10 Themes From ‘Emerging Trends in Real Estate’ Report That Will Shape 2023

Among real estate professionals, the start of 2022 was marked by optimism as the COVID-19 pandemic began to fade. But as the year progressed, Russia invaded Ukraine, energy prices rose rapidly, inflation skyrocketed to a 40-year high and the U.S. Federal Reserve began a drum beat of interest rate hikes in an effort to tame inflation.

Against this backdrop, commercial real estate rents and sales volumes are declining, the cost of capital is rising and development projects are being put on hold. Additionally, industry professionals are operating under the presumption that a recession is coming, but the length, depth and breadth are unknown.

Providing some perspective is the annual report “Emerging Trends in Real Estate,” published jointly by the Urban Land Institute and PwC. Through interviews, surveys and focus groups of real estate developers, advisors, private-equity investors and private property owners, the study evaluates the market conditions, challenges and opportunities for investors in the year ahead.

Below, LoopNet summarizes the report’s 10 key emerging trends expected for 2023 and beyond.

After several years of “pandemic-fuelled market distortions,” pricing is returning to more normal levels, according to the study. Prices of “most assets are declining as cap rates rise and transaction volumes fall from record levels, while rent gains for other [properties] are merely moderating as demand returns to more sustainable levels.”

One surprise is that these reversals are beginning to affect favored property sectors like multifamily and industrial and, in many cases, recent declines in property value may simply trim already healthy gains. “But many indicators suggest that the (really) good times may be over, at least for a while.”

Despite many day-to-day activities returning to some degree of normalcy, “we won’t be resuming our former lives in some key respects. The pandemic forced structural shifts in how and where we live, work, and recreate in ways that seem destined to endure, at least at some level,” noted the study.

• Retail. While shoppers increased online shopping during the deepest days of the pandemic due to safety concerns or store closures, they still shop online today because of other benefits like convenience, greater selection and price advantages. “The online share inevitably waned as the economy reopened and more consumers felt comfortable shopping in stores again. But don’t expect online spending to drop down to pre-pandemic levels,” said the study.
  
• Office. With most companies still in reconnaissance mode about how often and when employees should work from home, tenants are grappling with the now familiar issues of building workplace culture as well as employee mentoring and collaboration. But saving on occupancy costs is appealing to employers, and they are also trying to find ways to shorten employee commutes and provide more flexibility about where employees work. Design uncertainties continue regarding shared or dedicated desks as well as how collaborative spaces should be optimized.

With rising interest rates and a looming recession, “fewer investors and lenders will be providing capital for assets,” according to the study. There is still investor interest, but it has declined, with sales offers per property moving from 10 to three or four, according to the head of an investment firm quoted in the report. They added that two to three offers seems in line with typical, versus heated, market conditions.

Uncertainty about pricing is leading to hesitancy. As one senior investment banker said in the study, “transactions are being done at cap rates that are anywhere from 25 to 75 basis points wider than they were — but there is not any conviction that these are the right levels.” Buyers are concerned about overpaying and “sellers don’t want to sell their assets short and then see them retraded at higher prices once the markets improve,” said the study.

The core issue for many investors is how long the Fed will keep raising rates. The good news is that there are few signs of distress and few real estate professionals expect a liquidity crunch in property markets. “Balance sheets are generally strong, leverage is low, and values have not fallen very far, so few assets are underwater with their debt,” said the study.

For many people, neither for-sale nor rental housing is affordable, with the rise in mortgage rates further exacerbating the situation. But the fundamental issue is the persistent undersupply of housing, especially at affordable prices.

Restrictive zoning and building codes are blocking or limiting new supply, while not-in-my-back-yard activists delay or derail pre-approved projects. With affordable housing transactions becoming more complex and requiring more underwriting from a greater variety of capital sources, one developer said, “the average deal for us used to take 90 days to close, and now it’s over six months.”

One academic quoted in the study cited a unique condition affecting the affordability of single-family homes for individuals versus investors, saying that existing tax laws are stacked against the individual homebuyer. They explained, “Investors are allowed to not only deduct everything, but also, they can depreciate the unit. They also have access to lower cost of capital.”

Real estate capital markets are becoming more bifurcated between the favored and the scorned as investors, lenders and developers become more selective, seemingly preferring three distinct types of opportunities:

• Major product types with very strong demand fundamentals like industrial and multifamily seem to offer the most security for investors.
• Among sectors experiencing significant disruption like retail and office, investors are comfortable with the highest quality assets in the best locations.
• Concerning “niche” assets, student housing and single-family rentals are appealing.

