Home Real Estate 5 Insights on the Current State of Commercial Real Estate That Investors Must Know About

5 Insights on the Current State of Commercial Real Estate That Investors Must Know About

0 comment

If you are, or thinking about, investing in commercial real estate, what should you know about the commercial real estate market right now?

Well, the answers very much depend on who you ask. What’s very clear is that two opinions are much better than one. All the officially available data—construction rates, macroeconomic factors, and consumer sentiment reports—point toward a booming market.

It takes an experienced and independently-minded expert to read between the lines and question some of the data and the conclusions about it. That’s exactly what Dr. Peter Linneman did during the recent episode of the Walker Webcast. 

Full disclosure: His take on what’s in store for commercial real estate may not leave you feeling very optimistic, but it’s guaranteed to open your eyes to some of the issues shaping the sector. His insights (supported by solid research) may even save you from making some costly investment mistakes in the coming years.

1. True Rental Growth Is Lower Than CPI Rates

If you’ve been following the recent CPI coverage, you will have noticed that one core CPI marker seems to be continually driving inflation up: the rental market. In April alone, the shelter component of the core CPI was showing an increase of 0.4%, or 5.5% year over year.

For an investor in the rental market, this would seem like good news because the obvious translation of these figures is: Rents are growing; therefore, the rental market is a safe bet right now.

The reality is far less clear-cut. There are a couple of serious flaws in how the shelter segment of the CPI is calculated. One of them is the fact that actual rents include both old and new leases, which can skew the numbers significantly. According to several studies, the inclusion of rents, regardless of when the lease was signed, leads to a data lag of 12 to 18 months.

The other problem with the CPI calculation method is that it relies on the OER number for a third of its data. The OER, or Owners Equivalent Rent, estimates the amount of rent a property could generate based on its current value and relies on surveys of current homeowners. As such, it’s a number based entirely on people’s perceptions of current home values, not accurate valuations.

Unsurprisingly, the vast majority of homeowners have a wildly inaccurate perception of how much their homes are worth. According to Fitch Ratings, this occurred in 90% of the country’s metropolitan areas as of the end of 2023. On average, homeowners overestimate their home values by 11%.

Without these inflated metrics, the true rate of rental growth is much more modest. Zelman (a Walker & Dunlop Company) tracks actual single-family rental rates, and they’re up just over 3% year over year. 

2. The Office Space Sector Is in Trouble

The dramatic decline in demand for rental spaces during the pandemic has been well documented. And yet the projected return of office workers to office spaces was supposed to rebalance the office space market. Peter Linneman was one of several prominent economists predicting this return, but, as yet, this migration back to the office hasn’t materialized.

According to a study by the McKinsey Global Institute, office attendance has stabilized at 30% below pre-pandemic levels, and the office space real estate sector is following a consistently downward trajectory. The Institute estimates that demand for office spaces will have fallen by 13-38% between 2019 and 2030.

Apart from this very obvious factor that is triggering a decline in the office space sector, there are issues with how the construction and banking industries are handling the situation that are compounding the unfavorable conditions.

The construction industry is responding to the office space crisis in a way that is profoundly counterintuitive. Instead of slowing down the pace of construction, Dr. Linneman points out that there is $80 billion being poured into new office construction. The idea, apparently, is that commercial developers are hoping to entice companies to the most innovative and high-end office spaces. That is despite the fact that all indicators suggest that the issue is not with outdated office spaces but with changing work patterns.

Finally, the reluctance of lenders to take office buildings back through foreclosure could spell further issues down the line. Banks are preferring to restructure commercial loans instead of foreclosing. This is understandable since they don’t want to have to pour even more funds into the increasingly unprofitable real estate sector, but it is making it harder for investors to move on from this type of investment if it shows signs of failing.

3. Consumer Confidence May Be Wobbling

There’s a lot that’s been said over the past year about the remarkable resilience of consumers in the face of continued uncertainty about the economy. The narrative goes like this: unemployment is low, there are jobs, and credit card spending is high, but that’s actually an indicator of a strong economy. People may not be able to buy homes, but they’re spending on vacations, consumer goods, and eating out, which seems to paint a picture of people who are, by and large, feeling positive about their finances.

This positive assessment does not tell the whole story, however. The unemployment rate figure, in particular, is unreliable since it doesn’t take into account everyone who is currently un- or underemployed. That’s mainly because the figure presented by the US Bureau of Statistics relies on the Current Population Survey. As we’ve seen with the case of rents and home valuations, surveys do not provide accurate figures.

A more accurate unemployment rate may be much higher than the 3.9% April figure given by the Bureau of Labor Statistics. Peter’s own calculations bring that rate closer to 6.6%, almost double the official figure. If that number is closer to the truth, the overall picture of consumer confidence begins to look a lot less rosy. That’s not to mention the fact that the Consumer Confidence Index is showing a consecutive decline as of April. Currently, it’s at its lowest level since July 2022 and considerably lower than its peak levels in 2019. The effects of the pandemic on people’s finances may be more widespread and longer lasting than official economic readings like to admit. 

4. Multifamily Development is About to Slow Down

This is not the news any real estate investor wants to hear right now. Multifamily has been touted as a lucrative investment strategy, not least because the housing crisis is boosting demand for new multifamily starts.

However, there are further factors affecting the multifamily sector than just the supply-demand dynamic. The biggest among them is the fact of the rising construction and insurance costs coupled with stagnant or slowing rental growth. Developers are catching on to the fact that investors are more and more wary of increasing costs. Insurance costs, in particular, have risen sharply over the past year. 

Another factor that is slowing down the multifamily sector is what Peter refers to as the “not in my backyard” mentality many people have about having multifamily developments in their areas. This opposition has led to the upholding of zoning laws that restrict multifamily development and, in some areas has banned them altogether.

Overall, recent research suggests that multifamily development will begin to slow starting in 2026. It doesn’t make it a bad investment option per se, just not the housing holy grail it has sometimes been presented as.

5. The End-of-Year Fed Funds Rate Outlook is Still Uncertain

Finally, what every investor wants to know right now is whether the Fed will deliver the much-anticipated rate cuts this year. With so many contradictory narratives about what the economy is really doing, it’s understandable that so far, the Fed has been hesitant to promise anything definitively. 

Let’s have the good news first. Inflation is coming down, and if we take into account the potentially fictitious housing inflation figures based on OER, it could be a lot lower than the Fed currently believes. Peter’s thinking is that ‘‘the Fed will eventually come to terms with that at some point this year.’’ 

Now, the potentially not-so-good news. Because interest rates only truly affect the housing and auto industry segments of the economy in the short term, the Fed may simply not care enough to cut rates so long as the rest of the economy is doing well. They may well opt for the cautious approach and keep interest rates exactly where they are for now.

This article is presented by the Walker Webcast

Walker Webcast Main Tagline 02

The Walker Webcast is in the top 1.5% of podcasts globally and has over 10 million views. The webcast brings brilliant minds from broad and varied backgrounds to engage in conversation with our CEO, Willy Walker.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

Source link

You may also like

Copyright 2023 Digital Times. All Right Reserved.

Powered By