Three Commercial Real Estate Stories You Didn't Read This Week (but Should Have) - Dec 15th, 2023
Plus my take, plus ChatGPT's
Every week I scrounge the commercial real estate (“CRE”) rags and the occasional mainstream source for the most important, or perhaps soon-to-be-important, stories that may have slipped through the cracks. I summarize the piece, explain the broader implication and then give our friends at OpenAI a shot by asking ChatGPT a question about the story.
MY TAKE
Bottom calling is a dangerous art, given its proximity to the catching of falling knives. But Green Street, one of commercial real estate’s most respected data and analysis providers, is doing just that.
In a recent report, Green Street Co-Head of Strategic Research, Peter Rothemund, said "...commercial property is now fairly priced vs corporate bonds. Property pricing may well have hit bottom."
Rothemund cites recent swings in the Treasury market for his optimism, suggesting that after rising yields through September and October, a recent rally in bonds (rising prices drive yields lower), has breathed new life into the battered CRE market.
2022 and 2023 have been abysmal years for commercial real estate, with Green Street's institutional quality property index down 22% since it's peak in March 2022. This should come as no surprise, with borrowing rates rising sharply over the past 18 months, squeezing property owners, many of whom were already suffering from falling rents.
It's easy to question Green Street’s call, given rising levels of distress across property segments, especially the ongoing turmoil in the office market and recent declines in apartment rents nationwide. But we are now almost 24 months into this correction, and we are almost certainly closer to the bottom than we are to the top. Calling a bottom may be premature, but given the change in positioning at the Federal Reserve, Rothemund’s prediction could prove prescient.
Despite the ongoing debate about how soon and how much the Fed will lower rates next year, economic conditions would have to stage a remarkable turnaround for the direction of interest rates to be anything but flat-to-down from here.
It takes time for distress to work its way through the system, but forced sales are putting in a price floor in many markets, bringing buyers in off the sidelines. When you see trades at 60, 70 and up to 80% below previous valuations, it's hard to get excited about being even more bearish on values. Many more properties may trade at those levels before appreciation kicks in, so it's important not to confuse volume with values.
CHAT GPT TAKE
I asked ChatGPT if the calling of a bottom in CRE was too optimistic, or a balanced take given today's market conditions. I also asked it to take other market conditions into consideration, not just the information provided in the article.
Assessing the state of the U.S. commercial real estate market and the notion of a market bottom requires a multi-faceted approach, especially considering the various reports and forecasts currently available. Based on the information from your article and additional sources, here are some key insights:
Economic Outlook and Investment Activity: CBRE's midyear review in 2023 suggests a moderate recession in the U.S. from late 2023, extending into early 2024, with factors like higher interest rates and the restart of student loan payments impacting growth. They note a cautious investor sentiment with investment volume down by 60% year-over-year in Q2 2023, primarily due to uncertainty around interest rates and the economic outlook. A recovery in investment volume is now expected to begin in early 2024 rather than late 2023.
Cap Rate Trends: There has been an increase in cap rates, approximately 125 basis points for most property types and closer to 200 basis points for office assets. CBRE forecasts that cap rates will stabilize in early 2024 for all property types except offices, which may see continued expansion until mid-2024.
Sector-Specific Insights: The multifamily and industrial sectors have shown resilience. According to JPMorgan Chase, multifamily properties continue to perform well, and the industrial sector remains on a hot streak. However, the future of office space is less certain, and retail is at a crossroads. CBRE also notes that the office sector will likely evolve due to hybrid working, and the retail sector is attracting investor interest due to its recent changes.
Vacancy Rates and Absorption: The National Association of Realtors (NAR) reported in August 2023 that apart from the retail sector, vacancy rates have increased in the office, multifamily, and industrial sectors compared to a year ago. The office sector, in particular, has seen negative net absorption for almost a year.
Considering these factors, the notion that the commercial real estate market may have hit a bottom, as suggested in your article, is contingent on several variables. The increase in cap rates and the ongoing caution among investors indicate a market that is still adjusting to economic uncertainties and interest rate hikes. The diverging trends across different sectors, like the relative strength in multifamily and industrial versus the challenges in office and retail, also suggest a nuanced picture.
