Commercial Property Rebound
Like the rapid reopening of the US economy, commercial property markets are rebounding faster than in prior recovery periods, but this is highly variable by property type and geography. Given differences in underlying supply and demand fundamentals, it is not surprising that the commercial property transaction market is quickly moving back to pre-pandemic activity levels, driven largely by accelerated levels in the industrial and multi-family property markets. We expect this pace to accelerate for the remainder of 2021 as investors continue to increase their target allocations, both to real assets broadly and commercial property specifically.
Industrial Sector: Favorable Despite Consumer Habits
The near-term outlook for the US industrial sector remains highly favorable, given the demand uptick in recent quarters, as well as broader historical trends.
The broad substitution of logistical space for in-person retail, under way for some time, was accelerated by the pandemic and related changes in what businesses and consumers require, and where/how they access it. Industrial demand growth has largely outstripped supply growth for a decade, leading to declining availability and outsized rental increases.
E-commerce channel growth and broader spending on goods has been a continued trend supporting rising industrial space demands. Overall consumer spending took a dip during Covid, but spending on goods fared significantly better than services, given consumer inability to spend on in-person services.
Data shows that consumers expect they will continue to shop online with goods delivered more often post-pandemic than they did pre-pandemic. With spending on goods booming in 2021 and e-commerce sales continuing to expand, the perspective on the industrial sector is highly favorable in both the short and long term.
Office Property: Uncertainty of Future Work Dynamics
The US office market is facing continued uncertainty as it adjusts to the effects of a year of remote work and a tentative re-entry into a post-pandemic world. Overall, the spread between vacancy and availability rates has widened, suggesting that office tenants are taking a more cautious approach to leasing influenced by the evolving return-to-work dynamics.
The correlation between employment and office space demand is shifting in real time as many employees integrate some form of a hybrid work model, but the longer-term dynamics remain in question. The share of employees working from home due to the pandemic has been decreasing through 2021, particularly at the onset of summer. As illustrated in Figure 2 below, per the Bureau of Labor Statistics, the percentage of employees working from home in June 2021 is down by more than half from its May 2020 peak. While steps are being taken towards returning to work, the Delta variant may certainly lead to apprehension among workers if the rising case counts continue.
Figure 2 – Employed Persons who WFH in the last 4 weeks due to the pandemic
Source: US Bureau of Labor Statistics, AEW Research
The condition of office space will be an added consideration going forward. In aggregate, companies are evaluating their respective value positions with respect to employees being in the office, working remotely, or a hybrid model while taking into account their employees’ concerns and preferences. This will likely translate to a flight-to-quality that often shows up at this point in the cycle but will expand to incorporate health and safety attributes at the expense of older commodity office space.
Despite uncertainty in the sector, some metrics show signs of office demand returning in the long term, as evidenced by high leasing activity. In fact, some of the largest leases signed this quarter were by tech firms like Apple and Hulu, as well as several life sciences companies. We at AEW Research affirm the belief that many firms will still embrace a hybrid work environment. 2Q 2021 did see a strong return to the office, which is positive for the office outlook and supports the idea that when it is safe to return to the office, workers and companies will do so.
Apartment Sector: Strong V-Shaped Recovery
Improving fundamentals in the apartment sector – including declining vacancy rates and a record-setting quarter for net absorption – are translating into robust rent growth. Going forward, the continued economic recovery and accelerating job growth should prompt greater household formation. Meanwhile, a broad lack of affordability in for-sale housing and limited supply of homes for sale should yield greater increases in renter household formation. Supply growth will remain steady; however, the ongoing recovery in the apartment market is expected to continue. The US urban gateway markets that were most adversely affected by Covid will subsequently see the greatest ‘pops’ in rents as concessions continue to burn off and asking rents advance to and eclipse their pre-Covid levels. While the spread of the Delta Covid variant poses a risk to the outlook, the long-term prospects for the apartment market should remain favorable as the US is undersupplied in housing relative to the demographic-driven demand expected.
Retail Progress Report
Retail property remains largely out of favor with most investors as visibility into the full degree of dislocation comes into focus. However, the easing of Covid-19 restrictions and reopening of the US economy have begun to herald a recovery in the retail sector. Real-time indicators such as mobile phone location data show broad recovery with foot traffic, and in some cases, sales levels returning to pre-Covid levels. Most consumers are emerging from the pandemic in a better financial position, often with significant accumulated savings (not to mention federal stimulus and unemployment payments), which we expect to contribute to elevated consumption levels, and ultimately, retail sales over the rest of 2021 and into 2022. Store closures and retail bankruptcies have slowed in step with the reopening of the economy. Top line growth, in June 2021 for example, was led by department stores, miscellaneous store retailers, electronics and appliance stores, apparel stores, gas stations, and restaurant sales.
The improvement in fundamentals was driven by firming demand and continued modest construction. Improvements prevailed in multiple segments of retail, including the neighborhood and community shopping center segment (NCSC) and the power center (PC) segment, which has struggled in recent years. The lifestyle and mall (L&M) segment showed positive indications of recovery in late summer / early fall 2020, but has since stalled.
Continuing improvement in sales levels and consumption will largely depend on the strength and direction of the broader economy. Overall, though, we anticipate market fundamentals in all retail subsectors to continue to improve into 2022.
Competitive Transaction Market
US commercial real estate sales surpassed pre-pandemic levels in 2Q 2021. Following the trend of recent quarters, industrial and apartment sales accounted for the majority of transactions. Among other property types, retail and senior housing transaction volume also more than doubled on a y/y basis. The hotel sector reported the greatest increase in volume; however, this was driven by the Blackstone/Starwood joint acquisition of Extended Stay America. Laggards for the quarter were the office sector and development sites – it’s important to note that although they trailed the sector, volumes increased in both areas.
We are of the view that the transaction market has fully returned to pre-pandemic pacing, and we expect activity to remain strong through 2021 and into 2022.
Capitalization rates across all sectors have compressed in the open market. Going forward, with a wave of capital waiting to be deployed into real estate, we expect the transaction market will remain competitive, with prospects for the strong continued recovery translating into better rent and net operating income (NOI) growth, which will ultimately be capitalized into values. Our bottom line is that we expect cap rates to remain around their current level or perhaps nudge downward.