6 Real Estate Insights from Q2 2022 and What They Mean for You

The data is clear. Banks have tightened lending standards for commercial real estate considerably. Architectural design contracts have lessened. Input prices have dropped. Commercial real estate demand appears to be weakening and valuations may compress. The spread of cap rates to bond yields implies that valuations may decline, while public REITs’ funds from operations (FFO) multiples have already done so. Signs show that demand has weakened as the economy begins to slow down. Nationally, net absorptions for office space are still trending negative due to a slowing economy and weaker demand due to new work-from-home policies. Interestingly, job growth and population migration in the South are causing it to buck national trends.

What does all of this mean for you? Here are six trends to pay attention to this quarter in commercial real estate.

1. Future valuations face pressure as spreads between cap rates and investment-grade bonds continue to narrow.

A rising interest rate environment this year has resulted in the yield on investment-grade bonds rising considerably. Cap rates have not increased as fast, causing the spread between the two to narrow. If spreads revert toward historical levels, cap rates will increase. The Multi-family spread, which is now negative, has narrowed the most. Since cap rates are likely to move higher, any return for owners from multi-family properties must come from net operating income (NOI) growth. In contrast, the self-storage cap rate widened over the past quarter, but remains relatively narrow compared to other areas of commercial real estate.

What this means for you: Changes in cap rates have lagged bond yields, so you can expect cap rates to increase, which will result in lower valuations, all things equal. To help offset valuation compression, focus on growing NOI through rent escalation, increased occupancy rates and operational efficiencies.

2. Net absorption for office properties are weak nationally, yet strong in the South Atlantic.

Through Q2 2022, office real estate has been challenged by pandemic-induced work-from-home policies. Since the COVID-19 pandemic began, quarterly changes in national net absorptions have been mostly negative. The outlier has been the South Atlantic region, which has seen population migration and job growth. Its resiliency is evident in having more quarters of positive net absorption than negative since the pandemic began (including the most recent quarter).

What this means for you: Net absorptions can be a key leading indicator for rent negotiations and asset valuations. The resiliency in net absorptions in the South Atlantic indicates that demand for office space should be positive for building owners. Nationally, office space tenants may have negotiating leverage.

3. Publicly traded REITs are now trading at more attractive FFO multiples.

Prices for publicly-traded REITs have declined considerably year-to-date. As a multiple of Funds from Operation (FFO), they are reverting toward their 10-year averages. The largest discount relative to those averages are multi-family units and shopping centers. Healthcare and industrial REITs are still trading at a premium.

What this means for you: Public market valuations often lead private markets, so the reversion in the P/FFO multiple further indicates that we could see valuation reductions for private commercial real estate by the end of the year. Expect higher cap rates and lower valuations for any near-term transactions.

4. Banks quickly tighten lending standards in anticipation of an economic slowdown.

We are seeing banks anticipate an economic slowdown by quickly tightening their lending standards for commercial real estate loans to protect their balance sheets. While today’s standards are still looser than they were at the peak of the COVID-19 pandemic, they are approaching, and in some cases tighter, than 2016-2017 levels.

What this means for you: Tighter lending standards make accessing financing more difficult. This could hamper the volume of future commercial real estate deals and the supply of new construction. Lock in other avenues of financing, such as private markets, to raise capital for future deals.

5. The Architecture Billing Index implies tweaking future demand for new construction.

The Architecture Billings Index (ABI) can be a leading indicator into future supply of commercial and residential real estate. Relative to prior quarters, it shows a slowing of inquiries, contracts and billings in Q2 2022. Fewer developers are entering into design contracts with architects. That reality is reflected in slowing inquiries, which tend to be the most leading of the three indicators, and points to a weakening of new commercial real estate construction.

What this means for you: Architects seeing reduced inquiries and contracts could lead to less volatility in real estate valuations as future supply may be constricted. This would support the valuations of existing assets during an economic slowdown.

6. Input prices look less inflationary and more recessionary.

While 2021 saw input prices rise considerably with inflation, 2022 input prices have fallen dramatically. This is owed to the Fed quickly raising interest rates, lower expectations for global economic growth and the belief that inflation may have peaked in many areas. Commodities such as copper, lumber and industrial metals can be leading indicators into the health of the economy and imply lower future inflation. Cement and plastic, while still appearing hot, can lag their counterparts, so expect them to follow trend going forward.

What this means for you: Lower input prices will relieve some of the inflationary pressures of higher costs in real estate materials. However, falling input prices is also a sign of weaker demand. Anticipate a slower growth environment moving forward.

Next Steps

All signs point to weakening demand and a slowing economy. With banks tightening lending standards, achieving optimal outcomes in the commercial real estate market will require careful attention to detail, timing and strategy.

Schedule a consultation with an Aprio advisor to see what opportunities may be available for you!

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