Industrial Long-Term Outlook Strong, Office Remains Uncertain as it Adjusts to New Normal
American philosopher and baseball Hall of Famer, Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” Those who doubt his “wisdom” need only look to last year when most economists predicted a recession that never materialized (although it still may).
Making bold predictions about what will happen in 2024 in the office and industrial markets is still a little risky, given the level of uncertainty around the economy, interest rates, and world events. However, we can look at where we are now and examine the emerging trends based on leading CRE research and boots-on-the-ground reporting from SIORs to get a glimpse of what to expect in the coming year.
THE ECONOMY
At the close of 2023, much of the economic news was positive. The stock market indices were at or near all-time highs; the unemployment rate was 3.7%, and inflation fell to 3.1% – half of what it was in January 2023. However, the news was not all good, and storm clouds may be forming on the horizon for the CRE industry. Commercial mortgage delinquencies continued to increase in the third quarter of 2023, according to the Mortgage Bankers Association (MBA), a trend that is expected to accelerate; Moody's Analytics reported that $182 billion in CRE loans across all property types are expected to mature in 2024, including $47 billion in office loans; and although the Fed hinted there will be rate cuts in the second half of 2024, the prime rate was still 8.50% in December, making refinancing difficult. While current predictions for a recession range from none to a soft landing, the consensus on the economy is that it is expected to slow down in 2024.
CRE OUTLOOK: OFFICE TRENDS
Tobias Schultheiß, SIOR, managing partner at Blackbird Real Estate GmbH, says he and his colleagues have adopted the slogan, “Survive until ‘25,” when it comes to the office market in the European Union. Still, there is much more reason for optimism in the EU than in the U.S. office market. In Q3 of 2023, JLL reported that the overall vacancy rate in the EU was 7.8%, while in North America, it was 20.5%.
“The difference is that in the U.S., I’ve read that approximately 50% of people are back to the office; in Germany and the EU, it’s 70%-90%,” says Schultheiß. Much of the workforce is concentrated in the cities, he says, which eliminates long commutes, but there is also a “massive shortage” of residential units in Germany, “so the young professionals usually live in one-room apartments where you cannot work from home.”
One trend that the U.S. and European markets share is a flight to quality. Tenants are taking less space but are willing to pay up for amenity-filled Class-A office buildings. “Top tier office product – the top 10%-15% of any given market – has consistently outperformed lower quality product since 2020, registering 100 million square feet of positive net absorption,” states the Cushman & Wakefield 2024 U.S. Macro Outlook, and the same holds true in the E.U. Schultheiß says that in the top seven German cities, “you have increasing rents per square meter because every tenant is looking for the newest, most modern and ESG compliant buildings, but as soon as you leave the center of the city, demand goes down.”
The office space reduction by large users is driving much of the declining vacancy numbers in many markets. Wills Elliman, SIOR, senior managing director in the Wilmington, Del. office of Newmark, reports that companies like Bank of America, Capital One, AstraZeneca, and DuPont are shrinking their footprints in the market. “Capitol One has hundreds of thousands of square feet, but the offices are empty because they’re all remote,” he says. “Technically, that space is still occupied, but eventually, it will come up for renewal; they will not renew, and that will create even more vacancy.”
Elliman and other SIORs also expressed concern about how remote work will affect a firm’s character and identity. “How do you build a company culture when people don’t know each other? I’m sorry, but you don’t get to know people on Zoom.”
Another trend brought on by the reduction in space and the adoption of a hybrid work model has been an increased focus on designing office space with productivity and collaboration in mind. “I think WeWork had the right model in terms of changing the work environment,” says Gary Ralston, SIOR, managing partner with SVN/Saunders Ralston Dantzler Real Estate in Lakeland, Fla. He recently toured a newly relocated brokerage office in Denver that reduced its space by 70% but increased its brokerage team by 15%. The new space features workstations, collaborative space, interactive whiteboards with seating, two bars, a kitchen, and a snack area. The new office also has lockers for employees to store their belongings. “I think we’re going to see more of this trend as companies increase efficiency,” says Ralston.
He is also seeing more companies looking for flexibility in their leasing agreements. “They no longer want to sign a 10-year lease because they like the idea of expanding or contracting as their business changes,” says Ralston. “I think we’re going to see office buildings become more collaborative spaces. Building owners who make these adjustments will differentiate their buildings in a remarkable way.”
