Fundamentals Still Matter
Chart of the Week
May 2, 2023
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Commercial real estate (CRE) is facing cyclical headwinds. Asset values have eroded this year due to the impact of rising interest rates and cap rates on equity and debt availability and underwriting. We believe the Fed will hike interest rates just one more time this year, alleviating some uncertainty, which will stimulate investment activity in 2024. Consequently, we expect values will begin stabilizing later this year.
The stark interest rate risk has overshadowed CRE fundamentals for the time being. But healthy occupancy and rental gains during the past five years—the period CBRE EA assumes as the average lease term—means that for many assets, net operating income (NOI) will benefit as leases expire. This is particularly true for the industrial sector as income growth will largely offset the expected roughly 100-basis-point trough-to-peak increase in cap rates during this cycle, keeping capital values positive for the 2022-2024 period. Multifamily will see less benefit from lease rollover because, unlike industrial, occupancy levels are falling back toward historic norms.
Retail and office stand to see greater value loss. For the most part, retail’s considerable momentum in recent years, including occupancy and rent gains, will not be enough to counteract rising cap rates. Well-located retail centers may prove to be an exception as markedly improved fundamentals support continued income and value growth. Meanwhile, office faces both cyclical (interest rates/economy) and secular (hybrid work) challenges. Falling occupancy and lower effective rents mean NOI will decline as leases roll over through 2024, likely falling by 8% from 2019 levels.
Figure 1: NOI Growth and Change In Capital Values
Source: CBRE Econometric Advisors.
Senior Managing Economist, Econometric Advisors
Dennis Schoenmaker, Ph.D.
Executive Director | Principal Economist, Econometric Advisors