CRE Values Risk Further Decline in 2024, Led by Office

Commercial real estate values fell about five percent in 4Q 2023 amid subdued transaction volumes, which hit their lowest level since 2020. Roughly three-quarters of activity skewed toward the apartment and industrial sectors. Most transactions occurring in the second half of the year, providing a higher degree of price discovery. 

That’s according to the latest Current Valuation Insights, SitusAMC’s proprietary analysis that leverages the boots-on-the-ground perspective of our appraisal and valuation management teams.  The report gives investors real-time market and property-type insights ahead of many traditional CRE data sources. 

The NCREIF Open End Diversified Core Equity Index (NPI-ODCE) saw about $8 billion in volume in 2023, down almost 20% from the 10-year average. Volume was about $20 billion in 2023 for the overall NCREIF Property Index (NPI) universe, a 37% decline from the long-term average and the lowest level since 2012.  

Office has the worst outlook, the SitusAMC analysis found, with an estimated 15% value at risk in 2024. Apartment could decline as much as 9% to 10% and industrial looks to have around 7% to 8% value at risk. And retail, the relative darling of the property types in a turnaround from recent years, is nevertheless facing about a 5% reduction in value. However, we may see some value stabilization toward the latter part of this year, especially if interest rates begin to ease. 

Office Valuations and Cash Flows Struggle as Rates Increase 

Office saw values decline in fourth quarter, mostly driven by adjustments to investment rates, though space market fundamentals also continue to deteriorate. However, the sector has not hit bottom yet, as office continues to see value declines in first quarter 2024. 

The current quarter’s adjustments appear to be more targeted, with about 50% of appraisals seeing some type of rate adjustment. Appraisers are looking at occupancy, tenant risk, local economic conditions, and especially weighted-average lease terms (WALTs), with anything less than five years being a concern. 

Transactions and assets coming to market are indicating significant cap rate expansion, especially on the West Coast. Concerns are also growing over loan maturities and many banks are becoming more receptive to loan workouts. With value declines occurring in tandem with a sharp rise in borrowing costs, some landlords are choosing to walk away from their properties. Top-tier properties remain the most in demand. Office is a capital-intensive sector and may require owners to pour a substantial amount of capital for upgrades if they choose to weather the storm. 

Cash flows are coming into perspective as year-end actuals and 2024 budgets are being released. Expense increases are dampening net operating income (NOI). Office usage, according to Kastle, has stayed around 50% for well over a year and, consequently, parking and other revenue sources have decreased. Market rents have similarly been adjusted, especially in San Francisco and New York. Stabilized occupancy has decreased and adjustments are being made to lower renewal probabilities, although as tenants renew leases, many are considering downsizing. Tenant improvement (TI) costs continue to rise, and landlords are focusing on amenities in order to stay attractive in the very competitive market. 

In addition, market participants are keeping a close eye on developments with Chicago’s transfer tax initiative, known as the Mansion Tax, which would increase the tax on transactions over $1 million. Though the proposal is supposed to be voted on in March, a Cook County judge ruled the referendum is unconstitutional and should be removed from the ballot.  

Apartment Valuations Drop as Rent Growth Slows and Expenses Increase 

Apartment saw its largest value decrease of 2023 in the fourth quarter of around 4.3%, largely driven by the expansion of investment rates. Exit rates, discount rates and going-in rates all expanded by roughly 25 bps. In the current quarter, values continue to decrease but at a decelerated pace compared to year-end, with much of the changes coming from cash flow adjustments, as investment rate changes have been case-by-case. The heightened transaction volume at the end of the year has shed more light on where underwriting should be. San Diego saw its first Class A trade in over two years, providing a basis for upward adjustments in rates. However, recent trades are indicative of market-based conditions; a broad brush cannot be painted for rate adjustments across the entire apartment sector. 

On the fundamentals side, rents declined nationally in 2023, according to Reis, amid an uptick in new supply. Additionally, many assets that were seeing positive leasing are now experiencing a slowdown, though seasonality could be playing a factor.  Markets seeing negative or slower rent growth or a larger effect of economic loss are largely located in the West, such as Portland, Seattle, San Francisco and the Bay Area, where supply is greatly outpacing demand. Some Sun Belt locations are also starting to see similar trends, including Phoenix and Atlanta and several Florida markets.  

Negative value allocation is coming from expenses, which hits apartment NOI especially hard, because the sector does not get reimbursements for expenses. Rising insurance costs are a concern, particularly in Florida and other coastal markets, hitting older vintage assets with wood structural frames the hardest. Payroll, taxes, repairs and maintenance, and utilities expenses are also rising. However, as contract rents begin to soften and short-term concessions burn off, lease trade-out premiums pose one of the greatest components of potential value risk. 

Broader Industrial Flat to Slightly Down while Southern California Fared Poorly 

Like apartment, industrial rent growth has slowed over the past few quarters in certain markets. Demand has weakened as absorption cools and vacancies uptick. Fundamentals vary by market and product but are softening, in general. In the broad industrial sector, values are flat to slightly down. Recent trades, however, may be pointing to additional value depreciation. The sector is expected to see increasing transaction activity through the first half of the year.  

Southern California (SoCal) is faring the worst, with a marked regression in terms of leasing fundamentals after exponential rent growth over the past few years. Rents are retreating in the Inland Empire and other port markets. Oversupply from both new deliveries and infill has resulted in a large amount of availability in the Inland Empire and SoCal regions. In these areas, tenants are reluctant to take on new space and have pushed back on rents. Industrial prices are exceptionally high in these areas and there has been a material pullback in rates. However, there are pockets of optimism, including in South Florida, where rent growth and demand are strong. 

Retail Remains Slow and Steady 

Retail has remained relatively steady with stable occupation, mostly positive lease trade-outs, modest increases to market and contract rents, and a pickup in NOI growth. Though NOI growth is only half that of industrial on a one-year basis, it is outpacing the other major segments. Transaction activity is low compared with the other sectors, which is likely resulting in higher cap rates. Last quarter, valuations declined around 2% to 3%, mostly due to investment rate increases of between 25 and 50 bps. Additional rate changes are property specific.  

With a lack of retail transactions in 2023, particularly for core properties, it is difficult to pin down cap rates, though transaction volume jumped almost 85% month-over-month in January, to the highest level in almost a year, according to MSCI Real Assets. Issues remain with relatively large bid-ask spreads, but the hope is that more transactions by year-end will provide greater price discovery. Investors are looking toward opportunistic properties, but the consensus is that availability might be drying up. Buyers are waiting for a stabilization in interest rates before they begin purchasing properties, although capital on the sidelines appears to be robust. 

Grocery-anchored center fundamentals favor landlords, with limited supply and great demand. Suburban locations are outperforming CBD, in part due to work-from-home trends shifting more shopping to close-to-home retail. Consumer sentiment is strong, but this is expected to decline amid high interest rates, lack of affordable housing, and student loan payments affecting household budgets. Big box spaces with grocers, off-price retailers and fitness centers are seeing high demand and solid rent growth. However, large tenants may have more bargaining power, which could dampen future rent growth slightly. New supply is constrained as developments are difficult to pencil out at current market rents. The limited supply coming online tends to be focused on redevelopment into mixed-use and free-standing, single-asset retail.    

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