Optimism About CRE Deal Volume Rises Across Most Property Segments in 2Q 2024

Optimism about commercial real estate (CRE) transaction volume is growing across all major property segments except for office, but a large gap between prices and values persists. That’s according to the CRE Debt and Valuation Trends analysis, which leverages the boots-on-the-ground perspective of SitusAMC professionals across the organization, offering investors real-time market and property-type insights ahead of many traditional CRE data sources. Here are the highlights of the analysis.

Second-quarter “transaction” cap rates will likely experience slight compression for high-quality industrial, grocery-anchored retail and apartments, but this trend is more property- or market-specific; it is difficult to paint a broad brush across the entire segment.  

While the gap between price and value has been narrowing, it is important to distinguish between the two and recognize the gap that still exist in valuations, despite positive sentiment from bid activity in the transaction market. As a result, valuation cap rates, for the most part, should still be expanding. 

It appears that overall CRE returns will reflect less declines relative to first quarter, albeit still reporting a negative capital return. A divergence between value and price still exists, with the pricing put forth in the underwriting often still below property valuations. 

Band-Aid Is Coming Off in Office 

From a valuation perspective, there still needs to be a fundamental repricing in traditional office. Value erosion is not just occurring in lesser-quality assets, but also those that have historically been dominant in the market. However, not all office is bad. Newer, high-quality buildings offering numerous amenities are holding up with much higher occupancies than the balance of the commodity office product. Values will likely decline this quarter between 4% and 6%, with continued expansion of rates and ongoing erosion of current and future cash flows. High-risk properties – those below-stabilized occupancy and weighted-average lease terms (WALTs) of three years and under – are a big concern. Pain is likely still ahead in terms of rents. 

With interest rates expected to be higher for longer, landlords are looking to renegotiate their debt with their existing lender, even when that debt is not immediately coming due. Office has always been a capital-intensive asset class, but the risk of investing additional capital has never been more acute, particularly as landlords expect cash flow to dwindle as tenants fail to renew or decrease their space needs. Landlords are increasingly likely to hand the keys back to the lender rather than throw good money after bad until the loans mature. 

Office demand has generally fizzled. Many investors acquiring traditional office are opportunistic, with some high net worth or sovereign wealth funds trying to come into some premier assets. These investors believe there will be a bounce back in office over the long term and plan for a 10- to 15-year hold horizon. However, even though some property prices have declined upwards of 50%+ from their peak, willing buyers are often expecting cuts of another 20% to 30%, whereby some transactions occur near land value.  

A hot topic is office conversions. Some markets, like Chicago, are aggressively supporting office conversions to residential by offering significant subsidies. Major subsidies are often required to make these projects financially feasible because of infrastructure constraints. It is particularly challenging to complete these projects in cities as high-rise office buildings do not have floor plates conducive for multifamily. Current multifamily market rents often do not support the cost of the conversions.  

Investor sentiment will likely continue to sour on office until the industry gets more clarity on the future of remote work. Many big banks have publicly stated that they will return to five days in office. However, potential employees often eschew employers requiring a full return to office in favor of companies that offer flexibility. This will continue to hurt tenant demand for office space. Tenants that operate on a hybrid schedule still have to rent space for the full week, but it is likely that they will reduce their footprint as renewals come due. 

On the Debt Side, Pace of Underwriting Slows for Office 

From a CRE loan originations perspective, there has also been only limited activity in the office segment. CMBS originations are starting to tick up, mostly from alternative lenders instead of institutions. We are seeing a slow pace of office underwriting. Deals are difficult to push through as there is often a large gap between loan underwriting and appraisals, which requires several iterations to resolve. CRE debt also has the hurdle of getting the buyer and the rating agency to approve so that the transaction can be securitized. 