Therefore, while there are signs of potential stabilization in certain sectors, it's important to remain cautious and consider the specific dynamics of each sector. The potential for a bottom in the market might be more pronounced in sectors like multifamily and industrial, while office and retail could see continued challenges. Additionally, the broader economic context, especially regarding interest rates and the potential for a recession, will be crucial in determining the overall direction of the commercial real estate market.
Demand for Retail Space Hits Record High in the US - CoStar (paywall)
MY TAKE
If you woke up in the middle 2020, it would have been reasonable to think that the pandemic would put anyone owning a shopping mall, strip center or retail space out of business.
And it's true: a lot of retailers went out of business because of Covid and government-mandated lockdowns. But that was more like retail's last gasp than the beginning of the end. As recently as 2017, industry experts guesstimated that the U.S. had a billion square feet of real estate space that "need[ed] to go away," according to CoStar director of retail research Suzanne Mulvee.
That's billion, with a “B.”
Now only six years and a global pandemic later, CoStar reports that demand for retail spacer hit a record high, with Q3 2023 marking the 11th consecutive quarter of positive net absorption.
The article makes an interesting point about the nature of supply and demand, which has implications for today’s office property market.
While retail space market fundamentals are strong, more than a decade of minimal construction combined with persistent demand growth has led to a lack of institutional-quality space across many primary and even secondary corridors across the United States. As such, numerous retail tenants and tenant representatives have reported a lack of available space in desired locations as a factor weighing on the pace of demand growth, which has notably downshifted to more sustainable levels over the past year.
No one – and I mean no one – is thinking of building new office space right now, and likely won’t for the foreseeable future. But eventually, perhaps a decade from now, the market will grow into the overhang of empty office space and like retail today, there will be the inevitable imbalance between demand and supply which creates buying opportunities.
But that is not the same as saying owners of commodity, unremarkable class B office space can just sit around and wait until demand comes back.
Unlike money, property is not fungible. 10,000 square feet of space here is not the same as 10,000 square feet of space over there. It's not enough for there simply to be space available, it has to be the right space for what tenants want, or it’s the same as there be nothing available.
CHAT GPT TAKE
I asked ChatGPT to put on its investment advisor hat, and consider whether based on the information in this article and its own research, whether it would be a buyer of retail REITs.
Based on the current market conditions and trends, investing in retail REITs (Real Estate Investment Trusts) could be considered, but with a nuanced approach.
Retail REITs have shown signs of recovery post-pandemic, but many are still working towards reaching their pre-pandemic levels. The demand for retail space has been robust, with occupancy rates for retail properties remaining high. This is partly due to a lack of new development and limited availability of quality space, which has led to peak occupancy and healthy leasing volumes. However, these positive indicators are tempered by challenges such as higher interest rates, a stretched consumer base due to inflation, and the potential for retailer distress and store closures.
There's also a notable divide in the retail sector, particularly between malls and off-mall retail spaces. Off-mall retail spaces are expected to experience stronger rent growth, a key driver for net operating income growth in 2023 and 2024. On the other hand, malls, especially those rated three stars and below, are facing challenges with tenant losses and decreasing demand for space.
In terms of broader REIT market outlook, REITs have historically shown resilience in periods of economic downturn. They have outperformed both private real estate and the broader stock market during and after the last six recessions. With strong operational performance and disciplined balance sheets, REITs are considered well-positioned to navigate economic and market uncertainty in 2023. The late 2023 performance of REITs suggests a brighter outlook for the industry in 2024, with expectations of stabilizing and even declining interest rates.
However, it is important to consider that the retail sector, like any investment, carries its own set of risks and variables. Factors such as consumer spending patterns, inflation rates, and the overall economic environment will continue to impact the performance of retail REITs. Additionally, the retail landscape is evolving, with trends like e-commerce and changes in consumer behavior influencing the sector.
