Last year, the real estate industry's plan was simple: eliminate current risks and reposition the business for a period of sustainable growth and improved returns. <However, for the industry leaders we interviewed for this year's Emerging Trends in Real Estate report, the reality has become clear. They no longer expect a radical shift to the way things were before the pandemic. Instead, they have accepted the likelihood that many people will not return to their offices after all, or at least not at the same pace. This has profound implications not only for office owners, managers and brokers, but also for the country's downtown and other real estate sectors that rely on a vibrant office market.
The Future of Interest Rates
There is also a reluctant acceptance in the industry that interest rates will remain high for at least the next year and possibly longer. Even good news, such as investor appetite for new assets, is being tempered by gloomy sector data. For example, despite the available stock, transactions are down - and many in the industry point to instances where buyers and sellers can't agree on pricing because the dearth of sales limits price visibility.
Positively, there is also a reluctant acceptance in the industry that interest rates will remain high for at least the next year and possibly longer. On the positive side, respondents to this year's Emerging Trends Survey believe that the worst levels of inflation are behind us, which should give the Federal Reserve a reason to pause rate hikes.
On the positive side, respondents to this year's Emerging Trends Survey believe that the worst levels of inflation are behind us, which should give the Federal Reserve a reason to pause rate hikes. <Andrew Albertstein, Partner, Real Estate, PwC US, said: “Despite economic headwinds and challenges in accessing credit, there are opportunities for high-quality real estate that meets the needs of today's investors and tenants. ”Companies must learn to adapt their growth strategies to succeed in this period of higher interest rates for a longer period."
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Interest in commercial office sector wanes
<More than three years after the start of the pandemic, the real estate professionals we interviewed for Emerging Trends largely agreed that the real estate industry will never return to what it was before, as it was difficult to change patterns of work and commuting behavior. Even with corporate demands and incentives to return to the office. Office buildings have also lost their appeal to investors, with sales transactions more than twice as low as those of other major real estate types.
Office buildings have also lost their appeal to investors, with sales transactions more than twice as low as those of other major real estate types. <There is currently a bifurcated market in the office sector that includes both haves and have-nots, with a few properties in major cities that are still attractive to U.S. companies. These properties are typically the newest, safest and healthiest buildings with the best amenities in the most sought-after locations. These premier facilities attract a disproportionate share of leasing benefits. Moreover, office markets in many smaller and developing cities are not only surviving, but thriving even beyond pre-pandemic levels. <In the coming years, companies with business models that support remote work will continue to downsize their offices to save on rent. Going fully remote may also help companies win the battle for talent, as companies offering remote jobs have access to a wider pool of talent, allowing them to hire better workers at lower wages. Such economies may be too compelling for them to reverse course and rent office space as before.
What should office owners and cities do with empty real estate? While some in the industry advocate reusing vacant office buildings, the industry leaders surveyed warn that not all office buildings can be economically converted - even with government subsidies. They suggest that the best economic solution may be to demolish the buildings and reuse the land.
Despite the gloomy outlook, some of the industry leaders we interviewed have not given up on the future of office buildings. They want to learn from how the retail sector adapted and eventually recovered from the competition it faced over the past few decades from e-commerce, which emerged as a viable alternative to in-store shopping.
Despite the gloomy outlook, some of the industry leaders we interviewed have not given up on the future of office buildings.
Dealing with the credit crunch
The debt of U.S. households and businesses appears to be within reach of borrowers, with few signs of financial distress. This is usually a positive sign for commercial real estate. However, rapidly rising federal debt could be more problematic, potentially "crowding out“ private investment in the industry, leading to slower economic growth as well as higher interest rates - both of which will have a long-term impact on construction, investment and yields.
All of the industry experts reported that U.S. household and corporate debt appears to be out of reach for borrowers, with little signs of financial distress. <Almost all industry experts surveyed reported that debt (credit) has become less available since the Fed began raising interest rates in March 2022. <Assets have declined among all primary debt sources, including banks, commercial mortgage-backed securities and life insurance companies, although private debt sources sometimes step in to fill the gaps as others have cut back on lending. Several survey respondents also attributed lower sales transactions for 2023 in part to lower credit availability.
Many respondents also attributed lower sales transactions for 2023 in part to lower credit availability.
<Not only has it decreased, but credit has become more expensive and strictly collateralized. Instead of credit, borrowers have retained their existing debt, which is reflected in the growing volume of outstanding CRE debt. This has enabled banks to grow their books of business despite making fewer new loans.
