Commercial Real Estate 2022 Outlook: Fixing on the Horizon to Navigate Through Change
- Feb 1, 2022
- Joseph Rubin
The commercial real estate markets heading into 2022 are seemingly simple but are actually remarkably complex. The multiple and changing dynamics of demand and supply, affordability, capital flows, interest rates, inflation, climate change, and a relentless pandemic force us to dig deeper in both transaction diligence and portfolio performance monitoring to better measure and price risk over a five-to-ten-year investment horizon. While the real estate sector has made an extraordinary recovery from the economic impact of the pandemic, investors must look more closely to identify longer-term winners and losers. In 2021, debt and equity capital was abundant and record transaction volumes made up for the pandemic-induced malaise of 2020. 2022 promises to be another outstanding year as industry leaders and capital providers remain confident that continued economic growth will bolster demand across most property types, as long as you pick the right spots.
With the drive to price deals to perfection, real estate investing has necessarily become more nuanced. And national statistics and generalizations don’t tell the complete story. When we dig deeper we find a highly bifurcated market, with capital carefully choosing its directions. And the past may not be a good indicator of the future as we potentially pivot from a forty-year downward interest rate environment with no inflation, to a period of higher wages, higher interest rates, higher inflation, and less fiscal and monetary support from Washington. Add the increasingly alarming impact of climate change and the longer-term view isn’t negative, just more complex. We also need to get past the pandemic, which seems to trick us into complacency just as the next COVID variant is about to strike.
In our annual summary of key trends real estate investors should consider this year, we’ll explore the drivers of demand and how they may impact property types and markets. The pandemic makes everything in the short-term more difficult to predict. And because we may be in a liminal moment economically, we will focus on longer-term trends and how to manage through them.
The Context: Shifting Influencers of Real Estate Demand and Returns
Despite all obstacles the U.S. economy made a spectacular recovery in 2021, giving us momentum into 2022. Gross domestic product (GDP) and job growth were exceptionally strong, unemployment fell, wages rose, and retail sales rebounded. On the other side of the ledger, pent-up demand and supply shortages have created the first burst of inflation in decades, the Fed is about to end quantitative easing and raise short-term interest rates, it is unlikely that Congress will pass another stimulus package, and worker shortages are holding back the recovery. The Misery Index, the combination of the inflation and unemployment rates, has risen above 10% for the first time since the 1980s. While that index will likely fall in 2022 as inflation stabilizes, the psychological harm to society and the economy caused by the pandemic will take longer to heal. As Wharton Professor Adam Grant said late last year, we are “languishing.” And I would add that we are also exhausted. Perhaps that is why, despite the rise in retail sales, the University of Michigan Index of Consumer Sentiment fell 13% in 2021 to its lowest level since the start of the Great Recession in 2008.
Demographics: Population Stagnation
The population of the United States has been basically stagnant for the last decade and is expected to remain so for at least the next five years. The lack of growth is partly due to Millennials starting families later in life and also to the lowest immigration levels (both household immigration and foreign students studying at American universities) in decades. Looking at generational cohorts, the pandemic has accelerated around three million Baby Boomer retirements, meaning their spending will likely trend down. The Millennials do not have the earnings or savings to replace Boomer consumption. At the same time GenZ is emerging on the scene and, unlike Millennials, they will be graduating from college into a robust job market and should get a better start at building capital. Higher wages and household creation are clearly positive for real estate in the short-term, but a long-term stall in overall population growth could be troubling down the road.
Employment and Inflation
Job growth is the greatest driver of real estate demand, and last year a remarkable average of 537,000 jobs were created each month resulting in a year-end unemployment rate below 4%. Despite that, we face a great paradox: The U.S. still has 3.6 million less employed people than at the start of the pandemic yet there are almost ten million job openings. According to the Bureau of Labor Statistics, the job participation rate has fallen 1.5% to 61.9% since February 2020. The “quit rate” has reached record highs. This paradox has many pandemic-related causes, most of which will likely resolve in the short-term. The accelerated retirement of the Boomers may be permanent, taking the most experienced workers out of the market.
