As employers and employees struggle to find the right fit among return-to-office mandates, remote work and hybrid arrangements, the commercial real estate (CRE) industry also has been adjusting to the “new normal.” And it’s not just office space that’s facing headwinds: all CRE sectors likely will face vacancies, more expensive and harder-to-obtain capital and higher operating costs this year.
Dramatized by WeWork’s bankruptcy, nearly 20% of office space in major U.S. cities was vacant or unleased in 4Q 2023, the most since at least 1979 as tracked by Moody’s Analytics. That’s higher than both of the vacancy peaks that followed the 2000-era dot-com meltdown (17% in 2003) and the 2009 Great Recession (about 17% in 2012-13). Although those vacancy peaks were followed by recoveries, it’s uncertain if and when the current market will rebound.
And that’s not the only challenge CRE is facing. This has all been happening amid one of the most aggressive rate-hiking cycles the U.S. has ever seen, persistent inflation and tighter bank lending standards.
Borrowers and lenders take a more prudent approach
“It’s a different world from yesterday’s predictability, and we’ve become more conservative in the amount we’ll loan on a project, or the amount of equity needed to make a loan,” said Dan Easley, executive director of commercial real estate at BOK Financial®. The more expensive cost of capital has led both lenders and borrowers to take a more prudent approach to new projects—and in many cases hit the pause button, he said.
Based in Dallas, a relative hotbed of CRE activity where 600,000 jobs have been added since late 2018, Easley leads a CRE team operating in eight states. Most of the team’s lending is for new, ground-up construction focused on industrial, multi-family and senior housing projects developed by experienced operators and repeat clients who serve a well-defined market. For senior care centers, that often means facilities for private-pay residents who can afford the escalating costs of residency and care.
“The borrowing terms may not be what they used to be, but as lenders and borrowers working collaboratively, both sides appreciate the mutual familiarity that has grown over time,” Easley said.
“Our customers know that we’ll understand their challenges as they contend with uncontrollable factors like interest rates and then inflation that has been especially hard on materials costs and wages.”- Dan Easley, executive director of commercial real estate at BOK Financial
Although different CRE sectors face many of the same challenges, such as higher interest rates on debt, there are also, of course, obstacles and opportunities that are unique to each. Here’s what we expect for the industrial market in 2024—and what it’s facing now.
The industrial front
In what’s become a bit of an about-face, operators of industrial space will again contend with the effects of financing issues in 2024, even if interest rates fall midyear. “Industrial had been everybody’s darling for 10 years,” said Easley.
According to the 3Q 2023 Industrial Outlook by JLL, a global real estate services provider, the Unites States’ 15.2 billion square feet (sf) of industrial space is 75% occupied by warehouse or distribution facilities, and 25% by manufacturers. Here’s a breakdown:
- The Q3 2023 quarter’s net absorption of 47 million square feet was the lowest in three years.
- Vacancy rose quarter-over-quarter to nearly 5%. Contributing to the glut of space was cautious decision-making by prospects and evidenced by the lowest quarterly leasing volume, 90 million sf, since 2015.
- Delivery of new facilities—coupled with fewer groundbreakings exacerbated by high costs—have resulted in a 22.5% year-over-year decline in assets under construction.
- Dallas/Fort Worth, Phoenix and Houston are among the four metros that accounted for nearly 41% of the 163 million sf delivered in 3Q.
- Most telling perhaps was that the $50.7 billion YTD lease volume through Q3 2023 was less than half of 2022’s $106.3 billion and the lowest since 2016.
Rising costs are evidenced by the declining results of the industry’s key performance indicators. Vacancies and space availability are up amid slow-to-absorb projects. Lease commitments and construction investments are down sharply, to levels not seen since 2015-2016. In all, leasing decision makers have become more cautious, contributing to the glut.
Even high growth areas like Dallas/Fort Worth, Houston and Phoenix—three of four metros that accounted for nearly 41% of the 163 million sf delivered in 3Q—may be challenged to fill their markets’ highly concentrated spaces.
Long the darling of the commercial real estate industry, industrial-purposed projects are facing the combined effects of rapid expansion in the ecommerce era and lenders’ evolving practices resulting from elevated interest rates, which many hope will subside later this year.
A second article in this series will cover challenges facing developers of residential and office spaces.
. © 2024 BOKF, NA.