More trouble awaits the commercial real estate market next year, and it comes down to weak growth and high interest rates that will push property values down even further, according to a new report.
Commercial real estate property values will fall another 10% next year, after falling 11% this year, Capital Economics’ deputy chief property economist, Kiran Raichura, wrote in a recently released outlook for next year. The economic research firm defines the market size as more than $5 trillion, using a 2022 year-end estimate. That means the 11% decline in value this year equates to roughly $590 billion while the 10% fall expected next year equates to $480 billion.
Some sectors, like offices, are more distressed than others. Still, net operating income growth, a property’s total revenue minus its operating costs, is set to soften further next year as the “industrial rent boom gives way to more ‘normal’ growth rates and apartment rents flatline.” Translation: Nearly all sectors face headwinds.
Let’s start with the office sector, which isn’t simply facing the problem of elevated interest rates after an era of cheap money, but also a structural change due to the changes in how people work after the pandemic. And even with many companies pushing for a return to the office, in-office work may never be what it was. Falling revenues and rising capitalization rates that tend to translate to increased risk are behind the 15% decline in office values that Raichura and his team are predicting from next year to 2025. Capitalization rates are calculated by dividing a property’s net operating income with current market value, and is used to compare value with similar real estate assets.
“Four years after the pandemic, and the outlook for the office sector is still the joint-worst,” he wrote, referring to the tie at the bottom between office and industrial, which includes manufacturing, warehouses, and distribution centers. He added that the firm suspects total returns for offices to reach just 2.5% annually from next year to 2028.
Office-based job growth turned negative in September and office use remains well below pre-pandemic levels (with further space cutbacks to come). Therefore, Capital Economics expects weakened demand for office space over the next few years, as companies prioritize high-quality space over actual space by square footage. Additionally, Raichura expects office vacancies, which stood at 16.7% in the third quarter, according to real estate firm Colliers, to peak at 20.5% at the end of 2025 and hover there through 2028. Vacancies will then weigh on rent growth, although high quality offices may fare better.
“We think the overall peak-to-trough decline will reach 43%, compared with around 30% seen by the end of 2023,” in office values, Raichura wrote. That’s up from his initial forecast, predicting office values would fall 35% by the end of 2025.
Then there’s apartments, which face “several near-term headwinds,” he wrote. Rental affordability has improved this year, but it’s still expensive relative to disposable incomes and weighs on demand. There’s also a wave of newly built apartments entering the market that’ll push vacancies higher and pressure the net operating income of apartments. With that, Capital Economics expects apartment property values to fall next year, and provide a negative total return on investment, before recovering in 2025.
Rents have already shown signs of weakness, but with vacancies expected to peak at 6.6% next year, up from 5.9% this year, there’ll be more downward pressure on rents, according to the outlook. Overall, the firm expects capital values to fall 8.8% this year, and another 10.3% next year, as occupancy levels and rents plummet and costs rise in the higher interest rate environment. However, the firm expects interest rates will fall soon, and the Federal Reserve has signaled three rate cuts next year, which would lower borrowing costs for some property owners.
Meanwhile, retail is surprisingly a “bright spot,” according to Capital Economics. That’s based on its prediction that retail property will post total returns close to 6% annually during its five-year forecast period, after experiencing a “cyclical slowdown as a poor economic outlook weighs on demand next year,” Raichura wrote.
For the industrial sector, which Raichura said remains overvalued, he expects property values to decline 20% peak-to-trough—and returns to be negative next year, before becoming positive in 2025. “Those forecasts put industrial performance on a par with offices as the weakest sector,” he wrote.