After a tumultuous two years, commercial real estate market conditions still haven’t stabilized. The COVID-19 pandemic has entered a less urgent phase, but now the public and private sectors are contending with its repercussions, including the end of stimulus programs.

During its quarterly survey of brokers from its independently owned member firms, CORFAC found that overall business sentiment in member markets remains encouraging, even as concerns emerge about the effects of inflation and rising interest rates on potential deals.

“CORFAC members are seeing strong deal activity even as we continue to contend with political and economic unknowns,” said 2022 CORFAC president Mason L. Capitani, SIOR, principal of L. Mason Capitani/CORFAC International in Detroit, Michigan. “Our quarterly survey shows that our brokers have a unique perspective on how macro trends affect their markets and can use that to help their clients make better future-looking decisions.”

Where deal activity is coming from

Looking at where CORFAC business is growing, the largest source of new business this year is existing clients who are expanding, according to 70% of members surveyed – an increase from 63% the previous year. Clients relocating to the market was the next highest source of new business at nearly 50%. Investor interest in secondary markets where price pressure isn’t as great, including those across the Midwest, is creating opportunity for CRE brokers.

Industrial continues to be the strongest CRE subsector for CORFAC members with 65% of respondents saying it drove business activity. CORFAC brokers are also seeing new activity from specialized niches of retail and office, such as medical offices and quick-serve restaurants in retail, while big-box retail and large office buildings are being readapted as logistics spaces.

“While residential migration to outer markets has slowed, industrial interest in secondary markets is very strong,” said Hayim Mizrachi, CCIM, president of MDL Group/CORFAC International in Las Vegas, Nevada. “There is pent-up demand for this product.”

The impact of work and commerce changes

Shifting consumer behaviors in the 2020s ­– particularly the growth of work from home and digital commerce, as well as the great job migration – will shape CRE trends for the near future. Specifically, 62% of members believe office will be the CRE sector that changes the most in 2022, as companies are still adjusting to the growth of remote and hybrid workforces. However, some members point to huge multinational corporations such as Google bringing back employees to the office as a reason for optimism.

CORFAC brokers were asked what their greatest concerns are looking at current events and macroeconomic trends. More than 55% of members identified inflation and rising interest rates as the factor that will have the most negative effect on CRE transaction activity. Continued supply chain challenges and the constrained labor market are compounding those rising costs to cause uncertainty in the CRE marketplace.

As one member summed it up, “Consumer spending has been strong through the last 12 months as we thought we were rebounding from the global pandemic and all the related implications, but now with inflation rising and consumer spending reduced, the economy will slow and have rippling effects on all sectors.”

Strong sentiment in the face of concerns

Despite these worries, half of CORFAC members describe overall business sentiment in their market as “somewhat positive” and another third say it’s “very positive.” The strength of the industrial subsector and readily available capital are common reasons for this positivity. Yet, other members are hoping for some changes in government leadership, tax policy or both to help buoy businesses and CRE activity.

As business owners try to understand how economic policies will impact their real estate plans, CORFAC brokers will draw from local experience and global network insights to help them make confident decisions.

CORFAC International is a network of independently owned commercial real estate firms. CORFAC has 70 offices across the globe.

First there was COVID. Then came the uncertainty of when, or if, employees would return to the office. Now comes inflation and rising interest rates. No wonder the office market remains in limbo across the United States.

JLL recently released its second quarter office outlook and, in little surprise, it shows an office market that is still struggling to regain its momentum following the pandemic while facing an uncertain economy.

According to the report, office transactions remained largely flat in the second quarter. JLL reported that gross leasing activity totaled 47.2 million square feet in the quarter, an increase of just 0.1% from the first quarter of the year. The reason for the sluggish activity level? Tenants, both large and small, have put their expansion plans on hold as they wait to see the impact of inflation and rising interest rates.

The U.S. office sector is still lagging when compared to the months before the pandemic. JLL says that second quarter leasing activity in the U.S. office market is now at 75.5% of its pre-pandemic norms.

Despite economic uncertainty, nearly half of all completed office leases in the second quarter came in at 10 years or longer, keeping the average lease term at eight years. Short-term expansions remained below 20% of all office lease activity, JLL reported.

Net absorption remained negative in the U.S. office market in the second quarter, with 7.8 million square feet of net occupancy loss during the most recent three months. A majority of the quarter’s negative net absorption — 69.4% — came in the Class-B and Class-C sectors.

Combined with 11.8 million square feet of new office deliveries in the quarter, this negative net absorption led to a 30-basis point rise in vacancy to a new high of 18.9% across the United States. The office vacancy rate stood at 16.5% for buildings delivered since 2015 and 19% for older properties.

Even in the down market, developers are bringing new office space to the U.S. market. According to JLL, that 11.8 million square feet of new office space delivered between April and June brought year-to-date completions to 26.5 million square feet. That puts the U.S. office market on track to repeat 2021’s more than 50 million square feet of new office space.

