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Challenges in commercial real estate

The commercial real estate market has taken a battering in recent times. Property prices have registered a 7% decline in the last year. Since March 2022, they have fallen a staggering 21%.

The bad news does not end there. A massive $929 billion of CRE loans are due to mature in 2024, triggering a wave of refinancing in the current high-interest rate environment. For many borrowers, the only way out may be to sell their properties, adding fuel to the fire of plummeting property prices.

Here is a brief description of some other CRE challenges facing investors and property owners.

High cost of entry

Commercial properties can be expensive. Many can be beyond your budget. Even if you find an asset you can afford, you may not want to put all your eggs in one basket. One way out is to route your investment through a crowdfunding platform. Some accept non-accredited investors, while others require you to be accredited*.

* Accredited investors can invest in securities that may not be registered with the financial authorities. The Securities and Exchange Commission lists certain income, wealth, and other criteria defining these investors.

Rising interest rates

Commercial property prices and interest rates are inextricably linked. Rising rates have a negative effect on property valuations. Unfortunately for the commercial real estate industry, interest rates have been skyrocketing. In the last two years, the Fed rate has gone up from near-zero to over 5%.

Fed rate hikes from March 2022

FOMC meeting date Increase in rate (basis points) Federal funds rate
July 26, 2023 +25 5.25% to 5.50%
May 3, 2023 +25 5.00% to 5.25%
March 22, 2023 +25 4.75% to 5.00%
February 1, 2023 +25 4.50% to 4.75%
December 14, 2022 +50 4.25% to 4.5%
November 2, 2022 +75 3.75% to 4.00%
September 21, 2022 +75 3.00% to 3.25%
July 27, 2022 +75 2.25% to 2.50%
June 15, 2022 +75 1.50% to 1.75%
May 4, 2022 +50 0.75% to 1.00%
March 16, 2022 +25 0.25% to 0.50%

Here is the same data in a graph:

Fed rate hikes from March 2022

Screenshot of Fed rate hikes from March 2022 to May 2024.

Source: Federal Reserve Bank of St. Louis

Although rising interest rates are a big negative, experienced investors with adequate liquidity can take advantage of increasing rates and falling property values to buy distressed assets. Additionally, the high interest rate environment puts buyers in a better position to negotiate with sellers.

Changing economic climate

High interest rates have another adverse consequence. In addition to depressing property prices, they result in a slowdown in general economic activity. This further lowers the demand for commercial property and changes the outlook for commercial real estate.

Finding tenants

The post-COVID world has dealt a body blow to some sections of the property sector. Work from home seems here to stay, and this change is reflected in escalating office vacancy rates. According to data on Statista, office space vacancies stood at 12.6% in Q1 2020. Today, they are at 20.2%.

Will office occupancy rates pick up anytime soon? It is unlikely. A recent analysis by Green Street, a real estate advisory firm, states that it could take five years or more for U.S. office occupancy to reach the level it was at before the pandemic.

ESG considerations

The importance of environmental, social, and governance considerations is one of the most significant commercial real estate trends that have developed in recent times. Building owners, property developers, investors, and other commercial real estate stakeholders must familiarize themselves with ESG government regulations and ensure compliance.

The following is a brief description of the meaning of each ESG component:

  • Environmental: This refers primarily to the building’s carbon footprint, waste management, and water usage.
  • Social: What is the impact of the property on tenants and the local community?
  • Governance: This ESG component concerns diversity, equity, and inclusion (DE&I). It considers issues like whether the property discriminates based on race, gender, or religion.

The good news is that properties that pay adequate attention to ESG factors can gain a strategic advantage and increase asset value. Sustainable and green offices are the future. Property owners and developers should take proactive steps to comply with ESG rules.

Digital economy growth

As the digital economy expands, it will continue to impact commercial real estate. Let’s take data centers, for example. Demand for data center facilities is expected to mushroom. A report from the management consulting firm McKinsey & Company estimates that data center demand will grow by 10% a year until 2030.

However, the CRE industry has several hurdles to overcome to meet this increased demand. One of the biggest is energy. A data center can consume as much power as 80,000 households. Additionally, zoning regulations may need to be changed to accommodate the buildings that house the computers and related equipment. However, the ongoing expansion of the digital economy will ensure that data centers remain a growth area for years to come.

Changing demographics, changing needs

Demographic trends have contributed to the CRE market undergoing a sea of change in recent years. The following are the biggest contributors to the change:

  • More and more people are working from home. Office real estate has borne the brunt of the switch to WFH.
  • Millennials, the country’s most populous generation, prefer to live in the suburbs. Consequently, demand for single-family homes in suburban areas is expected to get a boost.
  • People are migrating from the Northeast and the Rust Belt to Florida, Texas, and the other Sunbelt states. This movement will significantly impact the commercial real estate outlook across both areas.