Not surprisingly, we are seeing heavy volume of office forensic diligence. Banks are increasingly taking back properties and planning for longer hold periods as they know it is unlikely that the properties can be flipped quickly. As banks take over properties, there may be immediate access to cash from funds set aside for tenant improvements (TIs) that were not used; however, banks are cognizant that within the next 12 to 18 months, they will need to sink money into the property. A danger for the banks is that a borrower may drain any net cash flow before handing the property over to the lender. This is why it is critical to scrutinize bank statements to make sure that borrowers do not run away with any cash before the takeback. 

Investors Favor Industrial Despite Some Downward Pressure on Rents 

There is a lot of capital seeking industrial from dedicated funds that have a lot of dry powder. Properties for sale are receiving several bids and going through multiple negotiation rounds. This is driving transparency on pricing.  

Industrial continues to benefit from the incredible run on rents of the last few years. But an increasing number of markets are experiencing downward pressure on rent growth. Los Angeles, both infill Los Angeles and in the Inland Empire, is a prime example. New Jersey rents have also been soft. However, other markets, like Dallas and Miami, are currently offering tenants a value proposition.  

Amazon is becoming more active in industrial real estate after sitting on the sidelines more recently. According to the Commercial Observer, the company has signed three leases, in Southern California this year, each for over one million square feet. 

Apartment Rent Growth Slows 

Most apartment valuations in the second quarter are flat to slightly down from last quarter, with some adjustments to investment rates. From a fundamentals standpoint, there is a broad slowdown in rent growth as an uptick in new supply continues to oversaturate various markets nationwide. 

Some markets are still faring better than others on rent growth, but overall contract and market rent spreads are continuing to tighten. New lease trade-outs in various markets are flat or negative while the renewal lease trade-outs have generally remained positive. With more competitive rents for new leases, tenants may decide to move rather than shoulder an increase in rents upon renewal. 

Only nominal changes are being made to expenses, as most adjustments were made during the budgeting process over the last two quarters. While some markets are seeing increases in taxes, many expenses are coming in below budget.  

Some of the stronger rent markets continue to be New Jersey, New York and Florida. Class A Boston and Chicago are showing their typical signs of seasonality this quarter and faring better than they have previously. San Francisco and Seattle also seem to be showing some signs of recovery this quarter, with positive rent growth. Some struggling markets include Portland, Atlanta, Phoenix, Denver and Florida Class B garden apartments. 

Trade activity appears to be improving. Buyer pools are getting bigger with more aggressive underwriting. There is a competitive bidding process, especially for assets with large discounts to replacement costs. There is still a wide gap between buyer and seller expectations – as much as 40 to 50 bps, and the gap between buyer underwriting for transactions that are occurring compared to current valuations can still be quite wide. 

Retail is Telling a Mostly Positive Story  

Non-mall retail leasing is generally positive, with higher base and market rents contributing to income growth. Asking rents are up year-over-year on the back of strong occupancy and limited new construction. New developments are generally hard to pencil out given current market rents. However, there is some new construction in the Sun Belt – particularly Texas, Florida and Arizona – which have seen strong population in-migration.   

Whereas traditional centers may have experienced a decline in foot traffic over the year, price-conscious retailers, like Aldi’s, are seeing an increase in customer activity. Power centers appear to be coming back into favor with investors and Class A++ malls are performing well. One area of concern is operating expenses. The extent to which tenants cannot manage their occupancy costs will determine the ability of the landlord to continue to push rents.  

The challenge for valuations is the lack of core transactions. Sales have been occurring primarily in secondary and tertiary markets and for grocery-anchored centers less than $50 million. The buyer pool for large centers is limited due to the operational expertise required to run them. 

Conclusion 

While sentiment regarding the CRE market is improving, a large gap between prices and values persists, with the pricing put forth in the underwriting often below property valuations. While the pain will likely continue in the office segment, retail seems to be performing well. While rent growth is generally slowing in industrial and apartments, the segments still continue to garner the most investor interest. As interest rates stabilize and bid-ask spreads compress, we should see deal activity pick back up.