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Lee & Associates’ First-Quarter 2023 Sector-by-Sector Analysis Indicates Market-Wide Cooling

by Sarah Daniels

High interest rates and economic uncertainty in the first quarter of this year contributed to lower absorption and declining rent growth in industrial, retail and multifamily sectors across the country, with some regional exceptions, according to Lee & Associates’ 2023 Q1 North America Market Report.

Meanwhile office continues to struggle. The sector experienced its third-largest quarterly contraction since the beginning of the pandemic, as work-from-home preferences decoupled office occupancy from job growth numbers.

The full Lee & Associates report is available (with further breakdowns of factors like vacancy rates, market rents, inventory square footage and cap rates by city) here. The analysis below provides an overview of four major commercial real estate sectors alongside trends, economic background and exceptions within each sector.

Industrial Overview: Sharp Decline Hits First-Quarter U.S. Demand

There was a sharp first-quarter decline in U.S. tenant demand for industrial space as wholesalers and retailers reconsider their inventory levels out of caution over the economic outlook. Net absorption in the first quarter totaled 39.4 million square feet, a 57 percent drop from the record set a year ago.

The overall U.S. vacancy rate settled at 4.4 percent, an increase of 40 basis points from the close of 2022, comfortably below the 7.3 percent market average over the last two decades. Vacant space at the end of March totaled 805.6 million square feet, up 81.4 million square feet from the previous quarter.

While a potential pullback in consumer spending poses downside risks for 2023, onshoring of high-tech manufacturing will likely be a key driver of U.S. absorption from 2024-26. The federal government’s 2022 passage of the CHIPS and Science Act, and the Inflation Reduction Act provided more than $400 billion worth of incentives for growth in U.S.-based high-tech manufacturing.

Newly completed space in the first quarter totaled 120.3 million square feet compared to 74 million square feet delivered in the same period last year. The stock of U.S. industrial property is set to grow nearly 4 percent in 2023 for the fastest pace of supply growth in more than 30 years. Barring a severe shock to the U.S. economy and industrial leasing, the volume of space set for delivery likely will produce only a moderate increase in vacancy without tipping the market in tenants’ favor.

Influencing long-term prospects, increased interest rates of the past two quarters and concern that the increased cost of new construction may exceed replacement cost have caused developers to pull back by up to 40 percent starting late last year. The recent slowing in net absorption is broad-based across most major markets. Los Angeles and Southern California’s Inland Empire — with respective vacancy rates of 3.4 percent and 3.1 percent, similar to other coastal markets — notably have posted outsized increases in space availability in recent months. Otherwise, the construction pipeline of projects is barely enough to meaningfully ease the space shortages in majority of coastal markets since the lockdown.

Imports have been declining at the national level since November. The slowing has been most pronounced at the Port of Los Angeles, where inbound cargo has been reduced by the COVID wave in China and risks of a strike by West Coast dockworkers. The potential strike has caused many importers to divert cargos to major East Coast ports, allowing East and Gulf Coast ports such as Newark, Savannah, Houston, Norfolk and Charleston to lead the United States in import growth.

Lehigh Valley, Richmond, Tampa, Jacksonville, Detroit and Reno have bucked the national trend and record tightening availability since mid-2022, even among properties larger than 100,000 square feet. U.S. and Canadian landlords in the first quarter are expecting annualized 9.9 percent and 14.1 percent rent growth, respectively. But those gains appear less likely to materialize as 2023’s record levels of deliveries will see 250 million square feet added in the second quarter and 650 million square feet projected this year.

Office Overview: Despite Job Gains Office Footprints Continue to Shrink

Tenant demand for North American office space over the last two quarters has gone from bad to worse for landlords, affirming that the lingering and painful impact of post-pandemic workplace arrangements has yet to play out.

Net absorption for U.S. office space in the first quarter was negative 28,749,399 square feet. It was the third-largest quarterly contraction since the COVID lockdown three years ago. It also comes on the heels of 16.6 million square feet of negative absorption in the last quarter of 2022. The combined 35.3 million square feet of negative absorption of the last six months represents 27 percent of the 131 million square feet that have been put back on the market since COVID.

The U.S. vacancy rate increased to 13 percent from 12.5 percent at the end of 2022. Comparisons with the effects of the so-called Great Recession are useful in calculating the character and magnitude of the current office downturn. In both cases there were declines of about 2.5 million office-using workers across the United States and Canada, but the office recoveries were significantly different. It took nearly six years to recover the jobs lost in the 2008-09 recession.

Despite the shock of the pandemic, all the positions lost were recovered in less than 20 months. Through January of 2023, office employment was nearly 6 percent more than in January 2020, when the COVID threat was first reported. In view of strong job growth, historical patterns dictate that office demand would have rebounded by now. But demand for increased space has decoupled from employment gains.

Corporate users have been reducing their office footprints, adding to available sublease inventory. Although several large companies are requiring more employees to report in person, in a Labor Department survey last year 67.4 percent of companies in the information sector said their staff worked remotely some or all the time. The same was reported by 49 percent of companies in the professional and business sector, which includes law and accounting firms.

The volume of second-hand space available has more than doubled since 2019. The impact is acute in markets like San Francisco, which has more than 11 million square feet available for sublease, or 5.8 percent of its inventory. New York has nearly 30 million square feet of sublease space available, representing 3 percent of the total inventory. Adding to the stress on the overall fundamentals is the 70 million square feet of space under construction, most of which is slated for completion in the first half this year. However, new starts have slowed dramatically. The 10 million square feet of new starts in the last quarter of 2022 is the lowest in 10 years.