Rise in experiential consumerism

In recent years, one of the other commercial real estate trends has been the closure of thousands of brick-and-mortar retail stores. This development has given retail real estate a bad name.

However, the reality is quite different.

Colliers, a leading real estate services and investment management company, points out that in 2023, there were 5,865 store openings but only 4,070 closings. One factor behind the expansion is experiential retail, a response to online retail. Brands are fighting back against Amazon and the likes by setting up stores that offer an omnichannel shopping experience that online retailers cannot hope to match.

Workforce housing shortages

The lack of affordable housing has been a stark reality for years. One estimate puts the shortage of affordable rental homes at 7.3 million. Rising land prices and construction costs have exacerbated the problem, and no solution exists.

Old versus new

There is much news about the oversupply of office CRE. A recent report points out that up to one-third of office space could be wiped out in the coming years. While this assertion could be true, it hides a related fact.

There is a shortage of Class-A office properties.

Tenants require modern, newly built office properties that meet their needs. The same is true for the retail sector. Every commercial real estate broker and developer should realize that the immediate requirement is retail and office transformations that cater to tenant preferences and needs.

Regulatory and legal challenges

Regulatory and legal challenges can fall into several categories:

  • Zoning and land-use rules
  • ESG requirements
  • Tax laws
  • Building codes

The best solution to minimize the level of risk from regulatory and legal challenges is to seek help from an experienced legal professional.

Limited liquidity

A December 2023 report from the National Bureau of Economic Research states that because of declines in property values following WFH policies, 14% of all commercial real estate loans and 44% of office loans are in “negative equity,” which means the value of the property is less than the outstanding loan balance.

Raising money for new CRE projects is becoming more difficult in this environment. Wells Fargo, the country’s largest CRE lender, has recently tightened credit norms.

Tips to navigate commercial real estate challenges

The following table outlines the steps you can take to meet the current CRE challenges:

Steps to follow Action points
Tip #1 Market research and analysis
  1. Analyze demographic trends
  2. Study the economic conditions in the immediate area
  3. Which are the predominant industries and businesses?
  4. Which CRE property type has the most scope for growth?
Tip #2 Adaptation and innovation
  1. Consider repurposing office buildings into residential
  2. Focus on steps that can be taken to boost tenant retention
  3. Collect and analyze data
  4. Evaluate new technology–be an early adopter
Tip #3 Collaboration and partnerships
  1. Closely review relevant commercial real estate reports
  2. Talk to lenders–consider innovative financing options
  3. Maintain relationships with other commercial real estate professionals
  4. Stay on top of regulatory and legal changes–stay in touch with an experienced legal professional
Tip #4 Sustainability and social responsibility
  1. Review energy and water consumption patterns
  2. Evaluate waste management systems and policies
  3. Consider setting goals for diversity, equity, and inclusion
  4. Develop ties with the local community and partner with local businesses

Opportunities in the commercial real estate market

Here are two CRE industry developments that can present new opportunities for investors and developers:

Evolution of workspace trends

The office market is in a sorry state because of remote working. However, Class-A office space is doing well. According to CRE services firm Cushman and Wakefield, rents for Class-A office buildings command a 51.5% premium over other office space. And there may not be enough high-quality office stock to meet demand.

Property managers should stay on top of evolving workspace trends by adopting smart real estate management techniques instead of continuing with a business-as-usual approach.

Emerging markets and urbanization

Some of the CRE markets expected to do well in the immediate future are:

  • Nashville, TN
  • Indianapolis, IN
  • Miami, FL
  • Phoenix, AZ
  • Tampa, FL

Benefits of investing in commercial real estate

CRE investments can offer several benefits:

  • Cash flow: CRE properties provide owners with a regular cash stream in the form of rents paid by tenants.
  • Appreciation: Commercial properties have the potential to increase in value. You can make significant long-term gains if the property appreciates and you hold on to it long enough.
  • Diversification: Within the CRE asset class, there are several options to choose from:
    • Multifamily
    • Retail
    • Industrial
    • Office
    • Hospitality
    • Mixed use
  • Tax benefits: Property owners can receive several types of tax benefits, including accelerated depreciation and interest deductions. Certain tax benefits are also available for the investor’s beneficiaries.

The bottom line

The CRE market is experiencing a rough patch. However, a well-researched and intelligent approach can provide investors and developers with profitable opportunities. Remember that your chances of success increase if you focus on developing meaningful collaborations and partnerships within the industry and adopting a well-thought-out approach to ESG considerations.

Publish Date & Time : 30 May 2024, 07:15 am

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Author

Jamie Stadtmauer is the Vice President of Business Development at Agora and has over 20 years of experience in commercial real estate investing.

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