Covid’s Long Shadow Still Spreads Over Commercial Real Estate

Covid continues to cast a long economic shadow, nowhere more than in commercial real estate. While rising interest rates have had a consistently negative impact on activity and pricing, the pandemic’s aftermath has had a decidedly mixed impact. Some areas, such as warehousing, have enjoyed a boost, while others, such as retail and office space, have suffered. These effects will likely linger.

The impact from rising interest rates is straightforward. The Federal Reserve’s (Fed’s) efforts to counter inflation have raised interest rates dramatically and across the board, raising financing costs in every real estate project. Even as developers have shifted away from debt toward equity financing and received more than the usual attention from pension funds and private equity, as well as hedge funds, these rising costs have discouraged ventures of every kind. And since the Fed has made clear that it intends to drive up interest rates further, these pressures and trends will likely persist at least for a while.

Covid’s legacy is more complex. The mix of effects were screened initially by the striking recovery from pandemic lockdowns and quarantines. From late 2020 to early 2022, commercial real estate boomed across the entire sector. During that time, prices in commercial real estate generally rose more than 80%. Sales rose nearly 30% in 2021 alone. But by the end of 2022, the boom was losing momentum. During the second half of that year, overall commercial real estate prices fell more than 40%, leaving the whole year down 13%. No doubt the rise in financing costs was the major factor creating the turn, but the softening also revealed the differential impact of Covid’s legacy.

Warehousing and logistics have been clear winners. Even before the pandemic, the startling growth of e-commerce was raising the need for warehousing space. The pandemic’s lockdowns greatly accelerated the trend, one that shows no signs of abating even now that economies have reopened. At the end of last year, warehouse vacancy rates stood at a low 3.2%. Pricing in this area, even late in 2022, was up in every region of the country, especially the northeast. The underlying pricing and sales trends are so strong that even recession in 2023 is not likely to reverse them entirely.

Multifamily housing has also led. The rising cost of financing may have pushed up the expense of development, but rising interest rates have also driven families that might have bought in the past into rental units of one kind or another. Demand had outstripped supply so significantly that the median rent rose almost 8% in 2021 and much more in major cities. It appears, however, that development has begun to catch supply up to demand. Median rent rose a relatively modest 5% in 2022. On this basis, gains for 2023, though likely positive, will be more modest.

If the bloom is coming off the rose of multi-family development, it still looks far more attractive than the retail area. In city centers, though many workers have returned to their offices, the foot traffic on which so many retailers rely is still well below pre-pandemic levels. That and the continuing trend toward e-commerce has kept retail real estate on its back foot. Malls have closed and many are being repurposed for residential and office space. With so little building and so much property off the market, things have begun to stabilize. Retail rents are rising again, though at 3.8% in the past year, slower than inflation. That stabilization may persist, but it is hard to see any real gains in 2023, especially given the still strong likelihood of recession.

Office building is probably the most problematic area. Construction costs have risen some 14% in the past year, hardly an encouragement, and most developers will likely remain skeptical until work from home trends and hybrid arrangements become clearer. Vacancy rates, already high at almost 13% continue to climb in every major market. Some suggest that some 10-20% of existing office space will have to be restructured in coming years. Pricing accordingly remains weak. Indicative of the hesitation dogging the sector, commitments to long-term leases have fallen steeply.

The picture can only be described as mixed. Though the rise in financing costs will act as a general drag in the sector in 2023 as will recession, some areas will deal with Covid’s legacy a lot better than others with warehousing in the lead for the time being, and office building, once the darling of the sector, bringing up the rear.

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