Matias Recchia is co-founder and CEO of keywaythe commercial real estate technology platform designed for small and medium-sized businesses.
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Despite economic uncertainty and rising interest rates, the commercial real estate market in the US experienced success in 2022. For example, between the fourth quarter of 2021 and the third quarter of 2022, Atlanta saw $30.7 billion in direct commercial real estate investment. Beijing, Tokyo and Singapore combined, according to data from JLL.
However, a lot has changed in recent months. I have found that due to higher borrowing costs and wide bid-ask spreads, many commercial real estate investments appear to have declined. came to a stop. This has left many institutional investors, who have been raising money in recent years, on the sidelines. But the fundamentals around the best-performing asset classes haven’t changed (e.g., the housing shortage still persists, providing a strong tailwind for housing), so I think institutions are just waiting for the right time to jump back in.
If interest rates rise to slow downI expect investors to return to the market in 2023. As the co-founder and CEO of a small-scale commercial real estate investment company, the area I focus on is the small sub-$50 million CRE space, where I’ve found relatively weaker competition due to fragmentation and less liquidity.
Which verticals could win and lose in small-scale commercial real estate in 2023?
Small-scale commercial real estate spans many different industries, and each will perform differently depending on market conditions and macroeconomics. It’s important to understand all of them, as this can provide information about how investors build their portfolios.
A few industries that I think could do well are:
• Class B Multifamily Homes: At the end of 2020, the US still faced a shortfall of 3.8 million homes, according to a report by Freddie Mac. I think Class B multi-family homes can outperform due to its unique position relative to Class A and Class C. Class A is loaded with sufficient new supplyand if many tenants want to reduce their housing costs due to economic stress, this could have a spillover effect on Class B. In addition, Class B performed better than class C during the 2008 recession, according to an analysis by CBRE.
• Owners of single-tenant properties: Many companies that recently owned or refinanced their properties are facing high rates. Working capital to grow the business becomes more expensive, as do many small business loans achieved double-digit interest rates. I think this could lead owners to seek lower capital costs through more creative financing methods, such as sale-leasebacks.
• Retail anchored by food and services: Armed with government stimulus and increased savings, spending on consumer durables rose $103 billion in 2020, while services fell $556 billion over the same period, according to Deloitte. However, I think spending will continue to normalize this year, and services could benefit as people move out and shift spending from durable goods to basics and services. Convenience stores that offer personal services saw a net absorption rate increase by 35% in the third quarter of 2022 versus 22% for retail spaces as a whole, according to the National Association of Brokers. I think neighborhood stores will continue to do well.
An industry that I believe may face challenges this year:
• Class B and Class C offices: Met recent layoffs and a slowing economy, I expect the office sector in general to face headwinds in 2023. Class B and Class C properties could struggle as, based on my observations, tenants seeking to lure staff back into the office seem to be leaning towards high-end class A office buildings. Class A listing rates were up 1.9% in 2022 compared to 2021, according to commercial edgewhile Class B was down 0.4% and is likely to be challenged.
What does this mean for investors?
While the market is pretty frozen right now, I expect investors with ready capital to be able to close deals once every 10 years. From my perspective, this will not be the stressed sellers of 2008 and 2009, but a softer landing that will create many opportunities. I expect a thaw to set in within months and some deals in verticals considered “recession proof” or hedge inflation will be available by the second half of the year.
After several years where it seemed like almost every market could only go up, market and submarket selection is critical going forward. From my perspective, many markets enjoyed pandemic-fuelled population growth, but with continued challenges in the technology sector, booms that relied heavily on the Great Tech Migration, for example, may not find enough footing to support a meaningful upswing.
Therefore, it is critical that investors in the small CRE sector thoroughly understand the specific investment they are considering and the area in which it is located. This is especially true given the unique factors that may have contributed to growth in recent years, some of which may not be reproducible or sustainable. For example, have prices increased because of a boost from the work-at-home population, or is there real growth in jobs from a diverse economy that could weather a potential recession?
In addition to looking at historical job growth, it can be helpful to map current and incoming employers with jobs. Another consideration could be whether rental growth assumptions are achievable by truly understanding the target investment and not relying solely on general market trends. For example, you can use credit card spending data to understand the performance of one medical office versus another, rather than assuming that all medical offices can support some degree of uniform rent increase.
After the rollercoaster year of 2022, the real estate market is adjusting to the new normal of interest rates and economic activity. In addition to identifying market trends, investors will also need to stay abreast of what’s happening on the ground floor.
The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice on your specific situation.
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