While the resulting labor shortage has somewhat impeded recovery, particularly in the hotel sector, the employment picture remains strong. However, job growth was historically a direct catalyst for office demand and current work from home (WFH) arrangements have muddied that relationship. More on the office sector later. Job availability has also helped drive wage growth, which reached an average 6.2% in 2021. Wage growth is not only driving the quit rate but is an important and possibly permanent driver of inflation. For the first time since the early 1980s, the Consumer Price Index grew 7% last year, and the Producer Price Index grew 9.7%. Much of this burst in pricing was due to the supply-demand imbalance in goods and supply chain disruptions, circumstances the Fed used to call “transitory.” The Wall Street Journal Economic Forecast Survey is predicting inflation to calm down to about 3% by the end of 2022. Continued high levels of wage inflation may play havoc with that estimate.
Stimulus: The Party Is Over
Since the Great Recession all business sectors including real estate have benefited from low interest rates, which have bolstered the values of everything from equities to real property. In the last two years the U.S. economy was treated to over $15 billion of fiscal and monetary stimulus. In other words, we haven’t really been operating in normal market economic conditions for about 15 years. The Fed has made clear that it will raise the Federal Funds rate at least three times this year, pointing toward 1.5% by December. They will also stop buying, and likely even start selling, Treasuries and mortgage-backed securities, sending long term rates, including mortgage rates, higher. The ten-year Treasury rate has already started to rise and predictions peg the rate at 2.25% to 3.0% by December 2022. The lack of consensus is not surprising given that the Fed needs to temper inflation without busting the employment cycle or blowing up the U.S. deficit.
The upshot is that between higher rates and higher inflation our industry will have to adapt to a new investment and operating environment in which almost no one currently in the business has experience managing (although I do remember shopping certificates of deposit at banks and getting 10% interest and a toaster oven). We have watched and waited for interest rates to start rising for a decade but stimulus prevented the market from accurately pricing capital. After forty years of declining interest rates, we may finally be at the turning point and entering an extended period of rising cost of capital. A key question going forward will be whether spreads will compress to make up the difference, or this new environment will be deemed more risky, increasing spreads and ultimately capitalization rates.
There has been great debate about the extent of migration among cities during the past two years and whether there is truly a change in where people want to live. The reality is that the move to the sun belt states began long before the pandemic, that migration is comprised primarily of more affluent Americans, and that many of the young people who left the cities at the start of the pandemic have already returned. However, secondary and tertiary cities are emerging as excellent places to live and will continue to draw people from traditional gateway cities. The gateway cities will survive, and the growth cities will thrive. Think of gateways as cash cows and cities like Austin and Nashville as rising stars. You want your portfolio to include both, and this market expansion can only be good for real estate investment.
Real Estate Capital: Money, Money Everywhere
Commercial real estate remains a highly attractive investment to core, value-add, and opportunistic investors. Both equity and debt capital continue to flow to the industry, seeking yield and, more recently, an inflation hedge. Institutional investors are again turning to real estate to rebalance their portfolios as equities reach new highs, seeking relative value against meager fixed income alternatives. That spread over corporates and Treasuries enabled the extraordinary issuance growth in commercial mortgage-backed securities (CMBS) and commercial loan obligations (CLO) from $64.3 billion in 2020 to $154.6 billion in 2021, per Trepp. Foreign investors returned, banks and life companies were eager to lend, and private equity funds bought massive portfolios on the equity side while more and more debt funds entered the business. According to Trepp, total commercial and multifamily lending reached a record of $690 billion in 2021.
