Commercial Real Estate Gets Ready for Its Next Phase

As the home stretch of 2024 comes into view, a resilient economy and the prospect of lower interest rates are buoying hopes for the commercial real estate (CRE) industry, which has endured an extended period of uncertainty and is now ready to begin a new cycle.

There are some signs of turbulence in the economic outlook. The labor market is clearly cooling, with the number of new jobs unable to keep pace with a growing labor force in recent months. The slowdown is particularly pronounced in knowledge-oriented industries, which, as explored below, has important ramifications for the office sector. Consumer debt is also a metric to watch, with delinquencies elevated alongside interest rates. And, of course, a presidential election always brings an air of apprehension.

Despite these concerns, the overall economy appears strong. Consumers are still spending, and retail sales are still rising. The inflation rate is below three percent for the first time in more than three years. And even though the labor market is softening, layoffs have yet to increase meaningfully. As a result, the Federal Reserve is expected to begin lowering interest rates soon, while many economists are reducing their odds of recession and revising their forecasts for GDP growth upward.

The CRE industry is watching this situation closely, hoping to emerge from an extended period of diminished activity. Investment sales volume averaged over $145 billion per quarter in the late 2010s but has been about 25 percent below that since the beginning of 2023. Industry professionals hope that a normalization of monetary policy will contribute to a more normal level of activity.

However, the next cycle will likely be one in which CRE property types do not respond monolithically to macroeconomic factors but instead react to the shifting secular trends that underpin demand for the uses they provide. The office sector, especially, figures to be in transition for several more years.

Office Seeks Its Floor

The slow reset in per-worker demand for office space is winding down, even as longer-term headwinds blow. Over the past two years, average office attendance has climbed from about 50 percent to around 70 percent of 2019 levels, according to the mobility data provider Placer.ai. But in that time, office users have continued to give back space, with cumulative negative absorption exceeding 1 percent of inventory. This has pushed the national vacancy rate to a record level of nearly 14 percent.

While ongoing adjustments to new usage patterns are clearly a factor, hybrid work itself bears only part of the blame for this occupier conservatism. Employment in the major office-using industries has cooled substantially from its red-hot pace in 2021 and 2022. As recently as July 2022, office-using employment was growing at a clip of more than five percent per year. A year later, the rate had fallen below one percent, about half its long-run average during economic expansions. By July of this year, year-over-year growth had slowed to a mere 0.4 percent. The deceleration has been especially acute in the tech-heavy—and formerly space-hungry—information sector, which now employs three percent fewer workers than it did two years ago.

Looking ahead, the knowledge workforce faces demographic constraints that are expected to hold growth well below its historical average. Oxford Economics projects an average growth rate of only 0.6 percent for the remainder of the decade. This and remaining pre-pandemic lease exposure could forestall the sector’s recovery.

As of August, over 40 percent of the space leased before April 2020 has yet to face expiration, which means many occupiers have not finalized whatever structural footprint adjustments they plan to make. Much of the impact of what remains has been brought forward through a combination of lease cancellations and sublet listings. Furthermore, about a third of the space yet to expire is tied down through at least 2030, making it unlikely to factor into the near-term fundamental balance. Still, there will almost certainly be more downsizings and move-outs as many of these leases expire in the next few years.

The Shifting Occupancy Market

The leasing market continues to adapt, with players who have smaller and narrower requirements now leading the way. In one sense, leasing activity is as high as it has been in at least a decade. The number of new leases being executed is nearly 10 percent above its average from 2015 to 2019. But transaction sizes are nearly 20 percent smaller than during the same period, keeping overall volume suppressed.

This demand is concentrated in certain pockets of the market, including premium, newly constructed buildings. But describing the trend as a “flight to quality” lacks nuance and could be misleading. It is true enough that 5-star trophy buildings are maintaining positive absorption, growing occupancy by about one percent of inventory over the past year. However, excluding new construction, the 5-star segment has lost the most relative occupancy. In contrast, 1- and 2-star buildings—those on the other end of the quality spectrum—have lost the least.