In conclusion, while there are positive indicators for retail REITs, especially in off-mall retail spaces, potential investors should carefully consider the specific characteristics of the retail REITs they are interested in, including their portfolio composition, geographical presence, tenant mix, and balance sheet strength. Diversification within a real estate investment portfolio and a keen understanding of the evolving retail landscape are key to navigating this sector.
Only 13% of San Francisco Offices Are Viable for Multifamily Conversion
- Moodys Analytics
MY TAKE
It seems like such an obvious trade: There are scores of empty office towers in downtown San Francisco selling at a fraction of their past values. Meanwhile, the city is struggling with a persistent housing shortage which has kept rents and home prices stubbornly high. So why not just turn those offices into apartments?
Problem, solved.
It is of course not that simple, and the team at Moody's Analytics does a respectable, if academic, job at tackling the problem of how viable it really it is to convert those lonely office buildings into housing.
Most assessments of this potential opportunity, which has been executed for years in Midwest cities like St Louis and Cincinnati and is gaining steam in New York, focus on the economics. Construction costs in San Francisco are higher than any city in the world and downtown rents are well down from their previous highs, which means that even though office properties are trading at values we last saw in the early 1990's, conversions simply do not pencil.
But Moody's took a different tack, considering not only the physical aspects of the building like floorplate size and window location, but also things like age, tenant makeup, neighborhood desirability, zoning and proximity to public transport.
They whittled down an initial list of over 400 conversion targets to the best 50, and then published the top 10 candidates in a recent report. And while Moody's stopped short of providing permit-ready plans for the conversions, their assessment of San Francisco itself was noteworthy.
The authors point out that perhaps surprisingly, San Francisco's economy has fared well since the pandemic. Job growth and GDP have both outpaced the national averages, while the creation of new housing inventory has tapered off even as it took off nationwide.
As I noted last week, in response to city officials easing regulations for office conversions and agreeing to waive certain development fees, a handful of developers submitted proposals for office to residential conversions. But word is that the proposals were largely lip service, developers and politicians with a mutual understanding that the half-measures pushed out of City Hall are just good enough for some positive press, but not generous enough to get developers back into the game.
Moody’s analysis is an interesting framework for evaluating conversions as a possible investment opportunity and path to easing San Francisco’s housing woes, but it also highlights the myriad challenges to taking these projects from concept to reality.
CHAT GPT TAKE
I asked Chat GPT whether office to residential conversions were a feasible path to addressing San Francisco’s chronic housing shortage.
The feasibility of converting office buildings to residential units in San Francisco is a complex subject with several important considerations. Recent studies and legislative changes suggest that such conversions are not only possible but also necessary to address the city's housing shortage and revitalize its downtown core.
A key finding from Moody's Analytics indicates that 13% of San Francisco's smaller, historic office buildings could be viable candidates for conversion into homes. This assessment is based on factors like building age, size, and location, particularly their proximity to public transit and the likelihood of lease renewals. A similar study by SPUR and ULI San Francisco, in partnership with Gensler and HR&A Advisors, found that while physically feasible, these conversions currently are not financially viable under existing economic conditions and policy frameworks. They suggest that to make such projects financially feasible, the city could consider easing building code requirements and reducing fees and taxes.
San Francisco has implemented several legislative changes to facilitate these conversions. For example, the city's Commercial to Residential Adaptive Reuse ordinance exempts certain projects from specific Planning Code requirements and proposes waiving all development impact fees for qualifying adaptive reuse projects, except for inclusionary housing requirements. These changes reflect a broader trend across cities to repurpose underutilized office spaces in response to shifting work patterns and urban development needs.
Gensler, a global architecture firm, has been leading efforts in assessing the suitability of office buildings for conversion. They have developed a proprietary building rating system and cost model to evaluate office buildings for adaptive reuse. In their study of 36 buildings in downtown San Francisco, they identified 12 candidates that rated well for conversion. This assessment included considerations such as building form, floor plate, and proximity to amenities.
In summary, office-to-residential conversions in San Francisco are seen as a viable solution to the city's housing shortage and a way to rejuvenate its urban core. However, achieving these conversions on a large scale will require a combination of favorable economic conditions, supportive public policies, and innovative approaches from developers and city planners.