That combination of capital sources enabled tremendous growth in transaction volumes in 2021. According to Real Capital Analytics total trades exceeded $800 billion, a third higher that the $600 billion of trades in pre-pandemic 2019. Not surprisingly, over 40% of those sales were in the multifamily sector where volume more than doubled last year from 2020. Industrial sales also grew by over 50% year over year. And despite their challenges, even office, retail, and hotel 2021 trade volumes exceeded their pre-pandemic levels.
The enormous liquidity in the market is also being used to recapitalize properties hit hard during the pandemic and, in many cases, prevent them from defaulting on their debt. The extensive distressed market many anticipated when the pandemic struck never materialized. According to Trepp, CMBS delinquency at the end of 2021 had fallen to 4.57% from around 7% in April 2020. Special servicing volume has fallen 27% despite a recent 19% increase in office loans. Bank mortgage delinquencies are just over 1%. CMBS loan losses have been a remarkably low 0.15% while the loss rate at banks and life insurance companies was only around 0.05%. Most of the losses in CMBS have been experienced in mall loans, where appraised values have fallen precipitously. Yet there has even been capital available to buy these malls in foreclosure, presumably to redevelop the properties for new uses.
Such abundant capital means competition for deals and often a deterioration of credit quality. Institutional players appear to have maintained their discipline. Leverage and coverage ratios for permanent debt remain conservative. But the vast majority of loans continue to have at least a partial period of interest-only payments, a credit hinderance that should not be necessary given such low interest rates. Time will tell whether the proliferation of new debt funds, whose volumes and underwriting are not transparent to the market, will continue to bring disciplined liquidity to the market.
There are several headwinds to this good news story. First, as mentioned, is the Fed’s withdrawal from quantitative easing and balance sheet reduction, which could suck trillions in liquidity from the market and send interest rates higher. While this may take years, the refinance risk for existing loans is real if rates are higher at maturity and rent growth hasn’t kept pace. Moreover, the accommodations given by regulators to banks and life insurance companies at the beginning of the pandemic finally expired at the end of last year. That means the lenders will have to resume taking impairments on troubled loans. Since March of 2020 we haven’t had much transparency into the levels of bank forbearance and other loan modifications. According to an analysis by Trepp, the level of criticized loans in bank portfolios has significantly increased. More information will come with the banks’ first quarter reports.
Property Type Round Robin
Industrial properties are the darlings of the industry and a magnet for investors. With vacancy approaching 4% and significant absorption and rent growth, industrial provides opportunities for both long-term income and appreciation. While increased demand is partly due to the rise of online shopping, warehouses and distribution centers also support bricks and mortar retail as well as business-to-business transactions. Last mile transportation and demand for same-day delivery has caused the value of infill facilities to soar. As a result, industrial is priced to perfection and investors need to pick their spots, avoiding overbuilt markets. Development will dump over 500 million square feet of new space into the market, and some markets will necessarily become overcrowded.
There isn’t much new in retail real estate. America has been overstored for many years and the onslaught of online shopping began well before the pandemic. According to the Census Bureau, e-commerce was 13% of total retail trade at the end of the third quarter of 2021, down from the early pandemic pop. As the pandemic recedes, consumers will go back to buying experiences instead of stuff, and the decline of in-store retail, particularly class B and C malls, will continue. While consumers have trillions in savings and pent-up demand, the recent surge in spending will likely be short-lived. We will always need physical stores, including malls. Just not so many of them. The painful process of achieving equilibrium between in-store demand and supply will take years.
The multifamily market had outstanding performance in 2021, as capital rushed to the sector offering such staggering prices to owners that they couldn’t refuse to sell. Marcus & Millichap is reporting national multifamily vacancy at 2.6%. Unlike retail where supply far exceeds demand, all types of housing in the U.S. remain supply constrained. According to a recent IRR Viewpoint 2022 report, “we continue to systematically under-produce housing.” The demand side for apartments has been fueled by unaffordable housing prices. The Case Shiller national home price index grew over 19% last year and, per the Census Bureau, the median home price in November 2021 rose to $416,900. As a result, many Millennials, the prime cohort seeking to buy homes, cannot afford the down payment or do not have the required credit for a mortgage. And that was before the recent onset of rising mortgage rates. So despite an 8.5% increase in home sales in 2021, the National Association of Realtors estimates that nearly one million renter households were priced out of the home buyer market. In response, Yardi Matrix estimates that apartment rents nationally grew 18% in 2021 and some cities experienced well over 30% rent growth. This may be good for multifamily investors but of course is a huge social issue for the country. A recent CREFC Housing Affordability Report indicated that half of all rental households in the U.S. are cost burdened, meaning the residents are spending more than 30% of their income on rent.
