Multifamily and industrial property values continued to show strong growth in the first quarter amid increased optimism about the post-pandemic prospects for office and retail, according to SitusAMC Insights’ new quarterly report, Current Valuation Insights. Our analysis leverages the boots-on-the-ground perspective of SitusAMC’s current appraisal and valuation management work, offering investors real-time market and property-type insights ahead of many traditional commercial real estate (CRE) data sources.
Bifurcation Continues in the Apartment Sector
First-quarter valuations are following the trends that dominated the end of 2021. Garden apartments continue to outperform all subtypes, while suburban is beating urban. Gateway markets are still lagging but show some signs of improvement. High-growth markets in Florida, Colorado, Arizona, Southern California, Texas, North Carolina, South Carolina, and Georgia remain hot. As was the case last year, this bifurcation shows the importance of portfolio allocations in this segment.
Strong sales activity continues, coming off an unprecedented year with double-digit rent growth for both new and renewing tenants. This has resulted in a material increase in market rents. In-place rents are becoming less relevant for underwriting, as things are moving quickly. Emphasis is shifting toward asking rents as an indicator of where rents will ultimately end up.
Investment rates continue to decrease, but they are market-specific and tied to many sales with aggressive cap rates in the low 3% range, if not lower. Investors are willing to accept very low overall returns in order to place capital.
The costs of payroll, insurance, and utilities continue to increase. It is not clear if they are being incorporated into the buyer underwriting, but it is certainly being captured within the cash flows for existing assets. The cost of heating by natural gas may go up as much as 30% this year. High inflation and rising interest rates do not appear to be affecting fundamentals or investing activity, but they’re something to keep an eye on throughout the year.
There has been a sharp uptick in permitting activity, with December seeing the highest level since 2006. This is a definite indicator of the strength of the market.
In South Florida, renewing tenants are seeing rental rates increase by as much as 30% YoY. But with housing prices rising so fast, many Americans have no choice but to keep renting. The exceptional growth in rents is likely to abate somewhat as affordability becomes more of an issue.
Industrial Rents Skyrocket Amid Supply Constraints
The industrial sector is also outperforming in 1Q22, a continuation of the astronomical growth seen last quarter. Tenant demand continues to be extraordinary across coastal markets. This is especially true in Los Angeles and New Jersey, where the strength of the ports, combined with ongoing supply chain constraints, are causing rents to skyrocket.
In Los Angeles, there is incredible pent-up demand for product, with competitive bidding for acquisitions and rentals in the South Bay, mid-counties, and out into the Inland Empire. In the first quarter, appraisers increased market rents in excess of 20% in certain submarkets, following similar increases in the third and fourth quarters of 2021.
New Jersey is also experiencing strong growth, particularly in the markets around the port. That strength is drifting toward all of the submarkets in the Northeast. And while New Jersey outperforms all other markets in the region, there has been plenty of rent growth as well in Lehigh Valley, Philadelphia, Boston, and the D.C.-Baltimore corridor. Cap rates are continuing to compress as well. For some of these strong markets, cap rates are in the mid to low 3% range. Secondary markets like Phoenix, Dallas, and Atlanta are also experiencing cap-rate compression.
Boston and Philadelphia have historically had an extremely limited supply of existing inventory, and that is causing rents to rise even higher. Supply is not going to catch up as quickly because of ongoing issues in the labor market and the limited availability of building materials. Costs are increasing and development timelines are expanding.
Land rents and prices have been going through the roof. Some investors are just renting out land, which is compounding the problem of limited supply of land and buildings. Parking is also at a premium. Existing buildings are being demolished or made smaller to gain more space for parking, while some companies are just renting space for parking.
Amid these trends, some investors are showing early signs of trepidation about how long the industrial boom can last, due to rising interest rates and declining returns. Still, strong performance endured in the quarter. Industrial has been the leading the way among all property types for nearly five years, with record appreciation for the past few quarters.
Post-Pandemic Optimism Spurs Office Sector Recovery
Office valuations are expected to remain flat, but such values are very market- and property-specific. There is a lot of optimism about Boston due to the large number of offices being converted to life science facilities. New York is still seeing good leasing activity. By contrast, investors are cautious about the D.C. market. It has been slowest to recover, partly due to concern about General Services Administration (GSA) space set to expire in the next several years. This will result in downsizing as more government employees shift toward working from home.
A big theme for the entire country is the flight to quality, with a growing spread between Class A and Class B. Sun Belt markets continue to have positive leasing and investment activity. On the West Coast, some assets in Los Angeles and Santa Monica are doing very well, with strong leasing pushing up rental rates substantially. In San Francisco, leasing interest has accelerated, but tenants are still fairly slow to sign. The end of indoor mask mandates may encourage leasing activity throughout California.
In most parts of the country, the sweet spot for leasing activity is 5,000 to 15,000 square feet. Turnkey properties are in higher demand as tenants look to avoid supply chain issues and high building costs. Tenants are shifting their space use, preferring more private areas as they look for opportunities that will entice employees to return to the office. Newer construction, updated designs, and good amenity packages with outdoor space top the list of demands.
Investors are showing more interest in value-add. Owners of non-Class A offices are working to improve amenities to attract tenants. Life science conversions are resulting in strong returns for investors. The office sector is growing in popularity as the profit margins of many other property types are dwindling.
Nonetheless, office has been slower to recover than other property types. With COVID-19 cases on the decline, workers are expected to return to offices in larger numbers soon. Before the pandemic, average occupancy was 4.5 days a week. Occupancy is expected to average about 3.5 days a week when things return to normal. Even with workers going to offices less frequently, companies are still going to need space. Large conference rooms that can accommodate in-person meetings are becoming a huge draw.
Occupancy is down about 6% in the last two years, and it will continue to decline to as leases expire. Renewals are down about 15 percentage points as tenants look to downsize. Meanwhile, costs have been increasing for insurance, cleaning, payroll, utilities, and security.
Retail Struggles to Recover from Pandemic Setbacks
Tenant sales and foot traffic rebounded strongly in the first quarter, as many tenants were better off financially in 2021 than in 2019. As has been the case throughout the pandemic, luxury retailers are thriving. Home furnishing retailers are also doing well, and grocery-anchored plazas are still the darling of retail.
Class A++ malls are expected to continue to do well. Their NOIs are back to growth mode. Deals are getting bigger, with several transactions of $100 million-plus. Some quality retail transactions have occurred below a 5% cap rate, which is encouraging. Class B and C mall markets, however, continue to struggle. There have been some sales, but most buyers are looking at either land plays or repurposing department stores into medical facilities or multifamily. In many cases, investors are simply buying debt at a discount.
During the pandemic, many mall landlords and tenants negotiated short-term leases of one or two years. As these leases come up for renewal, landlords are finding themselves in a better position to negotiate with tenants than they were just a few years ago.
There is still a huge concern about experiential tenants. Many are doing a bit better than they were during the height of the pandemic, but some have not yet repaid their deferred rent. Tenant sales for theaters are at around 60% of their pre-pandemic business. Gym memberships are down, but some fitness center leases are still being executed. Restaurants and other experiential locales like bowling alleys are generally not back to pre-pandemic levels.
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