The bid-ask spread is the most significant trend for us because that determines transaction volume…there's been a huge bid-ask gap.
CRE OUTLOOK: INDUSTRIAL
In their 2024 Global Investor Outlook report, Colliers forecasts that vacancy rates will keep rising in most markets due in part to the volume of new industrial product delivered in the last two years. Rates will stabilize at around 6.5% during the second half of 2024 – slightly above its 15-year average of 6.2%. Despite the increase in vacancies, rents will continue to increase by 4% to 8% after a year that saw rent growth exceed 15% in many markets.
According to the report, one of the several industrial trends identified was the increase in manufacturing facilities – driven primarily by reshoring – and manufacturing construction spending has never been higher. “With the CHIPs Act and what's happening with some of the EV battery manufacturing plants being built out in Arizona, Ohio, and throughout the United States, there are a lot of tailwinds for the overall manufacturing environment,” says Jeff Hoffman, SIOR, principal at Cushman & Wakefield/Boerke in Milwaukee. There are now 30 battery factories planned, under construction, or operational in the country as the U.S. attempts to end its reliance on China for ion lithium batteries following the pandemic-era chip shortage crisis.
Hoffman adds that the Inflation Reduction Act (IRA) is also spurring development. He recently closed a deal for a 130,000-square-foot facility and has another proposal out on a second for projects that will benefit directly from the IRA and the transition to green energy. “We are definitely seeing these tenants and users trying to take advantage of the opportunities that are available (in the IRA),” says Hoffman. “I've been doing industrial real estate for 23 years, and what I see here in Wisconsin is perhaps the most robust pipeline of manufacturing projects I have experienced in my career, so there is definitely a tailwind to ‘Made in the USA’ again. I think we’re looking at a generational investment in the manufacturing plant footprint here domestically.”
In the Greater Boston market, there has been a push for large facility (100,000 to 400,000 square feet) speculative industrial development in the last two years, with over a million square feet delivered in Q3 alone. Arlon Brown, SIOR, senior commercial real estate advisor for the SVN/Parsons Commercial Group in Boston, Mass., is concerned that the buildings don’t address the market needs. “We’ve had a large number of mega-warehouses built all over the region, and we just don't have that many users that are over 200,000 square feet,” says Brown. The facilities need to be subdivided to accommodate smaller tenants, and the cost of installing racking systems for 36’ to 40’ clear heights is wildly expensive. That is also reflected on the property sales side, where smaller owner-user properties “are still commanding very high numbers.”
INVESTMENT SALES MARKET
Despite a year in which CBRE reported U.S. CRE investment volume fell by 54% from Q3 2022 to Q3 2023 (Office -66.6%, Industrial -43.7) and Green Street reported pricing for institutional-quality commercial real estate decreased 22% from its March ’22 peak, there are signs that the stalled property sales market will begin to move forward again. Green Street research head Peter Rothemund believes “commercial property is now fairly priced vs. corporate bonds, and property pricing may well have hit bottom.”
The lack of sales can be attributed to last year’s dramatic rise in interest rates, but
Ian Grusd, SIOR, national director of training for Ten-X and a former broker, says the most consistent challenge in the market has been what buyers are willing to bid on properties, versus what the sellers are asking. “The bid-ask spread is the most significant trend for us because that determines transaction volume,” says Grusd. “There are people who want to buy and people who want to sell, but there's been a huge bid-ask gap.”
Grusd is seeing movement on the part of sellers as they adjust to market realities, with 68% of the property owners on his platform having adjusted their pricing from the initial ask. Office owners have been the most flexible, followed by hotels and industrial properties.
Looking to 2024, Grusd anticipates a substantial increase in transaction volume beginning in Q2. He expects that lenders will cease the "pretend and extend" on expiring loans, and property owners will be forced to sell or lose the property due to the challenge of refinancing at a much higher interest rate. Grusd suggests this shift will reset the cost basis, aligning lender-appraised values with market pricing.
In conclusion, with so much uncertainty in the market and the tsunami of loan maturities due to hit this year and next, 2024 looks to be one of upheaval as the office market recalibrates. The challenges are daunting, but we can only hope 2024 will be like 2023, a year that defied expectations.
This article was sponsored by the SIOR Foundation - Promoting and sponsoring initiatives that educate, enhance, and expand the commercial real estate community. The SIOR Foundation is a 501(c)(3) not-forprofit organization. All contributions are tax deductible to the extent of the law.
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