Industrial Gains Can’t Allay Concerns Over Commercial Market as a WholeSep 27, 2023 01:00PM ● By David Caraviello
It’s evident in a drive through a South Carolina landscape dotted with advanced manufacturing facilities that make everything from automobiles to airplanes — the industrial sector is among the more encouraging classes of a commercial real estate market still trying to claw its way out of the depths of the coronavirus pandemic.
Industrial vacancy rates nationwide have remained near where they were before the pandemic, in some markets even dropping below pre-pandemic levels, according to economists at Wells Fargo who offered a recent web presentation on the state of the commercial real estate industry. While industrial construction has leveled off partly due to interest rate increases, the number of industrial starts already underway has resulted in a vast amount of industrial space still rising up out of the ground.
“A big reason why industrial demand has been so strong following Covid is those government incentives for domestic production of things like electric vehicles and their parts, and semiconductors,” said Jackie Benson, vice president and economist at Wells Fargo Corporate and Investment Banking. “And the rapid rise in spending on manufacturing facilities has really been driven specifically by an upsurge in construction on computer and electrical manufacturing.”
South Carolina has been indicative of those trends. The industrial capital of the Upstate has seen nearly $6 billion in capital investments flood the region since the second quarter of 2020, which pushed the vacancy rate to a record low of 2.95 percent in 2022, according to the commercial real estate firm Colliers | South Carolina. The result was 27 million square feet of new flex, warehouse, and manufacturing space, not including projects under development like the 1 million-square-foot BMW electric battery plant near Woodruff.
Concerns, though, still exist. That wave of industrial construction appears to have crested in the Upstate, Colliers added, while the Charleston industrial market recently reported its highest vacancy rate in 18 months at 4.42 percent. In September, CoStar reported that industrial construction nationwide had fallen to a 10-year low, as rising interest rates led to increased hesitancy on the part of both developers and prospective tenants.
And while the industrial sector benefits from countless major projects still in the pipeline — there are 15 such facilities of at least 275,000 square feet under construction in the Upstate, according to Colliers, plus 10 more in the Lowcountry and four in the Columbia area — the across-the-board effects of rising interest rates in the commercial real estate market is one reason Wells Fargo researchers are still fretting over the prospect of an economic recession.
“We still have a modest recession in our forecast,” said Jay Bryson, managing director and chief economist at Wells Fargo. “Now, certainly we’ve acknowledged that the Fed potentially could pull off a soft landing. You may not get a recession next year. But I would say that it’s still more likely than not, just because of this passive tightening of monetary policy that’s going to be happening in the coming months. I think one way or another, growth in the next couple of quarters is going to be kind of subpar.”
Office market under strain
The diverse commercial real estate market represents a sizable chunk of the U.S. economy, with a total value of $24 trillion at the end of 2022. But unlike other areas of the economy, commercial real estate hasn’t proven as resilient to the effects of the rising interest rates that the Federal Reserve has used to try and stem inflation. The demand for commercial real estate loans “is essentially hovering at a recessionary level,” said Charlie Dougherty, director and senior economist at Wells Fargo.
“There are a lot of things happening right now — there are conflicting perceptions of property valuations, also a lot of uncertainty with regards to the overall economic outlook,” he added. “But I think the big thing that's happened is that interest rates have gone up pretty significantly over the past 18 months or so. So of course, banks have tightened lending standards, and lending has become a little bit more restrictive, especially after the banking sector volatility that we saw earlier this year. But the impact of higher interest rates is certainly weighing on commercial real estate transactions.”
Commercial real estate transaction volume, Dougherty added, is trending down by about 60 percent over the past year. “Simply put, a lot of deals just don’t pencil with this abrupt rise in the cost of capital that we’ve seen as the Fed has tightened monetary policy to kind of tamp down inflation pressure,” he said.
And while the fundamentals of some commercial real estate sectors like industrial and retail have remained “decently solid,” as Dougherty put it, the same can’t be said of an office sector that’s been fundamentally altered by the pandemic and the ongoing work-from-home movement that’s followed. Nationwide, demand for office space has been in negative territory for much of the past two years, and overall leasing activity remains slow.
“The office market very clearly is under some strain at the current moment,” Dougherty said. “The vacancy rate is rising, and currently is above the peak that occurred during the last cycle during 2008 and 2009 when the vacancy rate rose pretty quickly after the Great Recession. So obviously, demand for office space remains pretty weak in the aftermath of the hybrid work, sort of, revolution.”