When the Federal Reserve last month raised interest rates by three-quarters of a percentage point, it ranked as the agency’s most aggressive such hike since 1994.

The Fed made this move to combat inflation. But commercial real estate pros worry that rising interest rates could scuttle deals that were set to close but might no longer make sense now that rates are high.

How has this impacted commercial real estate deals so far? It’s still early, but CRE pros say they are keeping a close watch on deals in progress. Many are still closing, they say, but others will certainly crumble.

The consensus, though, is that interest rates have the possibility to slow the momentum that commercial real estate enjoys today, if the Fed is overly aggressive in boosting interest rates.

“I agree that a 50-basis-points to 75-basis-points increase is appropriate, but the Fed needs to be careful not to overcorrect,” sadi Joshua Simon, chief executive officer of SimonCRE, in a statement. “Inflation is going to be a lagging indicator that needs to be watched. They will need to raise rates, but at some point, they need to wait to see the results before enacting more increases. There has been major fallout already within transactions and further investments will be delayed.”

In his statement, Simon said that Fed reacted late in its efforts to combat inflation. This means that it must now enact larger rate hikes to make up for their earlier inaction.

“This means we should see a slowdown in activity to some extent, primarily in floating-rate deals,” Simon said. “Construction will have to slow down.”

A shock to the system

Hal Collett, chief operating officer with the Minneapolis office of Colliers Mortgage, said that it was unrealistic to expect interest rates to remain as low as they had been. Such low rates were unprecedented.

But that doesn’t mean that such a sudden rate hike by the Fed doesn’t hurt, he said.

“It is a bit of a shock to the system,” Collett said. “We all anticipated that we wouldn’t be at all-time low interest rates for the rest of our lives. But it is shocking how quickly they moved.”

As Collett says, Colliers Mortgage uses the 10-year Treasury to price many of its deals. That rate more than doubled after the Fed’s move.

“That was a bit of a shock,” Collett said. “The cost of capital went up. Refinance activity that might have been in place suddenly went away.”

Dan Trebil, managing director and senior vice president with the Minneapolis office of Northmarq, said that commercial real estate boasts some advantages that should help keep the deals and financing requests flowing, even with higher interest rates.

As Trebil says, investors still need to put their money somewhere, and commercial real estate remains a favored investment type.

“The good news is, there is still a lot of money out there,” Trebil said. “Real estate fundamentals are still good. People’s properties are still operating well. A quick run-up in interest rates like this has put the brakes on some refinances that might have made sense before but don’t make sense now. But there is still demand for commercial real estate.”

Trebil, though, is realistic. He says that the rising rates have caused some investors who were ready to acquire new properties to pause their plans. These investors are waiting to see the full impact higher interest rates might have on commercial real estate.

“There is a price discovery going on now between buyers and sellers, and lenders, too, on where to price debt now that rates have risen,” Trebil said.

Collett describes the commercial finance market as a bit more tempered today than it was before the Fed made its big move.

“People have had to recalibrate,” he said. “It has slowed down a little. It’s not as frothy as it was. But there is still a lot of business getting done out there.”

Collett said that how investors view today’s higher interest rates might depend on how they long they have been sinking their dollars in commercial real estate. As he says, the last 10 to 15 years of lower interest rates has been the anomaly. Today’s higher rates? They are closer to the historic norm.

Again, though, it’s been the suddenness of the jump in interest rates that has spooked many investors.

“Interest rates of 2% or 2.5% on big commercial deals is not normal,” Collett said. “People are just surprised when it goes from 2.5% to 4.5% within 90 days. You would’ve loved to have seen the Fed get ahead of inflation and raise rates naturally. That way, there would have been no shock to the system. But that didn’t occur. The shock of the sudden increase sent people spiraling for a minute.”

Financing requests still coming in

With that being said, Northmarq remains busy, and commercial financing requests continue to roll in, Trebil said. And Trebil said that he expects this to continue.

“It goes back to the fact that people still view real estate as an attractive asset class,” Trebil said. “A lot of money is still available out there.”

At the same time, commercial real estate remains a safe place for investor dollars. This is especially true with the multifamily and industrial sectors. But Trebil said that more financing requests are coming in for hospitality assets today, too. He’s even seen an increase in requests for retail properties.

The office sector? That one still faces plenty of uncertainty, Trebil said. And because of that uncertainty, there aren’t as many financing requests today for office investments or new developments.

“A lot of the questions about office are still there,” Trebil said. “But a lot of properties are working through that as tenants’ leases expire. They are resizing. Their space needs might or might not have changed. As companies work through that, there will be less unknowns about this sector. The big question is what those tenants who signed office leases before COVID will do now that their leases are coming up for renewal. Will they take 50% less space? Will they stick with what they have?”

Even with office’s challenges, Trebil sees plenty of positives in the commercial financing business. He said that the progress he’s seen in the hospitality industry is especially impressive.

“We weren’t talking about hotels at all a year ago, except as problems,” Trebil said. “The hospitality market is doing surprisingly well today. We are also seeing more financing requests for manufactured housing and self-storage. We are seeing a much broader spectrum in terms of the property types we are working with.”

