Office Values Fall, Retail Shows Stability in 4Q 2023

Rising investment rates continue to put pressure on commercial real estate (CRE) values in the fourth quarter of 2023, with office properties again seeing the sharpest decline, according to SitusAMC’s latest Current Valuation Insights analysis. SitusAMC anticipates continued deterioration in property values as the quarter plays out, with the retail sector showing the greatest value stability.  

Current Valuation Insights leverages the boots-on-the-ground perspective of SitusAMC’s appraisal and valuation management teams, offering investors real-time market and property-type insights ahead of many traditional CRE data sources.   

Though values have been declining for the past three quarters, values have still not caught up to declines in prices. The fourth quarter will likely see a material decline in the capital appreciation return, rivaling that seen in the same period last year. NCREIF’s NPI-ODCE Index, the common benchmark, shows 2023 apartment transaction sales through the third quarter traded at a 21% discount, and industrial at a 12% discount relative to their 2Q 2022 reported fair value. These two segments represent about 75% of 2023 ODCE transactions.  

Office sales transacted at a 40% discount, whereas retail transactions in 2023 were down just 4% relative to their fair value in 2Q 2022; however, retail represents only 10% of the ODCE Index. In addition, retail is bifurcated, with grocery-anchored assets dominating sales activity, malls, lifestyle centers and power centers seeing few sales. 

The capital markets environment is challenging, with the 10-year Treasury reflecting a high degree of volatility. Even with this positive news, it is important to maintain perspective that the apartment and industrial property types, which comprise 65% of the NPI-ODCE index, experienced an inverted cap rate spread over the 10-year Treasury in the third quarter, with trailing three-month annualized implied cap rates for apartment and industrial at 4% and 3.4%, respectively.  

Industrial Investors Willing to Accept Negative Leverage as Rent Growth Decelerates  

Industrial has seen continued expansion of both terminal and going-in cap rates through recent quarters. In the fourth quarter, industrial is seeing a paring back of growth, especially in terms of rent. Amazon and other major tenants remain on the sidelines, often not seeking big spaces, and smaller tenants have become more price-conscious. This is significantly hampering rent growth. Nevertheless, the dramatic rent increases over the past few years have helped soften the blow of recent rate expansion.  

Class A real estate in top-tier markets is trading near mid-4% yields and stabilizing to above 6% within three to five years. The stabilization percentage and time constraints have been increasing in recent quarters. Negative leverage has become increasingly accepted, as the high cost of leverage has catalyzed upward pressure on how many years yields will take to stabilize.  

Apartment Valuations Drop as Rates Expand and Rent Growth Slows 

Apartments are seeing some of the largest valuation declines in recent years. Driven by investment rates and partly by budgets, valuations have experienced declines anywhere from 3% to over 5% since last quarter. The Treasury rate has dialed back in recent months, easing some of the burden on exit rates. Nevertheless, due to the Treasury expansion, multifamily borrowing costs have skyrocketed, which is weighing on appraisals and recent transactions. 

Terminal and discount rates are showing upward movement between 25 to 75 basis points. Most trades now start with a 5% going-in cap rate, even for well-positioned. Tertiary markets are experiencing even higher rate expansion, with Class A properties well into the mid- to high- 5% range. The minimum underwriting for the best assets is a mid-6% discount rate and low-5% terminal rate, both large expansions from the prior quarter. 

Rent growth is generally decelerating, although it is uneven across markets. Assets that noted positive leasing activity last quarter are experiencing a continuation this quarter, including regions such as Chicago, Northern Virginia, New Jersey, Manhattan and Boston. Sunbelt markets are still seeing positive, though decelerating, rent growth. Slowing or negative rent growth is largely focused in cities on the West Coast, including Portland, Seattle, San Francisco, Phoenix, Las Vegas and some areas in Los Angeles and Atlanta. This is a continuing trend from the previous quarter, as apartment supply is heavily outweighing demand in these metros. There are few assets being written with above the standard 3% inflationary rent growth. 

Parking revenue increases have been seen across many assets, although mainly in densely populated areas. Payroll taxes, repairs and maintenance, and utilities increased this quarter. Because apartments do not receive the same benefit of expense reimbursement as other property types, these larger expenses are having an impact on net operating income (NOI). As we move into 2024, we will see if rent growth is able to offset these hikes. 

Sharp Value Declines Leave Office Owners with Few Options 

Office continues to fare the worst of all property types, with value declines greater than in previous quarters. Values are down 25% to 30% from the peak in 2Q 2022 for core ODCE portfolios, with some of the largest declines (between 50% to 75%) seen in San Francisco, New York, Boston, Washington, D.C., Los Angeles, Silicon Valley, Portland and Seattle. Markets least hit with value declines were in the Sunbelt. 

Office investment rates are seeing increases ranging from 25 to 150 bps across both terminal and discount rates. Assets with leasing challenges and near-term rollover, specifically those with weighted average lease terms (WALTs) of three years or under, are experiencing significant increases in their discount rates. But trophy Class A has fared slightly better because of longer WALTs and active leasing.  

There have been adjustments to cash flows, especially stabilized occupancy rates, but these rates remain stubbornly high relative to historical proven performance. Renewal probabilities are mostly in the 60% to 65% range, though some Class A assets in the Sunbelt may reach 70%. Appraisers are making adjustments on expenses, with the largest increase for insurance costs – ranging from 20% to 50%. The WeWork bankruptcy has further impacted appraisals, leaving many buildings with significant cash-flow uncertainty. 

Debt maturities are a significant issue for the office segment where higher interest rates are requiring owners to infuse a large amount of capital just to refinance. This, combined with lower NOI, makes it difficult for owners to stay in the market, and many are handing back the keys. Cash deals or seller financing are driving most of the sales activity. Some bottom-feeder sales are being made at below land value, particularly in San Francisco. A small hope for the sector is a gradual uptick in office use, as many transition from remote to hybrid work, though this “hope” has now been three years in the making.  

Investors are targeting medical offices as they divest from traditional office space, with an uptick in the number of medical office assets held. But the subtype is still not immune to the investment rate increases of the broader office sector. Fundamentals remain strong for the subtype, but expectations should be tempered with capital markets performance. 

Retail Finally Hit with Tempered Rate Changes 

In general, retail is finally seeing similar, though not as dramatic, investment rate changes as the other property types. Malls have not traded in a meaningful way since 2018 and 2019, although most continue to see strong sales and solid leasing. Unlike many of the other property types, retail did not experience a post-COVID write-up, so now it is not seeing as many write-downs either. 

Non-mall, grocery-anchored retail has been quiet on valuation changes, although investment rates appear to be moving upward on draft valuations. The highest-performing grocery-anchored centers that had cap rates in the low- to middle-5% range last quarter are now above 6%. Fundamentals remain strong. Centers have even been able to backfill space with relatively attractive rents after the Bed, Bath, and Beyond bankruptcy earlier this year. 

Retail sellers like Best Buy, Lowe’s, and Walmart have lowered their sales expectations significantly as a result of dampened consumer spending, though others like Uniqlo and H&M have shown increased sales. Holiday sales data should help clarify the strength of the retail market further. There also may be a significant number of lease expirations toward the end of January, as many centers use the holiday sales season to determine their tenant mix. 

Class Value Bifurcation for Self-Storage 

For self-storage, Class B has taken a hit to NOI and eroded considerably more in value than the Class A properties managed by large public REITs. Self-storage rents have the benefit of being able to mark to market quickly because they are not subject to long leases. 

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