Office leases that are being signed are for smaller spaces, averaging about 20 percent less square footage than before the onset of the Covid-19 pandemic. Rents are being pulled down by a glut of cheaper sublease space on the market. “And then there are still a lot of office leases that have yet to roll over,” Dougherty said. “And then once those office leases do indeed roll over, I think it's reasonable to assume a lot of those are going to be downsized to smaller spaces.”
Employers continue to vie for “Class A” or “Five Star” office space — the newest buildings with lots of amenities that companies hope will lure employees back to the workplace — evident in a national first-quarter absorption rate of 17.9 million square feet for Class A spaces, and negative-45.9 million for all other classes. “The problem here is Five Star buildings are a relatively small share of the overall office market, about 10 or 15 percent,” Dougherty said, “while all of those outdated buildings are still suffering from the knock-on effects of the pandemic and the rise of remote work.”
The struggles of the office sector can also vary greatly based on market — while San Francisco had a second-quarter vacancy rate of 24.4 percent, Greenville, Columbia, and Charleston were all around 17 percent, right around the national average of 16.5 percent. But the plight of the office sector is exacerbated by the refusal of many American workers to return to the office, shown in office occupancy running at only about 50 percent of where it was prior to the pandemic.
“I think it's fair to say that a lot of CEOs and firm leadership would like to have workers returned to the office in order to boost productivity, as well as all of those intangibles are really hard to measure like culture, building mentoring skills and things like that,” Dougherty said. “But right now, generally speaking, workers don't appear that they are fully on board with this. And with the current tight state of the labor market, workers still have the upper hand on their bosses.”
And as a result, new office starts have cratered, dropping to 7.7 million square feet nationally from 25 million in late 2019. “That sector is probably going to be challenged for the foreseeable future,” Dougherty said.
Retail following rooftops
At the other end of the commercial real estate spectrum is the retail sector, which was buoyed by stimulus checks at the height of the pandemic and has persevered throughout the 11 interest rate hikes the Fed has implemented in the year. While recently reported declines by major retailers like Target and Home Depot have hinted at a decline in that area, spending has remained at a high enough level to spare the retail sector the worst of the pandemic’s aftereffects.
“Following the pandemic, demand for retail space was very strong, bolstered by that strong consumer demand that in turn led supply to improve and try to catch up and vacancy rates to remain very low objectively,” Benson said. “CoStar estimates that it's just about over 4 percent or so, which is one of the lowest among asset classes.”
Retail follows rooftops, so the saying goes, and the bump in retail activity has been most evident in Sunbelt states like South Carolina that have benefited from large rates of in-migration in the aftermath of the pandemic. Retail vacancy rates in South Carolina have remained below the national average, dipping to 2.89 percent in the first quarter of 2023 before rising to 3.85 in the second, according to Colliers. Demand was reflected in 325,962 square feet of retail delivered in the second quarter, and nearly 1 million under construction.
The one weak point, Benson said, is regional malls. “Those were hurting before the pandemic as demand kind of shifted away from those traditional shopping malls, and they continue to have the highest vacancy rates today,” she said. “However, if you look at something like the neighborhood centers, where retailers are kind of integrated into neighborhoods or cityscapes, or those strip centers, which have those big-box retailers, demand and vacancies are all very healthy.”
It’s a similar story with hotels, where occupancy rates nationally “are on a steady path to recovery,” Benson said, even if they haven’t yet returned to pre-pandemic levels. The recovery of the hotel sector is concentrated mainly in luxury brands, she added, as opposed to midscale and economy brands which were showing signs of struggle even before the pandemic. The preference for luxury hotels shows in an average daily room rate that’s ballooned to $153.60 from around $90 in early 2020.
Clearly, commercial real estate in the aftermath of the pandemic remains a market in flux. While industrial benefited from a huge injection of initial capital, that wave has crested. Retail is persevering, but at a slow growth rate, while hotels are buoyed by high-end properties and multifamily is seeing fewer construction starts despite increased demand. Then there’s the office sector, which may never be the same again.
The title of the Wells Fargo presentation was “Is There Light at the End the Tunnel?” In some sectors, it certainly appears so. But continued concerns about interest rates and even a potential recession mean that light remains clouded at best.
“There’s definitely a lot of nuance to the commercial real estate market, which is very big and encompassing,” Dougherty said. “We’ve looked here at aggregate national statistics, but the similarity between smaller and larger segments is that debt plays such a critical role in commercial transactions. And with higher interest rates, the higher costs of borrowing is really placing commercial real estate overall under strain, and that’s not limited to large or small markets. A lot of people are impacted by that.”