The global pandemic may have faded into the background, but its lingering effects and mounting economic distress dealt the commercial real estate industry plenty of unexpected jolts since the beginning of the year.
Many predicted 2023 would be a year when transaction activity picked up again. Instead, a sudden spike in inflation and sharp rise in interest rates led real estate firms and economists to push back their forecasts for recovery; the consensus now seems to be mid- to late next year.
The Federal Reserve recently signaled it might be done raising rates. It's become a popular parlor game to guess when it might start cutting rates and why. Will members need to act because the economy is weakening too much, or because a so-called soft landing no longer requires such strong medicine?
“We’re kind of at peak uncertainty,” Bank of America's Chief United States Economist Michael Gapen wrote of interest rates' trajectory in a recent global markets report.
As the "rolling recession" continues to, well, roll along, property owners across the office, multifamily, retail, industrial and hospitality markets have had to weather other unexpected twists and turns of the year so far. Here are a few:
Return-To-Office Push and Pull
This was supposed to be the year workers began to return to the office. But getting people back to their desks proved more difficult than many anticipated, and office real estate markets felt the brunt.
It wasn't for lack of trying. Companies across the United States deployed a mix of strategies that included attendance-tracking apps and threats to link in-person time with annual performance reviews. Many settled for hybrid policies that require in-office attendance for three or four days a week.
Still, office use remains stubbornly below pre-pandemic levels in major metropolitan areas around the country, hovering near 50% in may large cities, according to data tracked by Kastle Systems and its office entry-card-swipe systems.
Companies around the country cut back on their space needs during the year. Snapchat's parent company, for example, implemented its revised in-office mandate earlier this year in which workers were told to be in the office for at least 80% of the time. Even so, the social media giant is weighing a move to offload up to three-fourths of the corporate space it occupies for its headquarters in Santa Monica, California, a sign that the return-to-office push may not be enough to cure the nation's post-pandemic vacancy woes.
Demand for Quality
With office leasing activity suffering from low demand and high vacancy rates, many braced for more gloom in 2023. But there was one unexpected bright spot: new office construction.
In top-tier cities around the world, a handful of developers have cast aside short-term doubts over the state of the market as their confidence in the demand for premium space strengthens. Construction for upwards of 5.1 million square feet of high-end office space began this year in London, according to Deloitte’s Winter 2023 London Office Crane Survey, the highest amount reported in nearly two decades.
"Interestingly, developers we have spoken to seem to be more concerned about the supply of, rather than demand for, premium space," Margaret Doyle, partner and chief insights officer for financial services and real estate at Deloitte, recently told CoStar News. "The macro-environment for the London office market remains challenging. But for now, developers seem prepared to bet that, if they build premium office space, the metropolis will continue to attract occupiers.”
In the United States, the market's limited leasing activity has been concentrated in the newest and nicest properties. While older properties have suffered from an extreme lack of demand, buildings constructed within the past three years have even reported stronger quarterly leasing volumes than in the decade prior to the pandemic, according to CoStar data.
Artificial Intelligence Takes on Real Space
The world's largest technology giants began the year making deep cuts to their global real estate portfolios, resigned to a slowing demand for their services and shift to hybrid or remote work.
To see one of most voracious occupiers in recent years suddenly go on a diet was a punch in the gut to San Francisco and other tech-heavy markets. But then hope arrived in the form of an industry based in the virtual world — artificial intelligence — that showed a newfound appetite for physical space.
The year's explosion of office leases to AI companies meant the tech industry was once again the leading source for office leasing growth, according to CBRE, with tenants collectively signing on for more than 7.3 million square feet of space, or roughly 16% of the nation's total office market. That boost helped lift regions such as the San Francisco Bay Area, New York, Boston and Los Angeles as startups quickly took over space they needed to accommodate ambitious growth plans.
"You need human intelligence to create artificial intelligence," said Colin Yasukochi, executive director of CBRE's Tech Insights Center. "This is such an emerging area that people need to be more together to collaborate and innovate, and that's ever more important."
Coworking Without the 'We'
WeWork's decision to file for bankruptcy protection felt nearly inevitable in 2023. Its filing was the result of a disastrous decision to lock in long-term leases to offer short-term rentals, a strategy that came back to bite it when the pandemic forced so many to work from home. But the company's collapse overshadowed the rise of a cohort of emerging companies looking to capitalize on rising demand for flexible space.
Beyond looking to differentiate themselves in an increasingly competitive industry, most — if not all — are trying to avoid mistakes made by WeWork and other earlier providers of flexible office space. That has meant opening locations beyond office towers in central business districts, making sure they sign less risky leases — even if that means slower growth rates — and providing more meeting and event spaces.
As WeWork moves through the bankruptcy process, trying to shed most of the billions of dollars of its financial obligations, it will likely look much different than the high-flyer that captured so much attention. But whatever the outcome, the global coworking industry showed it still has a future.
Industrial Appetite Ebbs After Pandemic Boom
Long regarded as the not-so-glamorous asset class, industrial space saw its stature rise remarkably during the pandemic. COVID-19 caused more people to shop online which resulted in a need for more distribution centers for shipping and storing goods.
Annual rent growth spiked to 11.1% in third-quarter 2022 in response to demand. Meanwhile, vacancy plummeted across the country and resulted in bidding wars for what little space was left.
Analysts and others predicted more of the same this year, saying the sector might be the exception among real estate asset classes. But then households began to spend less money in 2023 in response to inflation, high gas prices and other factors, resulting in less spending on goods. That led retailers to scale back plans to build larger distribution networks and, in response, construction on industrial property fell 31% year over year. Meanwhile, industrial vacancies have grown to 5.6% nationally which is near the 10-year average.
A year that started with such high expectations ended looking like the sector that might have hit a peak.
Distressed Hotel Market Never Materialized
There were prognostications in the early days of the pandemic that owners of shuttered hotels — that in many cases were not legally allowed to operate during the public health crisis — would end up needing to sell their properties.
Those predictions appear overrated today. In fact, overall sales for hospitality properties plummeted in 2023 similar to the rest of commercial real estate assets due to the higher cost of debt. In addition, the bid-ask gap remained wide throughout the year as buyers and sellers could not agree on how to price hotel properties.
Investors, though, did raise capital in anticipation of distressed deals. But that capital lost its value due to the rise of inflation and some opted to deploy the money in other ways.
Higher Interest Rates Just Wouldn't Quit
Overly optimistic real estate investors thought interest rates wouldn't stay high for long in 2023.
Of course, that didn't happen.
Inflation proved difficult to tame and interest rates today remain at roughly two-decade highs which has curbed demand to buy commercial real estate. Instead of hoping interest rates might fall, many began to accept the Fed's new "higher for longer" mantra.
Some are guessing that the Fed will cut rates early in 2024, but it remains to be seen how much cutting ends up happening. Inflation went down in the past month and prices were up 3.1% in November, but inflation is still above the Fed's goal of 2%.