CRE values will decline broadly, but notable opportunities exist
There’s a perception that there are no transactions out there, but when you think about real estate activity over the last decade, 2023 is shaping up to be “more or less” the same as what we’ve seen over the past decade, said Cedrick Lachance, director of research at Green Street, in a recent Green Street webinar on the outlook for commercial real estate (CRE). The year-to-date (YTD) volume of transactions in 2023 is $137 billion, which is above the 10-year YTD average of $130 billion.
Lachance did point to the tightness in the lending market, which is having a meaningful impact on investment, transactions, refinancing and the commercial real estate market in general.
One of the reasons lenders aren’t more active, in addition to the tightness in the lending market, is because “assessed values of real estate are still detached from what is very likely the value of the real estate,” said Lachance. Green Street observed that the NCREIF NPI shows that the real estate community is still overvaluing properties, which is a cause of concern for lenders.
Current lending interest differentiates by sector, however, said Lachance. Data center, industrial and, recently, the hotel sector have all seen significant lending interest. Green Street forecasts that the greatest M-RevPAF growth (a combination of market rent and occupancy growth) over the next five years will occur in the data center, cold storage and industrial sectors.
The greatest NOI growth for the next five years will be in the industrial, cold storage and single-family rental spaces, predicts Green Street.
One sector that has been in decline is self-storage. The sector has experienced a decrease in occupancy rates and rent growth due to current deliveries being in excess of what the market is willing to bear and because of the low level of activity in the for-sale housing market.
The office sector has been bludgeoned in the past year as valuations have dropped while work-from-home and hybrid work have become seemingly more permanent. Yet Lachance said that high-quality office is in great demand and that office prices seem to have stabilized in recent months. “What the public market is saying is nine-and-a-half cap rates, which is the average of the companies we cover, is more or less the right cap rate now,” he said. “It’s important to note that the public market is no longer reducing its expectations for office, so there is an element of stability that exists.”
Insurance costs have gone up significantly in various regions as the cost of climate events are coming into pricing, which “a lot of us would have factored in over a much longer period,” Lachance said. California, Florida and the Sunbelt region are experiencing particularly high increases in insurance costs.
As those costs increase, “at some point [it] will change the value proposition of moving to the Sunbelt or of staying in the Sunbelt, and in which Sunbelt market to be in,” he said. Those insurance costs should prompt investors to consider the near-term impact on expenses and the longer-term prospect that people may emigrate or decide not to live in particular regions, such as the Sunbelt, because of climate events and high insurance costs.
With coming CMBS maturities, many properties are going to need more equity to get to a 55 or 60 LTV ratio, and Lachance said that for Green Street, “That’s telling us that properties are going to have to change hands, that lenders are going to have to do something. In the CMBS business there’s not a lot of pretend and extend, so that will be more difficult. On the banking side I think we’ll see a lot of activity on the part of the banks to work with borrowers and potentially be very comfortable with taking a little bit longer risk not to mark loans down, something that the government regulators have already told them is absolutely acceptable.”
Lachance and Green Street expect there to be more than a 10 percent decrease on real estate asset values over the next 12 months. “All signs point to further decreases in asset value,” he said. “It has everything to do with rates. It has a lot to do with duration, in fact, and continued growth in real yields in the United States, and that is the biggest risk in the marketplace right now.”
He also discussed the changing landscape for data centers, which in the past decade have experienced decreases in market rents. That is changing quickly, as AI is increasing demand significantly. “We are very positive about the prospects for rent growth overall in the data center business,” Lachance commented, “with a lot of ability to push rents in some of the key top markets in the United States.”
Malls are also more intriguing than in past years. Green Street has recently been upgrading more mall properties than they have been downgrading, which reverses a trend. “These sectors, we really need to retool our minds, basically, when it comes to retail, and think of it as having gone past that big storm and being a very interesting potential investment,” said Lachance.
One topic that Lachance emphasized is the opportunity for investment in the public residential market. “The residential side in the public market is vastly cheaper than the private market,” he said. “You’ll make a lot more money doing it [buying apartments and building single-family rental portfolios] on the public side because the discounts you are assessed at value are so meaningful. You get to buy apartments at over a 6 cap rate today in the public market. I doubt that’s possible on the private side. And in the single-family rental business, you do partner with very high-quality operators on the public side, and on top of it, that can be done at an implied cap in the mid-fives that’s very interesting.”
Lachance also specifically highlighted Boston as a market that is poised for great market rent growth and for good returns in its apartment and office sectors. “The city that often shines for us is Boston,” he said. “It has this rent growth we just talked about, and the entry point is such that it’s a market that we find attractive.”
Toward the end of the webinar, asked about senior housing, Lachance observed that the sector is broadly in a big recovery. Assisted living facilities should recover to similar occupancy levels to pre-COVID, he said. For senior housing, it is independent living facilities that are most at risk for recovery rates, he said.