Discussions with leaders across the industry lead to the predictable conclusion that the quantity and location of property types is out of balance with too much office and retail in some locations and not enough industrial and housing in others. This misalignment sets the stage for adaptive reuse and retrofitting of buildings, as well as sites, in three general ways:

• Convert older offices to residential uses, or upgrade them into modern offices, where feasible and supported by the market.
• Repurpose excess retail space for other uses (including fulfilment, service office and residential) or improve them with mixed use (especially residential, office and hospitality).
• Scrape buildings to create land for development where conversion is not feasible, or where density can be increased, to build new housing.

Despite continued strong interest in the Sun Belt cities, issues like living costs, housing affordability and infrastructure quality were cited as regional disadvantages in focus groups held across the United States. These issues were most frequently mentioned as problems in some of the booming markets, like Austin, Texas and Nashville, Tennessee.

At the same time, “lower tax rates and perceived lighter regulatory burden” make these markets appealing, said the report. “But more relaxed taxation and regulation come at a cost, as evidenced by the challenges of accommodating massive population inflows.”

The perennial challenge for fast growing markets is how to accommodate growth while also maintaining the features that brought about their appeal. One focus group participant in Austin said, “The disadvantages of housing affordability, lack of mobility due to inadequate infrastructure, and property taxes will likely negatively impact our market in the coming years.”

Several areas of note affecting cities and regions emerged in the study based on the trillion-dollar infrastructure spending bill passed in 2022. They include:

• Reconnecting communities by capping divisive highways. Many highway projects and urban renewal programs of the 1950s and 1960s divided previously thriving communities of color, displacing thousands and destroying generational wealth. One billion dollars has been dedicated to fund “planning, design, demolition, and reconstruction of street grids, parks, or other infrastructure,” to reconnect these split communities, according to the study.
• Expanding broadband access. Recognizing the relatively high cost of service in the United States, the program also seeks to lower prices for internet service so more Americans can afford internet access. Expanding broadband access to underserved communities is also critical so employees in less affluent communities can also work from home. Sixty-five billion dollars has been allotted to expand broadband access to the 30 million Americans currently living without it.
• Transportation funding. The infrastructure funding bill will provide almost $600 billion in transportation funding. More than half of that will be allocated to the highway system, “the largest such investment since the Interstate Highway System began construction in the 1950s,” said the study. The bill also provides more than $90 billion to modernize transit, improve accessibility and continue existing transit programs.

The infrastructure bill also provides funding to create environmental resilience and expand water availability to help the industry “proactively address the impacts of climate change” on assets, said the study.

First, climate change may alter the dynamics of where we want to live. The hottest metro areas may soon face declining demand — and potentially an exodus — due to unbearable weather or lack of water from drought. Paying for upgrades that make buildings more resilient to events like flooding, for example, by elevating HVAC equipment from basements or ground levels to higher floors, is one approach. But some owners can’t justify the costs of doing this in case of an event that may or may not occur on their property. However, “that calculus could change if insurance costs are allowed to rise to reflect the full risks of climate change,” said the report.

“If private markets are slow to fix mounting problems that the property sector has played a central role in creating — notably climate change and housing affordability — some industry groups are calling for collective voluntary action,” the report said. But, based on the growing number of regulations under consideration at the local, state and federal levels, governments may be “getting impatient about the limited progress.”

Areas facing increased regulation include:

• ESG. Complying with ESG requirements means making capital improvements in buildings to reduce carbon impacts, but also creating systems to measure them and training staff to generate reports. These activities are costly and “could favor larger, better-capitalized investors, leading to more industry consolidation,” the study said.
• Addressing housing affordability and blight. With housing costs continuously straining household budgets, some state and local governments are resorting to regulation to address affordability and blight.
  
  • Rent control. As of spring 2022, at least 17 states were considering some form of rent control legislation, according to the National Multifamily Housing Council. Additionally, some local jurisdictions like Boston and Miami were also considering rent control laws. Several of these initiatives already failed to pass, “but the volume and range of these proposals show just how widespread the concerns are, and some of these initiatives could be revived if rents do not cool soon,” the study said.
  • Vacancy taxes. “These taxes can take various forms, but the goal is to increase the effective supply of housing by imposing costs on landlords who keep housing units vacant,” the study said. By encouraging property owners to put their buildings to productive use, the report indicates that blight can be addressed. For example, Oakland, California, enacted a flat vacant property tax of $6,000 on houses and nonresidential properties and $3,000 on condominium units used for less than 50 days a year. Vacancy taxes have been considered by several other cities in recent years, but “[they have] either rejected them or not yet voted on them,” the study said.