At the end of the year, we step back and look at longer term trends in our economy and culture and discuss their impact on the real estate investment business. We will do that in the second half of this update, but first we must address the remarkable fourth quarter. A year ago, the consensus forecast was that the economy would slow or move into recession in the second half of 2023 as the Federal Reserve continued its battle with inflation. It has not turned out that way.
In December, Fed Chairman Jerome Powell announced that the Federal Funds Rate would remain at 5.25 – 5.50% for the foreseeable future and indicated that as many as three reductions of the Rate could be on the horizon for 2024. The tide is turning. The 10-year Treasury rate has dropped by 75 bps from its October high of 4.95%. Price discovery is beginning to take place across all real estate asset types and evidence of distressed pricing is starting to appear. The capital markets are ready. “..as thousands of properties across the CRE landscape struggle to meet debt service coverage ratio and debt yield thresholds, the long-awaited reservoirs of debt and equity capital so often missing in 2023 appear ready to come to the rescue.” Brian Pascus, Commercial Observer
The interest rate peak and then decline in the fourth quarter
may be the beginning of the bottom for the property markets. Admittedly, the debt markets remain difficult, but in Washington DC, there were a surprising number of office buildings sold. Like much of the country, office has been Washington’s most battered asset class. As you can see from the accompanying chart, the recent transaction prices reflect a stunning drop from what was paid for these assets just a few years ago. This sure looks like capitulation by lenders and owners of office assets. The buyers of these assets were not the typical institutional buyers, but high net worth individuals and private equity funds targeting distressed real estate. While these prices seem low, the success of these investments remains to be seen. These downtown office properties are mostly older buildings, and even if renovated, the lack of tenant demand and the high cost of tenant improvements may increase the property basis such that there is very little value actually created. In some cases, the business plan may be to convert to another use, such as apartments, a common consideration in today’s market.
While 2024 has the potential to be the beginning of a classic cyclical recovery, the ways in which we live, work, shop and travel are evolving in the post-pandemic world. The rapid cultural changes taking place in our society, many of which were either masked by or accelerated by the pandemic, are causing some of the most significant shifts in real estate products in a generation. Real estate owners and developers do not lead the cultural change, they respond by building the products that the evolving culture demands. As we emerge from the pandemic, how do we determine which changes to the way we conduct our lives are cyclical, and which are more permanent secular shifts? Take work from home, for example. Of course, employees like the flexibility of working from home. Who wouldn’t like to have the choice? On the other hand, employers are increasingly leaning in to forcing everyone back into the office on most days to nurture culture, train new employees, and foster teamwork. Where this ultimately settles out has major implications beyond office properties.
With workers spending less time in the office since the pandemic, commute times have been reduced. That’s a good thing. However, as there are now fewer workers in cities across the country; retailers are closing; office values are plummeting; the tax base in cities is shrinking; and crime is on the upswing. If this is the new normal, cities will have to adapt to fewer workers downtown on a daily basis, and new real estate products will be introduced to respond to these changes. In both the city and the suburbs, the number of obsolete properties is at an all-time high. Some office buildings will be converted to other uses while many others will be demolished.
Other product types are facing similar shifting sands. The relentless growth of e-commerce has forced adaptation of the supply chain and changes in the location and configuration of warehouse and distribution properties. Retail will continue to be pressed by the growth of e-commerce with malls feeling the greatest effect and neighborhood shopping centers the least. And if this isn’t enough, the revolutionary changes we will see from AI are right around the corner.
Real estate projects take years to plan, approve and build. Developers and investors will need to be nimble and flexible in the face of these cultural changes. As we recover from the pandemic and the recent inflation scare, conversions and change of use concepts are increasing to meet these tidal shifts in the near term. Uncertainty has always created opportunity for those who are willing to embrace change. We are entering a period where that approach has never been truer.