Continued uncertainty over interest rates
<One clear theme of this year's emerging trends is the fact that commercial real estate investors are becoming increasingly cautious in their expectations and more selective in their asset selection. Investors are slowly lining up to capitalize on undervalued assets and acquire new ones. For example, the 2024 Emerging Trends Barometer recorded its highest buy rating since 2010, likely reflecting recent and expected price declines, making this a more favorable entry point for acquisitions after a decade of sustained appreciation.
But even the most cautious investors are slowly lining up to capitalize on undervalued assets and acquire new ones. <But even optimistic investors, who have been aggressively raising capital to buy distressed real estate, are finding a limited number of promising opportunities to pursue. These investors have moved to the sidelines in anticipation that there will be more favorable opportunities in the future. Deal activity in the real estate sector is likely to depend on how interest rates change, as the Fed's longer-term higher approach to interest rates is likely to slow economic growth.
Climate risk rises as need for sustainability grows
<After another record-breaking summer, 2023 is shaping up to be among the hottest years on record. In addition, the number of climate events with billions of dollars in losses continues to rise<Real estate owners and managers now find themselves subject to increasing government regulations and ESG (environmental, social and governance) mandates. In addition, city governments in some CRE markets have enacted regulations in recent years that mandate regular energy audits and require commercial buildings to implement energy-saving measures.
Real estate owners and managers are also feeling the heat.
Property owners are also increasingly concerned about their insurance costs, which have increased - in some cases, dramatically - in recent years. Insurance premium increases are typically passed on to tenants, but there is concern among some professionals we interviewed that tenants in this market may balk or that the costs may limit future rent increases. It all hinges on landlords getting coverage, as many insurers have stopped offering plans in areas prone to extreme weather events such as California and Florida. <Aside from rising insurance costs, the growing correlation between real estate assets and sustainability performance is another key reason for the industry to plan its next moves with sustainability in mind. Over the years, CRE investors and fund managers have faced complex and difficult choices in considering how to move forward toward sustainability. Now, decarbonization, energy efficiency, indoor environmental quality, climate resilience and related issues are becoming more urgent as extreme weather events escalate and the risks and costs to owners rise. Going forward, investors are likely to be more risk-averse and will conduct extensive due diligence to understand the risks and potentially change their investments.
Unaffordability of housing
<In last year's Emerging Trends Report, we noted that housing affordability had fallen to its lowest level in more than 30 years, with both for-sale and rental housing costs rising to record levels. This year, the situation is even worse, especially for homebuyers. Rents are also higher, although they are rising more slowly in some markets. <The industry's focus on housing affordability in this era of rising interest rates is likely to remain for a while longer. The troubling combination of rising home prices and rapid increases in borrowing costs has put homebuying out of reach for more people.However, the housing crisis has been a catalyst for the industry's focus on housing affordability in this era of rising interest rates. <However, the current housing affordability crisis has been more favorable for renters of late, as national rental growth has remained flat or minimal, having peaked in early 2022. This is the result of healthy additions to supply, including apartment construction, which is on pace to add more than 460,000 units in the U.S. this year, on top of more than 700,000 units since the start of the pandemic. <As we've previously discovered, the solution to the nation's housing crisis is to build more of it, preferably at all price points. But the reality is that we are not building enough units that are affordable to low-income renters in particular - so not all new supply will necessarily lead to improved affordability.
The importance of AI applications in real estate
Advances in the field of artificial intelligence (AI), including generative AI, are showing promising results in the real estate sector. For one thing, AI is starting to enhance the process of researching and analyzing real estate. It is reshaping how real estate investors analyze potential investment opportunities, improve the customer experience, help streamline due diligence and improve fraud detection in real estate transactions, among other activities. In addition, some of the investors we interviewed for Emerging Trends point to AI's ability to generate a new source of demand for office space, particularly in traditional tech markets like San Francisco, where a significant portion of venture capital and AI employment is concentrated.
Although AI's potential to transform the way real estate investors analyze potential investment opportunities, improve customer experience, and help streamline due diligence and improve fraud detection in real estate transactions, among other activities. <However, although AI has been used in real estate for years, many of the technology's capabilities and functions remain largely unknown to the leaders we interviewed. In addition to a lack of understanding, interviewees pointed to AI-related misinformation as a major barrier to adoption.
In addition to a lack of understanding, interviewees pointed to misinformation about AI as a major barrier to adoption. <To help combat misinformation and other risks, leaders should conduct thorough research on the topic and learn how to make responsible AI part of their larger AI strategy. Organizations must also consider data privacy and security, especially for systems that rely on large sets of data, as protecting personal and sensitive information is critical.
