Bustle in the city with street lights and crowds of people on the sidewalk

Commercial real estate professionals are certainly keeping a close eye on the economy, including interest rates, the Fed’s next move, capitalization rates, the multifamily housing and residential markets, and of course companies’ ongoing decision whether or not to return to the office. 

With these issues in mind, Baker Tilly’s real estate advisory team hosted a webinar, “State of the commercial real estate market 2023.” We were joined by a panel featuring Stephen Zsigray, Senior Vice President of Corporate Finance and Strategy at Ashford, Inc.; Chris Fogle, Principal and Portfolio Manager at The Carlyle Group; and Ashley Grigsby, Managing Director, Capital Markets of Transwestern Development Company. 

The webinar recording can be found here, and a summary of the key topics discussed and recent trends can be found below. 

An impending recession 

During the February webinar, regarding his expectations for the rest of the year, Zsigray said, “As far as overall risk of a recession, I think the chances of that, at least in 2023, are certainly subsiding. The labor market is still strong, [and] if the Fed intends to not inflict a ton of harm on the entire economy, I think the likelihood of a recession is pretty low.”

However, sitting here in May in the wake of the turmoil facing First Republic and other banks across the U.S., more and more signs are now pointing to a potential recession in the near future. 

One thing is clear: There will continue to be a lot of uncertainty for the remainder of the year. The answer regarding a potential recession may have been simpler before the recent banking chaos, but now it is just very difficult to project where the economy is going to go from here.

The future of capitalization rates 

There was a compression of capitalization rates at the beginning of 2022, but then we saw those bottom out. Ever since, there has been upward pressure – and that is likely to continue as we get deeper into 2023.  

Cap rates likely will increase over the next several years, although the increase will vary by product type. We expect office cap rates to increase the most, followed by retail, multifamily and industrial, which could increase moderately. Factors that will drive cap rate expectations are cost of debt, rent and margin growth, while technology could enhance properties’ margins, thereby lowering the capitalization rates. 

The state of the multifamily and residential market  

As it pertains to the current state of the multifamily and residential markets, Fogle said: “We’ve seen rent growth in many cases run in double digits for going on two years now. We’ve seen a little bit of slowing of growth, in particular in late 2022 into the early part of 2023. But looking at year-over-year growth, it’s been extremely strong in the face of inflation. … From a real estate investor’s standpoint, though, we have seen values hold up relatively well in various forms of rental housing because you are seeing rent with high growth that is generally paced with inflation, or paced ahead of inflation, which provides some level of defense to rising interest rates and cap rates, generally.” 

Returning to the office? 

We expect to see more occurrences of office loan defaults in cities such as New York, San Francisco and Chicago, as these markets typically feature flagship offices. Additionally, these cities were generally the slowest to return to the office initially in 2020, and even as of today, many of these major cities have proven to be among the slowest in returning to the office. So, the defaults in these markets could be outsized in comparison to some of their peers, particularly those cities in the southern part of the U.S. 

Furthermore, if the labor market switches to an employer’s market due to a recession (or a combination of other reasons), employers will take this opportunity to get people back to the office for culture/mentorship reasons. That doesn’t necessarily mean that workers will return to the office four or five days a week – it might be one day, it might be two – but for many companies, that is still considered a “return to the office” at this point. 

It’s difficult to see the majority of companies insisting on a return to the office five days a week at this point. It appears that the concept of working from the office on Fridays is largely off the table for most organizations, at least in the short term and probably in the long run, as well.  

What is going to drive this demand for office space in the future? From our perspective, it’ll be flight-to-quality amenities and user experience. The youngest generation of workers continues to make it clear that they want to work in urban settings – at least early in their careers – and companies certainly are taking note of this as they desperately try to attract and retain talented people. 

Still, it is fair to expect some choppy waters as companies attempt to navigate their return to the office. It certainly will be interesting to see where things stand in 5-to-10 years. At this point, it’s very hard to predict. There is such a wide variety of market sizes, geopolitical issues and government responses throughout the country – not to mention the unpredictability of the pandemic itself – that this was always going to be difficult to anticipate.  

The reality is that office did relatively well in the early stages of the pandemic. Tenants were still paying their rent at the time, even while they were unsure about their workspace needs moving forward. However, now more and more companies are reevaluating their space needs and, in many cases, letting their leases expire. 

2023 and beyond 

There is a significant amount of capital parked on the sidelines seeking the right opportunity. We continue to see an appetite for mixed-use projects on a market-by-market basis, and there has been a strong outflow of capital to the suburbs to these mixed-use developments. 

Regarding the current state of transaction activity and the outlook for the rest of 2023, Grigsby noted: “We’re seeing if you have a construction loan that you need – that is $30 million or less – there are lenders out there for that. But as you start to go over $30 million, it’s going to have to be some type of participation versus syndication. And most of the lenders are not willing to fully underwrite and accept that risk, so they want to come in knowing they have a partner or bring in a participating lender group, on the front end.” 

Stay up to date on notable commercial real estate transaction activity, data and analytics by reading our quarterly REcap: Baker Tilly's signature commercial real estate market report. 

Brent W. Maier
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