April 21, 2023

Hi, Brian Beaulieu from ITR Economics here and I want to talk to you about the commercial real estate market. There’s been news lately about the refinancing wall for ’23, ’24, and how much of that debt needs to be refinanced, and most of it, 70% of it, reportedly, is going to be refinanced through regional and small banks. The big banks don’t typically play in that space. That doesn’t mean they can’t. It doesn’t mean that the Federal Reserve isn’t going to come along and do some more bailing up, that seems to be one of their forte, but it’s a risk to the business cycle, all of this refinancing. But it’s not a broad base risk. We’ve been looking at the vacancy rates and, for instance, in the commercial vacancy rate overall, the 6.4%, that’s not a problem level. Apartments are at a relatively low rate of vacancy at 4.2% nationwide, and retail is very low at 3.7% vacancy rate. That one’s noteworthy for being low. And the lowest of them all is industrial space. That’s at 2.2%, which is noteworthy low.

Where there is the potential for a real problem is in office real estate. There the vacancy rate is 10.7% and that’s elevated. It shouldn’t be that high right now, but between the distributed workforce and other financial stresses going on, it’s not surprising to find it at 10.7%. So that’s the space that is at risk over the course of ’23 and 2024.

We’re already seeing real estate prices, commercial real estate prices in general, coming down. For the last three months, looking at all space, according to the Green Street all Commercial Property Price Index, those prices are down 14.7% from one year ago. If you look at the core space, again, Green Street data, that’s down 17.6% from one year ago, the same quarter. Those prices are weakening and they’re going to continue to weaken, and I think you’re going to see it most acutely in that office space.

Fortunately, at least in terms of private non-res construction, office space accounts for, I think it’s 13% of the total, it could be 14% of the total. If you look at overall non-residential construction, including government spending, it drops down to about 9% of all non-residential space. So unless there’s a contagion to where we are not seeing a problem right now, I think it’s going to be fairly limited in scope for this business cycle. I don’t expect that it’s going to get out of hand, but I certainly wouldn’t be running out and buying any commercial real estate at this time unless I was the right real estate owner occupied and in the right demographic economic area.

The criteria for buying right now has to be very high given the precipitous decline that we’ve seen in prices. And I say precipitous on purpose. Seeing the rate of change go below negative is unusual. And even the 12 over 12 rate of change, which is much slower to move, right now is below the zero line. That happened during COVID and that happened during the Great Recession. So clearly this is a noteworthy event and we wanted you to know we’re keeping our eye on it, but right now it looks like it should be limited to office space as the most dangerous part. That’s where we see a lot of non-owner occupied vacancies not getting any better given the distributive workforce. Be careful out there. There’s going to be some great buying opportunities ahead. I just wouldn’t be in a hurry to do it right now.

So what’s going on in prices, historically, means non-residential construction should be going through an inflection, through a business cycle high. Indeed, we had forecasted that we would be seeing a 3/12 rate of change high in private non-residential construction right around March, April time period. It looks like it’s come in February and it’s come at 19.9% year-over-year gain. So it’s a very high 3/12 rate of change amplitude, and we forecasted that it would be at 19.7, but it’s here. We’re going through the transition from overt business cycle rise to first phase C, slow in growth, and then there is going to be some phase D activity out there. The pricing trend already is indicating that, that’s consistent with our forecast. This is the heyday right now for this part of the cycle and non-residential construction.

Office space going to get dinged more than in most other spaces. But unless it’s industrial or government related, we’re likely going to see it spread, in terms of construction activity, to other areas. And by the end of 2024, we’re going to see phase D in multiple areas, phase D being the worst phase of the business cycle. So thanks for watching. Appreciate you taking the time to hear what we have to say here at ITR Economics and we’ll see you next time on TrendsTalk.