What could suppress multifamily demand is the increasing unaffordability of rental units, which could cause households to consolidate and send Gen Zers and young Millennials back to their parents’ houses (they had a lot of practice during the first year of the pandemic). Another obstacle to multifamily is the increasing demand for, and supply of, single family rentals. At a price point between apartments and purchased homes, home rentals provide more space for families, typically with a garage and a yard, particularly well suited to the work from home crowd. The problem is that rents on these homes are also soaring, as is the land they sit on. So while new “horizontal rental communities” are being built to meet demand, developers are fighting for land parcels with traditional home builders exacerbating the affordability crisis.
Few in the industry other than the office REIT CEOs will argue that office sector performance is highly uncertain. Office demand will go down as tenants rethink how they use their space, and owners will require significant capital to be competitive going forward. More than any other property type, office is bifurcated between older, inefficient, even obsolete product and newer properties with modern design, environmental and wellness certifications, state of the art air ventilation, and tenant amenities. New lease notifications in the real estate newsletters touting record-breaking rents rarely disclose the actual net effective rent, reflecting the increasing concessions and tenant improvement packages now required in most markets.
Debate is raging on the longevity of the pandemic-driven work from home phenomenon. While WFH provides flexibility, convenience, no commuting, and a reduced wardrobe budget, there are obvious downsides: the difficulty in building teams, innovating, mentoring, and creating and sustaining culture. The longer people are isolated away from the office environment, the less they will develop relationships with their coworkers and feel connected to their companies. At some point, likely sooner than later, we will discover that for many businesses full-time WFH arrangements simply cannot work and retaining talent will become an even greater challenge. Most importantly, WFH often stymies the realization of diversity, equity, and inclusion goals.
Given the many variables and infinite tenant-by-tenant, market-by-market circumstances, trying to predict the long-term outcome of the office sector seems senseless. So here goes: Most businesses will require their employees to come to the office for teamwork, company meetings, training, and other collaborative activities with the remainder of the time retaining the flexibility of WFH if desired by the employee. That means office space will be configured for more group interaction and cubicle farms may finally meet their demise. It also means companies will need less space, and possibly rent auditoriums for larger meetings. This is not the scenario being touted by real estate owners, but by the users of the space. According to CBRE’s 2021 Occupier Survey, 87% of employers plan to adopt a hybrid model as the pandemic recedes.
Tenants will be thinking harder about space needs and configuration going forward, and many companies may take the opportunity to upgrade to smaller, higher quality office space. But WFH is not the only problem in the office sector. Cushman & Wakefield estimated that national office vacancy is already almost 18% and rising, not counting sub-lease activity. According to ULI’s 2022 Emerging Trends in Real Estate, one quarter of the entire office building stock, more than 4 billion square feet, is at least 60 years old. What will happen to all this older space as demand wanes? Owners will face a wave of required capital expenditures, some voluntary to remain competitive and some required by local authorities. The costs of reconfiguring space to meet new tenant requirements, investing in more fuel efficient systems, reducing greenhouse gas emissions, improving air and water quality, and upgrading windows will add up quickly and is already causing investor hesitation. A large portion of new capital flowing to the office sector will likely be for multifamily conversions. If you can’t beat ‘em, join ‘em.
