Long-term demand drivers will keep the CRE correction at bay

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The US economy is “still strong” and will support demand for commercial real estate space, although inflation will remain a headwind for several years, forcing the Fed to tighten monetary policy. And while rising interest rates may restrain CRE deal activity, it won’t be widespread, with effects most visible in the types of properties and markets with the most aggressive price rises in recent years. years.

That’s according to Marcus & Millichap’s John Chang, who says CRE will continue to see strong demand from investors in the near term. He also says investors shouldn’t expect a housing bubble, either in housing or commercial real estate in general.

“There are too many long-term demand factors at play for any of the sectors to face a meaningful correction,” Chang said.

He notes that the self-storage sector will be boosted as millennials age: the demographic “over-indexes” as storage users with only 28% of the population renting 9% of storage units. That bodes well for storage demand, but there are development risks for the property type on the horizon, he says.

“As we emerge from lockdowns and demographics drive real estate demand, the bigger picture points to generally strong drivers across the real estate spectrum,” Chang says. “Some segments like city offices and senior housing still face challenges, but it looks like most other segments are in a growth phase of the cycle.”

Housing demand hit an all-time high in 2022, with total unit uptake reaching 660,000 units, nearly doubling the previous peak set in 2000. Demand also continued into 2022 to deliver the strongest first quarter never recorded.

“The record demand reflects household unbundling as vaccines became readily available and states ended lockdowns,” Chang said. “Many weddings and other household-forming events have been delayed by the pandemic and we have seen the release of this pent-up demand over the past year.”

The result was a record vacancy rate at the end of the first quarter at 2.4% and a spectacular rise in rents. Average rents in the first quarter rose 17.3% year-over-year, another record. And while those numbers may seem mind-boggling, Chang says they need to be contextualized in the context of the end of eviction moratoriums and other rent relief programs, and notes that rents have actually gone down by 0. .8% between the first quarter of 2020 and the first quarter of 2021. Between the first quarter of 2020 and the first quarter of 2022, rents increased by just over 16%, an average of 8% per year.

“It’s still high, but not shocking,” Chang says, adding that single-family home prices have risen twice as fast over the same period. “At the heart of the problem is the housing shortage. Even though a record 400,000 apartments are due for completion this year, we will still fall short of demand.

Marcus & Millichap expects the vacancy rate to remain at 2.4% through the end of the year and says rent growth will decline to 9.4% in 2022.

“We have a wave of demographics about to move on their own,” Chang says. “That’s why I don’t think the housing market needs to undergo a correction. There is a housing shortage and it will not be resolved for several years.

Self-storage is another market strongly impacted by demographics, as is multi-family. Chang says at the start of the pandemic, self-storage properties reduced rents, but demand jumped as households doubled and students moved out.

Although there was a glut of self-storage supply before the pandemic, Chang says, most vacant space was quickly absorbed, with the vacancy rate dropping from 9.5% at the start of COVID to 6 .6% at the end of 2021, a record level. This translated into rent growth of 7.6% last year.

“We’re seeing demand come down a bit and construction starting to ramp up, so vacancy rates could start to rise again,” Chang predicted, noting that Marcus & Millichap expects vacancy to rise to 6, 9% by the end of the year with the growth in rents. within the 4% range for 2022.

As for the industry, demand has reached record levels in 2021, also pushing vacancy to an all-time high. Construction will likely set a record in 2022 as well, adding 420 million square feet, but M&M expects vacancy to continue to decline.

“The most important force driving industrial demand is a tangled supply chain,” Chang says. “Companies face great challenges in sourcing internationally made products, especially those made in China.” And for that reason, Chang says manufacturing relocation and offshoring will be something to watch over the next few years as many companies consider moving their manufacturing operations to Mexico from China.

Industrial demand has been driven primarily by retail sales, which have been “off the charts”, up 27% since the onset of COVID. But as e-commerce sales, which pushed core retail sales at the start of the health crisis, return to their pre-pandemic growth trajectory, in-store retail sales jumped more than 19% in during this period.

Necessity retail, such as malls anchored at a grocery store, performed best, but restaurants and other service-based retail businesses have already rebounded in states that ended shutdowns earliest. Oversized may still exist for those subsectors in states that ended lockdowns later, Chang says. Nationally, the multi-tenant vacancy rate is expected to drop below 6% this year.

And as for the office, significant variations exist depending on the location, the type of building and the type of tenant. Vacancy peaked at 16.1% in the second quarter of 2021 and has fallen to 16% since then. However, the suburban office vacancy rate peaked at just 15.8%.

“Perceptions of office space demand tend to be worse than reality,” Chang says. Although many believe working from home will be the death of office space, we’ve actually seen four consecutive quarters of positive space demand. Based on the company messages I hear, there will be some flexibility in where staff members work, but big companies are slowly pushing towards a substantial return to the office. It will likely take a few years for the office sector to fully recover, especially in markets that opened up later…but the momentum is starting to pick up.

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