to outperform expectations. There also appears to be significant upturn potential for trophy assets, boutique hotels in prime or supply-constrained destinations, and newer or remodeled central business district properties. 

Investor activity has rebounded and is expected to improve further in 2023. A recent survey of global hotel investors found that 20% of respondents plan to deploy USD501 million to USD1 billion+ worth of capital into the sector, up from 7% of respondents in 2021 and 16% in 2020. As in other sectors, tightening credit, higher interest rates and an impending recession could dampen investor enthusiasm. 

The expected modest rise in overall unemployment could partially alleviate the labor shortage across the hospitality sector, but the industry likely will continue to face structural labor challenges, driving adoption of new technology and practices, such as mobile or kiosk-based check-in.

Other Sectors to Pay Attention to in 2022

Multifamily

The US multifamily sector benefited from strong tenant demand between 2020 and 2022, with 3% vacancy and double-digit rent growth. Demand for multifamily rentals was particularly strong in lower-density and less-expensive submarkets due to, among other things, a pandemic fueled move out of cities and the growth of millennial families. Although leasing activity has slowed from pandemic-era highs, the sector is expected to hold up relatively well in the coming months. CBRE predicts that multifamily occupancy rates will stay above 95%, driving 4% rent growth in 2023.

Among the factors propping up residential rental demand is the steep increase in the costs of home ownership. The average monthly cost for a newly purchased home in the third quarter of 2022 was 57% higher than the average monthly apartment rent – the largest gap on record, and well above an average pre-pandemic premium of 8.5%, according to CBRE. Rising interest rates and tightening credit will likely increase this discrepancy.  Significant supply-side pressure should remain. While CBRE estimates that 450,000 multifamily units in 69 markets will be completed this year, adding 2.6% to the total inventory, nationally 3.5 million additional market-rate multifamily units will be needed by 2035 to keep pace with demand, according to CBRE. Despite a supply-constrained market, investment performance will be pressured by inflation in energy costs, materials costs and other maintenance inputs, increasing interest rates and credit constraint.

Senior housing

Continuing a rebound, the US senior housing sector is attracting more interest as investors seek higher yields from alternative asset classes with solid market fundamentals and growing demand. A recent JLL survey found that 44% of respondents might increase investment exposure to senior housing this year, while another 44% had no plans to change their current exposure, indicating optimism or at least a belief in the sector’s stability. With the 75-plus population in the USA projected to grow sharply in the coming years, more senior housing likely will be needed to meet the surge in demand from this “silver tsunami”.  Again, rising interest rates and operating costs combined with constrained credit may dampen investor enthusiasm in 2023. 

Conclusion

The depth and duration of the slowdown in real estate investment activity largely will depend on the future direction of inflation, monetary policy and health of the credit markets. Many economists are confident that a US recession, should it occur, will be relatively shallow and short-lived. Investors continue to prefer fast-growing Sun Belt markets such as Austin, Dallas, Los Angeles, Miami and Nashville. The most sought-after sectors include multifamily and industrial, led by modern logistics centers in key markets. Whether pandemic trends in working behavior continue or abate could dictate the extent to which the gap between Class A and secondary office space widens further. Concerns over inflation, banking failures, higher loan defaults, rising interest rates and a possible recession likely will weigh on investment volumes through the first half of 2023, but as these issues stabilize, possibly by year-end, investment activity could pick up again in 2024.