In 2020 we said the hospitality industry would recover in 2024 and we stand by our prediction. The return of business and large conference travel has begun and will gain momentum if COVID variants stop emerging. The biggest issue the sector is dealing with right now is a labor shortage and the need to pay higher wages to attract talent. According to the Bureau of Labor Statistics, hospitality has experienced the highest wage growth of all industries, almost 20% since 2019. To compensate for the higher cost, some operators, especially in the leisure segment, have been able to raise rates. Through this transition period, fresh capital is helping to keep the industry afloat. During the servicer panel at the January CREFC conference, participants mentioned that many hotel loans have coverage ratios below 1.0x but the sponsors are funding the deficits. Capital is available for the sector not only because of the expected recovery but because hotel owners can take the most advantage of inflation.
Hot Topics for 2022
Government Action and Inaction
Following the progress of legislation in Washington this past year took a lot of concentration. The bi-partisan Infrastructure Investment and Jobs Act can only be good for real estate. It is unlikely we will see another bill pouring so much money into roads and bridges, public transit, and other infrastructure projects that will enable cities to grow and people to move more efficiently from place to place. The bill also provides funding to support environmental sustainability including cleaner water and energy efficiency.
The Build Back Better Act, which after much negotiation was never passed in the Senate, included many tax proposals over the course of the year that would have greatly impacted real estate owners and investors. Early drafts of the bill included the repeal of IRC Sec. 1031 like-kind exchanges; higher tax rates on income, capital gains, and carried interest; and a provision to crystalize unrealized capital gains at death as well as eliminate the basis step up to current value. By the time the House passed the bill in November, all these proposals had been dropped. But the draft bill possibly still in play contains a provision that real estate professionals would no longer be exempt from paying net investment income (NII) tax (currently 3.8%) on property operating income and capital gains from real estate ownership activities. This would result in additional tax to real estate owner-operators, developers and fund manager promotes, and should be carefully watched if debate on the bill resumes.
Environmental, Social, and Governance Strategies
The continuing focus on environmental, social, and governance (ESG) initiatives in companies across all industries has gained urgency as the disastrous impacts of climate change become more frequent and social justice takes a more prominent place in American discourse. ESG is not new to the real estate industry. The public REITS and large asset managers have been publishing detailed reports on their ESG strategies and initiatives for several years. What is new, and must be front and center for non-public real estate investors and operators as well, is the incorporation of ESG in real estate company attitudes and processes. ESG is no longer a “feel good” activity and no longer optional. Tenants are increasingly considering ESG when selecting space, in part because their employees are insisting on being in properties that not only provide a healthy environment but are managed to reduce their carbon footprint. Debt and equity capital providers are incorporating the analysis of climate-related vulnerabilities in their transaction diligence. Recent floods, fires, and extreme heat are forcing tenants (and their insurers) to rapidly assess property vulnerabilities. Consider the following:
- Hodes Weill’s 2021 Institutional Real Estate Allocations Monitor indicates that 49% of investors globally consider the ESG policies of the investee.
- ULI’s 2022 Emerging Trends in Real Estate indicates that 82% of survey respondents consider ESG elements when making operational or investment decisions.
- A recent report by JLL showed that office tenants are considering an owner’s ESG activities when selecting space, focusing particularly on building sustainability and efforts to create a healthy work environment, including quality air flow.
- A Cushman & Wakefield study found that sellers are achieving 25% higher prices per square foot in Class A LEED-certified office buildings and 77% higher prices in Class B LEED-certified office buildings than non-certified buildings.
Real estate company ownership and management must learn all the components of ESG and develop a plan for prioritizing the implementation of policies and initiatives. The initial investment will be repaid as these companies attract tenants and capital on the revenue side and reduce operating costs. At the same time the industry will be boosting environmental sustainability, property resiliency, work force inclusiveness and growth, community engagement, and transparency.
