“Overall, the outlook for commercial real estate next year is muted in terms of capital and space market performance, with a continued recalibration of sorts across all sectors,” Ermengarde Jabir, Senior Economist at Moody’s Analytics.

Commercial real estate trends across asset classes

While uncertainty around interest rates and office remain top of mind, performance varies across other asset classes.

• Office’s ongoing obstacles: The national office vacancy rate reached 19.2% in Q3 2023, according to Moody’s Analytics. That’s up from Q2 and approaching the historic peak of 19.3%. “Despite these headwinds for office, it’s important to remember that while there is and will continue to be obsolete office, the office is not obsolete,” Jabir said. With a flight to quality in reach for more office occupants, some older, less-desirable Class B and C offices may face obsolescence. As a result, there could be opportunities to convert central business districts’ office space into apartments or data centers. 
• Industrial’s signs of softening: Industrial continues to perform well, especially cold-storage properties. Re-shoring and nearshoring efforts in manufacturing may provide a further boost for the sector. But the asset class may be moderating as the post-pandemic demand for more inventory decreases and renters hold off on expansion. “Although industrial is beginning to show signs of softening, the sector’s long-term prospects remain positive,” Jabir said. “Moody’s Analytics CRE forecasts that annual rent growth for warehouse and distribution properties will consistently track at approximately 5% to 6% per annum over the 10-year forecast period, indicating that the sector has reached its new steady state.”
• Neighborhood retail success: Many see retail as synonymous with Class B and C malls, which haven’t performed well for years. But retail also includes neighborhood shopping centers in densely populated urban and suburban areas. While e-commerce continues to grow, it only makes up about 15% of all retail, so there’s plenty of room for brick-and-mortar operators. “Retail will emerge as the stalwart in 2024,” Jabir said. “The asset class is expected to experience steady performance, with unchanging vacancy rates and moderately positive rent growth for neighborhood and community shopping centers.”
• Multifamily holding strong: Multifamily properties continue to perform well. Although rent growth has slowed, the vacancy rate has remained roughly 5% throughout 2023. Current high interest rates will likely keep mortgage rates up, continuing to price out would-be homebuyers and sustaining multifamily demand. The only notable concern is lack of demand for luxury apartments. They may be easy to build, but they’re not necessarily easy to occupy. As a result, many high-end apartments have reduced rents and offered concessions to attract residents.

Industry challenges

Interest rates and rising costs are among the top concerns in commercial real estate:

Interest rates’ ongoing drama

The bond market was turbulent during the first half of Q4 in 2023, with the five-year Treasury yield moving through a range of more than 0.50%. This was a result of investors’ frequently resetting their expectations about the Federal Reserve’s future course—sometimes two or three times a week. 

Chances of further Fed rate hikes have diminished more recently. Many foresee the need for one or more rate cuts in 2024. But the Fed likely won’t be too influenced by one sharp move in the numbers—it wants to see clear trends established before changing course.

It’s important to note the Fed directly acts upon short-term interest rates, such as Prime or SOFR, but not Treasuries and other fixed rates. Market forces, including inflationary expectations, drive fixed rates—which leaves the future of fixed-rate financing open to non-Fed influence.

Rising costs

High inflation has raised the costs of construction materials and labor. Combined with more frequent and severe natural disasters, the result is higher insurance premiums and payouts. 

Commercial real estate property coverage isn’t just more expensive, it’s often less comprehensive and less available. The National Multifamily Housing Council (NMHC) 2023 State of Multifamily Risk Survey and Report found that 56.8% of respondents’ insurers added new policy limitations to reduce their exposure, and 60.6% have been forced to increase their deductibles to maintain affordability.

To address rising costs, owners and operators can also increase rent and decrease operating expenses by streamlining the payables and receivables processes via treasury services.

Commercial real estate opportunities ahead

Although there are obstacles ahead, 2024 offers commercial real estate investors several opportunities.

• Cash optimization: Amid market uncertainty, cash is king. The ability to move quickly to purchase an asset under stress can’t be overemphasized. Being able to access cash quickly can often provide better terms. Commercial real estate businesses can better capitalize on opportunities, particularly when rates drop, by investing in treasury services and rent payment solutions.
• Affordable housing: The lack of affordable housing is one of the biggest problems facing the country. The industry has already found some innovative methods to increase the housing supply, including modular construction, adaptive reuse and Historic Tax Credit equity. But there also needs to be a push to update zoning and tackle NIMBYism. 
• Proptech: Proptech is wide-ranging, continuously evolving and ripe with opportunities. Whether it’s installing smart thermostats or offering digital rent payment options, commercial real estate owners and investors can use proptech to make better-informed decisions, operate their buildings more efficiently and gain a competitive advantage.
• Energy-efficient upgrades: As energy prices increase, these updates are more important than ever. For example, by converting to solar power and recycling gray water, owner and investors can save money on utilities and attract eco-minded tenants. Similarly, cities often look at how much energy an apartment building will use before granting a permit, so energy-saving measures may be able to save valuable time in the development process.

The bottom line: While the 2024 commercial real estate outlook is muted, it’s important to keep your eyes and ears open. As many asset classes moderate, investors should have liquidity to pounce when there's an opportunity—and there will be some.

_{Originally published by Commercial Observer on December 6, 2023.}