Transaction volume also has slowed considerably. Investment capital is abundant, but buyers are moving to the sidelines until repricing is complete. Sales at the close of 2022 were the lowest of any fourth quarter since 2009. Last year’s $81.8 billion in sales was second to 2020 for the least volume in 10 years.

Retail Overview: Net Absorption Dips in the First Quarter

Despite healthy consumer spending and strong successive quarterly merchant demand, overall net absorption for North American retail space eased in the first quarter. Net growth in the United States totaled 7.7 million square feet in the first quarter. That was down from 22.4 million square feet for the same period a year ago and off from 20.7 million in the fourth quarter of 2022. The 74.8 million square feet absorbed last year was the most since 2017. There have been eight straight quarters of net growth across the country. Overall first-quarter vacancy rates were unchanged at 4.2 percent in the United States.

Otherwise, supply-demand fundamentals continue to improve as new retail development activity remains minimal. Slightly more than 48 million square feet of space was completed in 2022 and 66.8 million square feet are underway. With about 80 percent of new development pre-leased, the U.S. retail market faces virtually no threat from new supply as developers and lenders continue to shy away from large spec projects. The vast majority of new construction consists of single-tenant build-to-suits or smaller ground-floor spaces in mixed-use projects.

Availability rates continued to fall across the United States in 2022 and ended the year at a 15-year low of 4.9 percent. Availabilities are now in line or lower than pre-pandemic levels across all retail segments, with the most significant contractions recorded in neighborhood and power centers thanks to strong demand from grocers, discounters, off-price merchants and experiential tenants.

Fundamental tightening and rising retail sales pushed asking rents upward last year at their fastest clip in more than a decade at 4.1 percent, with average net asking rents closing the year at a record $24 per square foot. However, growth has been slowing and is expected to decelerate further in the coming quarter while above-average inflation will continue to weigh on the real rate of rent growth. Leasing activity continues to be driven by strong growth for smaller spaces as the average footprint for space hovers near the all-time low of just over 3,000 square feet.

This leasing activity is propelled by growth in store counts from quick-service brands such as Starbucks, Crumbl Cookies, Yum Brands and Restaurant Brands International, which owns BK, Tim Hortons, Popeyes and Firehouse Subs. Cellular retailers T-Mobile and AT&T have also signed for dozens of small shop spaces this year. Growth in larger space has been driven primarily by discounters such as Dollar Tree and Dollar General and off-price merchants TJ Maxx and Burlington.

While leasing activity has rebounded off pandemic-induced lows, activity has accelerated fastest in markets posting the most population growth and include Las Vegas, Phoenix, Fort Lauderdale, Tampa, Atlanta, Dallas and Houston. Availabilities now are lower than pre-pandemic levels within small to mid-sized centers and freestanding single-tenant properties. Conversely, available space in lifestyle centers, regional and super-regional malls is greater than before the pandemic. Despite a relatively strong retail demand environment and the highest net operating income growth since 2014, investment in retail properties trended downward in 2022 amid higher interest rates and greater economic uncertainty.

Multifamily Overview: Rent Growth Continues to Slow

Demand remained tepid in the first quarter among U.S. renters growing anxious about the prospects of a recession. Rent growth continued to moderate as new apartment deliveries far outpaced absorption. First-quarter net absorption totaled 44,796 units, which was off 17 percent from the same period last year. The addition of nearly 100,000 deliveries in the first quarter of 2023 helped push the national vacancy rate up 170 basis points to 6.6 percent. Meanwhile, overall year-over-year rents increased 3.9 percent. Rent for an average apartment totaled $1,633 per unit or $1.84 per square feet. Also influencing apartment demand is reduced fear of COVID infection in crowded living arrangements. Additionally, workers returning to offices and children returning to classrooms have reduced the need for work and study space.

Sun Belt markets that dominated the growth boom in 2021 experienced the largest pullbacks in rents last year. Las Vegas and Phoenix rents suffered the largest about-face, going from more than 20 percent annual growth to slightly negative of the last four quarters. Rents in California’s 12 largest counties are down 3.5 percent since peaking last August.

Midwest and Northeast markets fared better. For example, Kansas City and St. Louis posted 5.7 percent annual rent growth in 2022. With only 141,000 units absorbed in 2022, completions totaled 435,000 apartments and the new supply outpaced demand in each quarter. At the end of 2022 there were a record 959,000 units under construction and expected 2023 deliveries total 507,000, an all-time high, as developers struggled with material disruptions and labor shortages. With most new construction consisting of mid- and high-rise apartments, the time in the construction pipeline is two or three times longer than for garden-style and low-rise units.

Multifamily continued to be the most sought-after asset type in 2022 but there was a downturn in sales activity in eight of the last nine months. Despite the pullback in transactions, sales totaled $227 billion with the majority of deals occurring in the first half of the year. There was a 25 percent decline in property trading in the last six months of 2022.

Persistent inflation and the potential for interest rates to remain elevated are affecting terminal cap rates as investors adjust their rent growth assumptions and plan their exits.

— Lee & Associates Research Department. Lee & Associates is a content partner of REBusinessOnline. To read all of Lee & Associates’ 2023 Q1 North America Market Reportclick here.
Photo by Alexander Kovacs on Unsplash

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