The Maturing of Proptech
Over the past decade the proptech industry has exploded, with increasing capital driving innovation across both residential and commercial real estate. According to the Center for Real Estate Technology & Innovation, over $32 billion was invested in 2021. Of that total, 49% was focused on the residential market, including listing services, marketplaces, and mortgage brokerage; 19% on construction; 21% on multifamily; and 8% on the commercial sector. Adam Schuit of venture capital group A/O PropTech relayed that the commercial dollars were primarily spent in a few key areas:
- Commercial listing portals
- Leasing co-working spaces so that companies can find space for employees working outside the office
- Access management, door locking mechanisms, and occupancy tracking, which ties to utility management
- Air purification systems and air quality measurements
- Smart lighting, including using alternative intelligence to learn about usage in different parts of the building 24/7 and reduce utility costs
As important as the development of new technologies to make business run more efficiently and reduce costs is the rising adoption by the industry. Key areas for 2022 include disrupting inefficiencies in commercial mortgage origination by automatically incorporating and organizing property performance and market data to generate underwriting models, and the tokenization of commercial real estate, where ownership in an asset is divided into a fixed number of tokens. Tokenization could revolutionize how real is owned and capital is sourced, and thoroughly disrupt the current system of proof of title and title insurance by using block chain to register the tokens.
Navigating Through Change and Uncertainty
With few exceptions, demand for space across property types is high and the fundamentals are strong heading into 2022. A recovering economy and strong job market will support higher rents and occupancy. The capital sources that fueled record transaction volume in 2021 are still there and have the added incentive of seeking an inflation hedge. Transaction volumes this year will likely break records again. In the mid- to long-term, however, the withdrawal of fiscal and monetary stimulus has the potential to create a shifting investment environment, and capital providers will have to dig deeper to identify and price longer-term risks, particularly anticipating market conditions when refinancing or exiting an investment. It is possible we are entering a prolonged period of rising interest rates, higher inflation, lower liquidity, and reduced real investment returns. If the environment appears more risky, capitalization rates could ultimately rise, negatively impacting asset values. Despite these trends, real estate remains a relative value play and will continue to attract significant domestic and foreign capital for the foreseeable future.
As these fundamental economic shifts are taking place in the long-run, property owners and operators will be focusing on more immediate issues. No one can productively run their business without the right talent, and the search for and retention of talent has become more difficult. Higher turnover means higher recruiting and training costs, and less efficient operations. The industry will need to continue to open itself to a more diverse work force, which will bring with it new insights and innovation. And management will have to spend more time on formal training, career development, and mentorship programs.
Perhaps the most important and long-lasting trend for our industry is ESG. As mentioned, the immediate need is assessing property resilience against the forces of climate change. But we are just at the forefront of significant efforts to make buildings more sustainable, reducing the carbon footprint of an industry that currently contributes an inordinate share of green house gas emissions. In the long run perhaps the greatest threat of climate change to the industry will be the migration of people away from markets that are the most prone to extreme weather and also happen to be some of the most expensive and fastest growing markets in the nation. The social and governance components of ESG are also gaining greater importance, which is natural for an industry whose purpose, after all, is to create great places for people to live and work. The success of all real estate ventures is integrally connected to the successful growth of their communities. ESG will ultimately be ingrained in all real estate business processes, not just property management but also the credit criteria of lenders and institutional equity providers.
Finally, an industry that has resisted technology for decades has finally taken the plunge. This will modernize archaic processes, making operations more efficient and reducing costs. Technology will accelerate sustainability efforts and better connect organizations to capital. If tokenization takes hold, the way property is owned will be fully disrupted. Leaping even further into the metaverse, the essential question is whether commercial real estate will exist in the future, or will we just send our avatars to virtual spaces to work, shop, and be entertained -- the ultimate realization of work from home. Until then, investors in the realverse will be focused on carefully monitoring interest rate and inflation to developing new strategies to preserve long-term returns in a post-pandemic environment.
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Joseph Rubin has experience working with real estate transactions, governance and reporting and distressed debt restructuring.
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