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New Commercial Real Estate Data Shows a Surprisingly Good Pandemic Recovery

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If you were to look at the pandemic as two acts in a play, 2020 would be Act I, and 2021 would be Act II. The first act always contains the “inciting incident,” in this analogy, which would be the start of the pandemic. In contrast, 2021 is living up to our hopes for the second act’s “ascending action” in the form of an economic recovery, at least when it comes to real estate value. 

A new analysis of fourth-quarter 2021 Open End Diversified Core Equity (ODCE) index performance data, released by Altus Group, shows that ODCE funds recorded a 19 percent rate of unleveraged return for 2021, which contrasts the muted 2.1 percent return delivered in 2020. While this turnaround is good news for many in real estate, it doesn’t show the entire plotline, with variances playing out across the sectors and the broader geographical landscape.

Industrial is the star of the show

The industrial sector was the real standout, swelling to a 44.5 percent return in 2021 and averaging 26.7 percent over the last two years. Thanks to commercial demand for warehouses and the ongoing supply chain crisis, there’s an expectation that this sector will continue to grow.

While it should be noted that industrial is strengthening across all geographies, it was the Southern California markets, wider New York-New Jersey region, and down the I-95 corridor in the South East that stole the headlines. Riverside on the West Coast is the front runner commanding an eye-watering 75 percent investment return in the last year, built on a rapid escalation in fundamentals market rents up over 45 percent in the previous year.

Apartments have also performed well, netting a 10 percent return overall since the start of the pandemic. The “other” property types grouping (mainly storage) have also proved attractive during the pandemic, reaching 17.1 percent in two-year appreciation.

Ongoing struggles and signs of improvement for office and retail

The tremendous appreciation of industrial properties is in stark contrast to the retail and office sectors, where values are both net down since the onset of the pandemic. Retail, in particular, felt quite the sting over the pandemic as brick-and-mortar stores were forced to shut their doors. It has been grappling with an unleveraged appreciation return of negative 12.3 percent since the start of the pandemic. However, there are positive signs that the situation for the sector is starting to improve as restrictions continue to lift, especially as brick-and-mortar stores integrate e-commerce strategies into their model. Added to which grocery-anchored retail seems to be offering a degree of resilience where value change has turned positive in the last year. 

Yet, the office sector is also shrouded in uncertainty. Some rental reductions which lowered values over the pandemic are starting to reverse course throughout the last year (2021). That said, it should be noted that the central business district space of the main gateway markets continues to see near-term rental reductions leading to further value reduction through to the back end of last year. On the upside, suburban markets are trending towards the upper end of the performance order within the office sector.

Mixed bag for multifamily

Multifamily properties generally performed well despite COVID-19, except for the assets in densely populated urban areas that had lost population due to the urban flight caused by the pandemic. Sunbelt markets fared the best, where increases in rental rates have helped push property valuations to new highs, the likes of Phoenix and Miami being lead performers in that regard. Lower down on the performance spectrum, the ‘gateway’ markets such as Chicago, New York, and San Francisco are witnessing only muted improvements in market rents. This is because projected rent growth rates have been factored down, and rent concessions still negatively impact values.

Metrics for the real estate market’s overall health

Over the past three quarters, the growth overshadows the value write-downs brought on by the pandemic, which defines the uncharted territory where the overall market now finds itself. Appreciation returns have been doubling quarter over quarter and continue to strengthen in the final three months of last year. The levels of return that we’re witnessing now, which in previous periods took almost a full year to play out, are now delivered in the space of an individual quarter. In addition to appreciation, the market continues to deliver an income return of about 1 percent within those overall returns, which is a key attraction to investors. 

Along with historically low-interest rates from the Federal Reserve, the strength that the economy flexed at the market reopenings are fundamentally helping the real estate sector revival.

The operating expense ratio, which measures the change in the ratio of the first year projected operating expense as a percentage of the growth in anticipated rent, is another metric to consider when looking at the market’s overall health. This cost to revenue ratio has trended upwards across retail office and apartment sectors, particularly at the onset of the pandemic as near-term rent concessions took their toll on values. More recently, the broader cost escalation story has also impacted these trends, with operating expenses linked to the wider inflationary pressure rising over the pandemic, specifically. More specifically, property taxes have been on the rise, which is evident across all market sectors.

One final metric to consider is the capital expense ratio, which measures the amount of  budgeted capital cost as a percentage of value and how that ratio changes over the quarter. The capital expense ratio has been edging outwards, particularly on the office side and apartments and retail, which may reflect a need to invest more into assets in these sectors to ensure they remain competitive, given the change in the prevailing circumstance of the market landscape.

After commercial property suffered an immediate setback at the onset of the COVID-19 pandemic, the market has been playing out its second act. More firmly fixed on an upward trajectory, setting record rates of return quarter over quarter through the course of 2021. While there is still a historically low amount of for-sale inventory, data shows that commercial real estate values as a whole have now risen to 11.3 percent since the start of the pandemic. The impact of the pandemic is beginning to feel like a distant memory and the second act of the recovery is so far well-received. We still need to wait and see what the third act has in store for us and whether factors like inflation and recession make an entrance.

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