Still, multifamily and industrial continue to account for the majority of financing requests today, Trebil said. And that doesn’t look to change any time soon.

Trebil said that multifamily remains especially strong, even in markets such as Minneapolis in which monthly rents haven’t been soaring quite as much.

“The rental market has been really strong,” Trebil said. “Minneapolis doesn’t have the same kind of apartment rent growth as you see in a lot of other markets across the country. A lot of markets, especially down south, are seeing huge rent increases on a year-over-year basis. We don’t see those big numbers, but we are still an attractive market. We are a stable, steady multifamily market.”

Collett agrees that multifamily and industrial remain the biggest draw for financing dollars. He said, too, that healthcare and seniors housing are also generating a greater number of financing requests today.

In little surprise, Collett agreed that financing requests for the office sector were coming in at a far slower pace.

While many big companies are demanding that employees come back to the office, there is still no consensus on whether workers will comply. Collett said that this approach will work for some major companies, but others might lose employees who find jobs that offer more flexible working conditions.

“Flexible schedules are here to stay,” Collett said. “That will impact the demand for office space. Multifamily, industrial, seniors housing and healthcare remain the best investments. They have been the best investments for the last five years.”

The hot housing market has boosted demand for multifamily assets, Collett said. Single-family home prices continue to rise. Renting for an extended period, then, makes financial sense for many. And because of this, developers are building more apartment developments and investors are gobbling up these assets as monthly rents rise.

“Back in the day, people would get married, get a house, have 2.5 kids and get a dog,” Collett said. “That’s no longer the case. People wait longer to get married. They want to live near places with lots of amenities. They want a short commute to work. It’s all led to more demand for multifamily. From an investment perspective, multifamily is a very attractive option. It holds up very effectively.”

Industrial is thriving today, too, and the requests for financing to fund projects and acquisitions in this sector continue at a steady pace. Collett said that he expects this sector to remain hot throughout the rest of this year and into 2023.

“Industrial is a resilient asset that comes at a reasonable cost,” he said. “You don’t have a lot of overhead like you do with office assets. Industrial is an efficient investment. There are plenty of opportunities for investors in the industrial side.”

When considering financing requests, and whether to approve them, Northmarq looks at several factors, Trebil said. Some of this has changed now that interest rates have risen. As Trebil says, depending on the financing source, it’s no longer possible to always get to 75% or 85% leverage on deals.

“We are recognizing that we might not be able to get to the same dollar amounts because of where interest rates are,” Trebil said. “One of the factors we have to consider, then, is if the dollar amount being requested is realistic.”

Otherwise, Northmarq still considers the same basic factors when evaluating financing requests: How strong is the sponsor and is the project being acquired or developed in a quality location?

Pain. That’s what inflation is bringing to both businesses and consumers today. Gas prices are soaring. Families are spending more at the grocery store. And the average interest rate on 30-year, fixed-rate mortgages has been inching ever closer to 6%.

Inflation is also upending the business models of commercial real estate occupiers, something that Cushman & Wakefield addresses in its latest research.

As the report says, the largest expenses for most businesses are labor costs, which range from about 30% of total operating expenses for transportation firms to 60% for office-using businesses such as accounting, legal, medical and professional services. And today, labor costs for real estate occupiers are rising more quickly than at any time in recent memory, according to Cushman & Wakefield.

According to the Employment Cost Index for the private sector, median wage growth in the first quarter of 2022 rose 6% when compared to the same quarter a year earlier. That’s tied for the fastest rate on record dating back to 1990.

Another challenge for occupiers? Retaining employees. Cushman & Wakefield reported that workers who changed jobs in April of this year received a year-over-year wage increase of 7.2% compared to the average wage increase of 5.3% that workers staying in their current roles saw. Workers understand that they’ll typically earn more by jumping to another company. This makes it especially difficult for companies to keep their best employees if they don’t want to match those bigger wage increases.

It’s little surprise then, that Cushman & Wakefield reports that the number of people quitting jobs remains near an all-time high.

These challenges aren’t likely to disappear soon, either. As Cushman & Wakefield says, escalating labor costs don’t ease as quickly as other forms of inflation. Wages tend to be sticky.

Rising labor costs aren’t the only inflation challenges that businesses face. Cushman & Wakefield says that commercial real estate occupiers are also facing higher electricity, heating and cooling costs. In the United States, the consumer price index for electricity rose 11% during the previous 12 months ending in April, while the consumer price index for natural gas rose 22.7%.

Then there are soaring transportation costs, increases that are especially difficult on companies that ship their product across the country. As Cushman & Wakefield reports there is no sign that these costs are heading down anytime soon.

Another rising expense? The cost of materials. According to Cushman & Wakefield, the Producer Price Index for industrial commodities — excluding fuel– rose 13.8% during the 12 months ending in April, with certain products such as plywood, steel and chemicals rising by even larger margins.