Michael McGuinness is CEO of NAIOP New Jersey
By Michael G. McGuinness
In late October, PwC and the Urban Land Institute jointly published Emerging Trends in Real Estate 2023: United States and Canada. This year’s annual report was based on interviews and surveys with nearly 2,000 individuals including property owners, developers, asset managers and investors of real estate properties. The consensus is one of cautious optimism that we will ride out any near-term slump and be well positioned for another period of sustained growth and strong returns, although a short and mild recession is expected. The article highlights 10 trends for 2023 as summarized below. Many of these trends have led to creative project deals throughout New Jersey, such as Ironside Newark, ON3, Bell Works, Party City’s new headquarters and the HalRay Newark Portfolio.
Normalizing
Defying nearly all predictions during the uncertain days of the COVID lockdown, U.S. commercial property markets subsequently made a remarkable run, with some of the strongest returns, rent growth and price appreciation rates ever recorded. Now, more than two years later, property investors and managers are learning that enormous growth and profits eventually fall back to earth. Property market fundamentals are “normalizing” as some markets weaken due to diminishing pandemic tailwinds and the potential for a cyclical economic downturn. Some property sectors may cool, including residential and industrial, while others may heat up to historical average levels, such as hotels and retail. Finally, returns and prices of most assets are declining as cap rates rise and transaction volumes fall from record levels, while rent gains for others are merely moderating as demand returns to a more sustainable pace.
Still, we’ve changed some
Even as some property markets begin to “normalize” in many ways, many activities — shopping, business travel and office space — and how we use space are not likely to return to the old ways. The pandemic forced structural shifts in how and where we live, work and recreate in ways that seem destined to endure. Online spending is receding from its pandemic peaks but is not likely to revert to pre-pandemic levels. Business travel is unlikely to recover to pre-COVID levels for at least several years, meaning business hotels, fine dining and conference facilities will continue to face challenges. The greatest changes may be in how and where we work. The impact on office use and leasing is still evolving, and a significant share of the existing stock may need to be repositioned to remain competitive.
Capital moving to the sidelines or to other assets
After a robust first half of 2022, real estate property transactions began declining, primarily because buyers and sellers cannot agree on pricing due to heightened market uncertainty. Also, rising debt costs and restrictive underwriting standards are limiting transaction volumes. The denominator effect may force some institutional investors to reduce their CRE exposure, but any negative impact could be limited by the growing market share held by nontraded REITs, high-net-worth investors and other noninstitutional investors.
Too much for too many
Housing affordability has fallen to its lowest level in over 30 years. Prices and rents have soared relative to incomes. Spiraling mortgage rates have pushed the homeownership bar further out of reach for a growing share of households. The chronic undersupply of housing is the result of government policies that limit new supply or increase construction costs and is exacerbated by a labor shortage, as well as NIMBYism. Simply constructing more housing may be the most obvious and effective solution, but is far from easy to achieve.
Give me quality, give me niche
Investment demand for commercial real estate assets is still healthy, but more tentative, as noted above. Real estate capital markets are also becoming more bifurcated between the favored and the scorned as investors, lenders and developers turn more selective than they have been in recent years. What assets will find love and capital in the coming years? Investors and developers seem to be preferring three distinct types of opportunities: (1) the security of major product types with the strongest demand fundamentals, notably industrial and multifamily housing; (2) best-quality assets in sectors undergoing significant demand disruption, especially retail and office; and (3) narrowly targeted subsectors, like student housing, and newer “niche” asset types, like single-family rentals. There is much less appetite now for riskier opportunistic investments. The survey also confirms continuing strong interest in Sun Belt markets.
Finding a higher purpose
Long-term demographic trends and more recent structural demand shifts have rendered countless existing buildings and properties either redundant or obsolete. Many of these buildings may ultimately need to be repurposed or upgraded to meet new market requirements. Key repositioning targets are concentrated among retail, office and older industrial structures and sites. Promising opportunities include residential units and newer or better-located industrial stock, as well as opportunities to “retrofit” for the future. These conversions are often much easier to envision than to execute, however, often requiring specialized expertise and substantial investment to execute. The value loss that owners may need to recognize in order to justify the transformative investment could be the greatest barrier to project feasibility. Many of those surveyed felt that there is too much retail space and too many office buildings, and not enough residential units or modern industrial space. Also, there is not enough developable land on which to build all the housing and warehouses where needed.
Rewards and growing pains in the sun belt
Despite their continued popularity among residents, employers, tenants and investors, some Sun Belt markets are experiencing growing pains. “Big city” problems are coming to these markets known for their affordability and quality of life after years of continuous economic and population growth. These destination markets typically offer lower tax rates and lighter regulatory burdens than many gateway markets, heightening their appeal to many businesses. Conversely, some of these attractive characteristics may limit their capacity to accommodate continued massive population inflows. These markets will remain popular for both business and residential in-migration but could see the pace of both occur at more moderate levels.
Smarter, fairer cities through infrastructure spending
Infrastructure spending is back among the top trends. New federal infrastructure spending provides the opportunity to replace and expand critical urban infrastructure to rebuild cities and spur new development — and address historical inequities. After years of uncoordinated local efforts, the new national programs may provide the leadership needed to transform the built environment.
Climate change’s growing impact on real estate
The CRE sector has an important role to play in mitigating climate change. But with climate risks growing, the real estate industry must proactively address the impacts of climate change on assets. Climate change may alter the dynamics of where people want to live and invest. In addition to the discomfort and health risks of living in ever-hotter climates, energy costs rise with temperatures, as do the risks of power outages as more strain is placed on power grids. Extended drought conditions may limit new development because authorities may limit new hookups. Many investors rely on insurance rather than capital improvements to protect their investments, but changing investor sentiment toward climate risks may force more affirmative changes.
Action through regulation
Pressures for greater ESG disclosure by real estate owners and investors are intensifying due to efforts both from industry groups like NCREIF and PREA and from government regulation by the SEC. As shelter costs increasingly strain household budgets, state and local governments are resorting to regulation to address affordability, including various types of rent control and vacancy taxes. While building owners and developers benefit from various government incentives, the industry faces an increasingly challenging set of environmental and economic regulations. Will certain regulations end up being counterproductive? Preceding trends highlighted several areas where private markets have been slow to fix mounting problems that the property sector has played a central role in creating, notably climate change and housing affordability. Industry groups are calling for collective voluntary action, which is a start. But, if the growing number of regulations being considered at the federal, state and local levels is any indication, governments are getting impatient about the limited progress.
As stated earlier, many exciting real estate deals are transforming our communities, thanks to the visionary leaders and entrepreneurial developers who are taking risks and making calculated investments to sustainably repurpose existing and often obsolete property types. Why not plan to have your efforts recognized this spring by entering the NAIOP NJ’s Creative Deal of the Year contest? Winners to be announced the evening of May 18 at the 36th Annual Commercial Real Estate Awards Gala at the Palace in Somerset, New Jersey. Entry forms will be available in early January at www.naiopnj.org and the deadline for their submittal is Feb. 3, 2023. For more information, contact laterza@naiopnj.org.
Michael McGuinness is CEO of NAIOP New Jersey and has led the commercial real estate development association since 1997. NAIOP represents developers, owners, asset managers and investors of commercial, industrial and mixed-use properties, with 850 members in New Jersey and over 19,000 members throughout North America.