Accordingly, the market is polarized. On the one hand, there remains a demand for low-cost, commoditized office space among a certain price-sensitive group of occupiers. On the other hand, new buildings in premium locations compete for a different set of occupiers, those seeking the best possible workplaces to help them activate their talent. Caught in the middle are a group of nominally Class A and B+ buildings that cannot differentiate themselves in comparison to premium buildings yet are too expensive for down-market occupiers.

Market participants report that tenants seeking prime space continue to want custom- or pre-built spaces, putting pressure on landlords to balance capital investment in the space with lease packages that still make economic sense. Meanwhile, large blocks of sublet inventory in second-generation buildings are going unleased despite being offered at 20 to 30 percent discounts to direct space.

Thus, tenants with smaller requirements are driving the top end of the market, seeking spaces in high-quality buildings that they can move into quickly. Meanwhile, after a period of high-profile downsizings, larger occupiers are increasingly standing pat. Many have slowed or stopped hiring and now appear to be awaiting further clarity that the economic “soft landing” scenario is playing out. Ironically, a greater tendency to renew in place could support overall occupancy in the short term since large organizations have tended to shrink their spaces when they have moved in the past two years. For the most part, though, they do not yet appear to be supporting much net new demand.

One exception is the increasing propensity in the past year for space users to become owners of the buildings they occupy. Occupiers are now involved in nearly a quarter of office purchases, double their typical share. Today’s market offers attractive pricing for occupiers confident of their location and space requirements. However, the ongoing correction is a source of consternation for existing investors. CoStar’s Commercial Repeat Sales Index shows that, on a value-weighted basis, office valuations are down about 40 percent from their peak in late 2021, a figure comparable to what occurred during and after the Great Recession.

Supply Stalls Out

A rapidly shrinking supply pipeline should bring some stability to office vacancies by the end of next year. The current pipeline of less than 90 million square feet is the smallest amount under construction since mid-2013, and more than 80 percent of it is slated for delivery before the end of 2025. Construction starts have hovered near a 25-year low for each of the previous four quarters, so the pipeline will only decrease further in the near term.

By 2027, buildings under three years old will comprise only about one percent of inventory, a historical low. The response to this phenomenon could take a variety of forms. In the absence of available premium first-generation space, tenants may begin to backfill the tens of millions of well-located Class A square feet currently on the sublet market. Alternatively, if the expected decline in interest rates triggers a restart in development, some occupiers may choose to wait it out until new options emerge, while others could seek build-to-suit opportunities. In the interim, some owners seeking high yields may pursue renovations designed to make stale buildings competitive for the best tenants. While risky, this strategy could prove successful, especially for owners able to acquire buildings at a low basis with little debt.

An Industrial Normalization

Things generally look brighter in the industrial sector, even though has been below historical norms in recent quarters. Many tenants are pushing pause after a period of unprecedented growth mid-pandemic, but net absorption has remained positive even amid this cooldown. Leasing activity jumped more than 10 percent in the second quarter, and there are other clear signals that a reacceleration in tenant demand is getting underway.

Real consumer goods spending has been trending upward for over a year as inflation subsides. Employment in warehousing and storage employment, which declined throughout 2023, has been growing consistently in recent months. Monthly imports, which also declined last year, have been rising at double-digit year-over-year rates since February, meaning the volume of goods flowing through distribution centers across the country is back on the rise.

For the next few quarters, oncoming new supply will likely push the national vacancy rate up further; however, the recent wave of completions is on its last legs. Higher interest rates have caused construction starts on new industrial projects to plummet over the past two years, and the inevitable drop-off in construction completions coming in mid-2025 should set the stage for vacancies to begin tightening again.

The Next Normal

The consensus macroeconomic outlook of economic growth (albeit tepid), slow inflation, and falling interest rates would likely support a resurgence in the CRE capital markets. More liquidity would be a welcome turn of events for industry practitioners waiting to return to a more traditional activity level. Still, more movement will not necessarily equate to uniform success.

As is often the case at the beginning of new cycles, operating fundamentals will be in sharp focus. A more stable financing environment should allow supply and demand drivers to re-establish themselves as primary sources of asset value. As this occurs, there is likely to be some pain, especially in the office sector. Even so, the next phase of CRE looks to be based on the healthy function of active markets.