Matias Recchia is Co-Founder and CEO of Keyway, the commercial real estate technology platform designed for small and medium businesses.
Despite economic uncertainty and growing interest rates, the U.S. commercial real estate market experienced successes in 2022. As one example, Atlanta saw $30.7 billion in direct commercial real estate investments between the fourth quarter of 2021 and the third quarter of 2022. That’s as much as Beijing, Tokyo and Singapore combined, according to data from JLL.
However, a lot has changed in the past few months. I’ve observed that as a result of higher borrowing costs and wide bid-ask spreads, a lot of commercial real estate investment activity seems to have ground to a halt. This is leaving many institutional investors, who have raised money over the past few years, on the sidelines. But the fundamentals around the strongest-performing asset classes haven’t changed (e.g., the housing shortage still persists, which provides a strong tailwind for residential), so I believe institutions are simply waiting for the right moment to jump back in.
If the interest rate increases slow down, I expect to see investors return to the market in 2023. As the co-founder and CEO of a small-scale commercial real estate investment company, the area I’m paying attention to is the sub-$50 million small CRE space, where I’ve found there is relatively weaker competition due to fragmentation and less liquidity.
Within small-scale commercial real estate, which verticals might win and lose in 2023?
Small-scale commercial real estate encompasses many different verticals, and each will perform differently depending on market conditions and the macroeconomy. It’s important to understand each, as this can inform how investors build their portfolios.
MORE FROMFORBES ADVISOR
A few verticals I think could fare well include:
• Class B multifamily: At the end of 2020, the U.S. still faced a shortage of 3.8 million housing units, according to a report by Freddie Mac. I believe Class B multifamily could outperform due to its unique position relative to Class A and Class C. Class A is burdened with ample new supply, and if many tenants look to reduce their housing costs due to economic stress, this could create a trickle-down effect on Class B. In addition, Class B performed better during the 2008 recession than Class C, an analysis by CBRE found.
• Single-tenant property owners: Many businesses that owned or refinanced their real estate recently are facing elevated rates. Working capital to grow the business is becoming more expensive, as many small-business loans have reached double-digit interest rates. I believe this could lead owners to seek lower costs of capital via more creative ways of financing, such as sale-leasebacks.
• Retail anchored by food and services: Armed with government stimulus and increased savings, spending on durable consumer goods increased by $103 billion in 2020, while services fell by $556 billion over the same period, according to Deloitte. However, I believe that spending will continue to normalize this year, and services could benefit as people go out and divert spending away from durable goods and into staples and services. Neighborhood retail that offers in-person services saw the net absorption rate rise by 35% in the third quarter of 2022 versus 22% for retail spaces as a whole, according to the National Association of Realtors. I believe neighborhood retail will continue to perform well.
A vertical that I believe could face challenges this year:
• Class B and Class C offices: With recent waves of layoffs and a slowing economy, I expect the office sector, in general, to face headwinds in 2023. Class B and Class C properties could struggle, as, based on my observations, tenants looking to attract staff back to the office seem to be leaning toward high-end Class A office buildings. Class A listing rates were up 1.9% in 2022 compared to 2021, according to Commercial Edge, while Class B slid 0.4% and will likely continue to be challenged.
What does this mean for investors?
While the market is quite frozen right now, I expect investors with ready capital will be able to act on once-in-a-decade deals. From my perspective, this won’t be the stressed sellers of 2008 and 2009, but a softer landing that will create lots of opportunities. I anticipate a thaw will start in months and that by the second half of the year, a number of deals in verticals considered “recession-resilient” or that hedge inflation will be available.
Coming off several years where it seemed almost every market could only go up, market and sub-market selection going forward is key. From my perspective, many markets enjoyed pandemic-fueled population growth, but with ongoing challenges in the tech sector, booms that relied heavily on the Great Tech Migration, for example, might not find sufficient footing to support a meaningful rebound.
Because of this, it is crucial that investors in the small CRE sector deeply understand the specific investment they’re considering and the area in which it is located. This is especially true given the unique factors that might have contributed to its growth during the past several years, some of which might not be replicable or sustainable. For example, did prices go up because of a boost from the work-from-home population, or is there a genuine growth in jobs from a diverse economy that could weather a potential recession?
In addition to looking at historical job growth, mapping current and incoming employers with jobs could be helpful. Another consideration might be whether rent growth assumptions are achievable by really understanding the target investment and not just relying on the general market’s trends. For instance, perhaps you could use credit card spending data to understand one medical office’s performance versus another, rather than assuming all medical offices can support some level of a uniform rent increase.
After the roller coaster year of 2022, the real estate market is adjusting to the new normal of interest rates and economic activity. Investors will need to keep their pulse on what’s happening at the ground level in addition to identifying market trends.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Forbes Business Council is the foremost growth and networking organization for business owners and leaders. Do I qualify?