A look into the current commercial real estate climate

This Q&A was published as part of PitchBook's H1 2023 Global Real Estate Report sponsored by Baker Tilly.

In this pivotal time of uncertainty in the commercial real estate market, our real estate professionals analyze the current state of the market and offer insight on strategies moving forward.

There's been much discussion of many macro factors for both commercial and residential real estate around return-to-office trends, interest rates and more. What are the factors that you don't see discussed as much that you are watching closely?

It is understandable that those associated with commercial real estate have been keenly focused on interest rates, inflationary pressures, and return-to-office metrics. These issues have been constant since the beginning of 2022. Interest rates have increased 11 times since March 2022, inflation peaked at 9.1% in June 2022, and office occupancies and utilization rates have remained perplexing.

Still, other market factors help paint a more comprehensive picture of the marketplace, both as it stands today and in looking ahead in the near term.

The amount of dry powder—capital sitting on the sidelines and not yet deployed—is a critical barometer that demonstrates the long-term appetite and demand for investment-grade real estate by institutions, family offices, and private investors. The level of undeployed capital, especially in private equity, is substantial. Yet a myriad of factors, including uncertainty around values, the large gap in the bid-ask spread, and the challenge of securing financing, among others, have throttled transaction activity. Investors will return when either values are low enough or when they can underwrite with more certainty.

Because these factors are all interrelated, transaction volumes, another key barometer, are down considerably. The decline is even more dramatic when considering that recent activity levels have been unprecedented, particularly in the industrial and multifamily sectors.

However, real estate investors are transaction-oriented and want to complete acquisitions, dispositions, and development deals. But patience is needed to identify those that make sense and provide the appropriate level of returns for the risk involved.

What concerns are your clients primarily bringing to you?

Our clients, and the industry, are working to weather this period of inactivity and uncertainty. Some are focused on fortifying balance sheets, enhancing operations, and improving net operating income to meet current obligations and position themselves for future opportunities. Other clients seek additional sources of capital—be it fund sponsors seeking investors, or developers/owners aiming to supplement or round-out a capital stack that has changed because of lower valuations, shifting allocations, and the retreat of many banks to the sidelines, among other factors.

Increasingly, we also see businesses that are looking at outsourcing solutions for non-core accounting and fund administration activities. These clients are looking to emerge from the current business and economic environment as fiscally and operationally healthy as possible. This will better position them to identify and take advantage of future opportunities.

Which tactics have proven most successful for your commercial real estate clients in adapting to the challenges in 2023 to date? Which have been the least effective?

Periods of challenge and uncertainty are not unexpected. During uncertain times, the tactics that have been most successful include focusing on core business strategies and existing portfolios rather than aggressively expanding. Unless a business has a significant risk tolerance, now is not the time for experimentation. At the same time, being nimble and able to respond quickly to market conditions and opportunities have been tactics that are instrumental in how clients adapt to a rapidly changing or uncertain environment.

Our clients understand that completing marginal transactions simply to do a deal is not effective. An ill-advised transaction today may only create future problems. Instead, they understand that being disciplined, as challenging as that may be, is critical.

Innovation in real estate comes in many forms—where do you think it is most promising?

Innovation and creativity take on many forms in commercial real estate, from adopting state of the art technology applications and platforms to integrating new processes and programs to enhance performance and minimize risk. Further, leveraging innovation pays dividends during strong economic growth periods and when challenges and uncertainties are present.

The growth in commercial real estate property technology (proptech) has been fascinating to witness. Our clients find that incorporating technology elevates the user experience, regardless of the asset class. In commercial and multifamily buildings, for example, building tenants can enter their offices or apartments with an app and conveniently claim packages with high tech delivery systems, among other conveniences made possible through technological innovation. Leveraging the wide variety of proptech offerings makes properties more competitive and may serve to separate them from other assets in the market while potentially lowering operating costs.

Technology and innovation also play an important role in enhancing the experience and confidence of other stakeholders, including investors who have an entirely different set of requirements to know their investments and associated risks are being managed and communicated effectively. This has become increasingly important as the focus on environmental, social & governance continues to evolve.

What trends across different geographies are you seeing, and how are they evolving in the current environment?

The impact of the evolution of some of the trends that began at or about the time of the COVID-19 pandemic is still in question, regardless of geography. Each geography is different, and success is predicated on understanding nuances.

One of the greatest issues or trends across all geographies is closely linked to the office sector and the work-from-home phenomenon. It could take a decade or more to work through the return to office. However, for now, it appears that three days in the office per week is the new norm. To the detriment of many downtown central business district (CBD) ecosystems, the current employment market offers tremendous flexibility, allowing many functions to be carried out remotely.

Many suburban office markets across the country have improved since COVID-19 because of a workforce that would rather drive and park, with greater flexibility, than take public transportation to downtown CBDs. As an extension of that, suburban multifamily markets have continued to be strong as people moved there to have more space and be closer to suburban offices.

Markets across the South and Southwest experienced significant growth because of the flexibility to work remotely. It remains to be seen whether those who took advantage of those opportunities will return to their original cities, remain in place, or leave the workforce.

In the event of a slow-growth-but-no-recessionary environment in the back half of 2023, how do you think that would affect real estate markets?

We believe H2 2023 will be much the same as the first half of the year as the Federal Reserve (the Fed) continues its battle to trim inflation to its 2.0% target level.

The first half of 2024 will be a pivotal period where investors will either get clarity—which would create a robust transaction market leading to value appreciation—or there could be stagflation, high inflation coupled with low economic growth, which could be a significant concern. If economic growth is weak while inflation is above the Fed’s 2.0% target rate, cost of capital will remain elevated or even increase, and property fundamentals will be far from certain.

While many people are positive and optimistic by nature, investors are smart and will move with certainty and the right cost of capital, which has led to the unprecedented level of dry powder on the sidelines as investors seek yield on their investments. When certainty returns, so will the transaction activity and value appreciation.

For more information on this topic, or learn how Baker Tilly specialists can help, contact our team.