And while nothing close to an apocalypse has occurred, retail did take another turn in its long journey. Staples of 20th-century shopping such as Sears and Bed, Bath & Beyond have largely shuttered their doors. Others, like JCPenney, are doing whatever they can to stay afloat. Many malls have permanently closed, with others on the chopping block. And even some power centers and neighborhood centers have either closed or sit half empty.

When we look at the long-term national-level performance and development data, it is hard to find many bright spots. Construction of retail property has been anemic, with less than 100 million square feet of space added over the past decade, or less than 5% of total U.S. inventory, Moody’s Analytics found. For context, office-sector inventory grew by about 10% during the same period. As for rent growth, retail assets have fallen well short of inflation, even prior to the recent run-up in consumer prices.

But all of that is in the past, and while the retail sector will continue to see changes, we do see a new equilibrium on the horizon. The industry has somewhat rightsized itself, finding ways to appeal to consumers who desire the more social aspects of shopping and entertainment while also providing “showrooms” and customized spaces to enhance the online experience.

How have the performance metrics fared recently? As the accompanying chart illustrates, the U.S. retail vacancy rate has stabilized at a shade over 10%, while effective rent growth has picked up. This data shows that the sector still has plenty of room for further growth, but the aggregate statistics also mask some interesting pockets of positive activity.

One of the most startling statistics is rent by vintage. In the majority of metros around the country, there is a rent premium of 50% to 100% for properties built in the past decade — and recent rent growth has followed suit. Metro-level differences are also noteworthy. The areas of the country that have not seen large population or income gains tend to have elevated vacancy rates, often due to the disproportionate amount of older properties that are tied to a lack of development funding.

Some of the clearest examples of this trend include Indianapolis; New Orleans; New Haven, Connecticut; and Syracuse, New York, each of which have retail vacancy rates of more than 15%. Creative, modern developments in these metros may have great potential given the older stock.

Where does this ever-evolving property type head from here? Well, e-commerce is likely to continue growing. The online share of all retail sales has been trending around 15% for a while, and Moody’s Analytics expects it to jump to 20% by the end of the decade. Along with continued shifts in population and consumer preferences, this will sustain some of the same nuances for sector.

The national-level metrics will stay similar to where they are now, while older inventory will make way for trendy developments that incorporate more of the experiential and omnichannel needs of modern society. As always with commercial real estate (and maybe most importantly with retail), a close inspection of the asset, the tenants and the location are vital for a successful investment endeavor. ●

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In the third quarter of this year, net absorption across the sector was strongly negative, with the total amount of leased square footage declining by 12.4 million square feet at the national level. This was the largest decline in the Moody’s Analytics dataset since early 2021. Furthermore, as the chart on this page shows, the current vacancy rate has reached 19.2%, the highest level since the tail end of the savings and loan crisis in the early 1990s. We expect this bumpy ride to result in another increase of 20 to 40 basis points (bps) over the next 12 to 18 months.

On the surface, this is a sour story, with data and anecdotes likely to confirm many pundits’ expectations of an apocalypse for the office sector. And while it’s easy to concede this as one of the most challenging moments in the history of the office property type, it’s also important to recognize the depth and nuance of a story that actually began many years prior to the start of the COVID-19 pandemic.

What is this story? Well, it’s more of an epic than a tale, with an overarching theme of obsolescence and change. The pandemic served to accelerate the demand shift toward newer and more flexible spaces for the country’s massive and growing knowledge-based economy, but this evolution actually started long ago.

There are a few facts to ponder. First, the decline in leased office space in third-quarter 2023 (the aforementioned 12.4 million square feet) is only about one-third the amount of the worst quarterly decline recorded during the financial crisis of the late 2000s. Second, as shown on the chart above, the vacancy delta during the Great Recession was a massive 500 bps, whereas the post-pandemic change is about 200 bps.

Third, the most intriguing and telling fact may be that during the expansionary period of 2010 to 2019, the national office vacancy rate retreated by only 130 bps from its peak before floundering at a level above its long-run average of 16% — until the pandemic arrived. Given that construction activity during this expansion was modest at best, this is evidence of an attitude shift and evolution for the office market that began long ago.

Languishing national-level property values confirm this market sluggishness. Gains in office values from 2010 to 2019 amounted to about 50% of the commercial real estate market as a whole during this decade. But it’s also worth noting that not all properties are faring equally.

Akin to the retail sector of the past three decades, we are seeing successful office properties built between 1960 and 2000 make way for a modern standard in urban or suburban locations that have become more en vogue. Well-placed new construction has leased up reasonably well as tenants have been willing and able to move into these spaces for more than a decade.

The current flux in the office market is simply serving to update the timeline for changes that have been in the works for quite a while. This is not an end to the office, but it is a fundamental change in the locations of power and buildings within each city.

It’s expected that successful office buildings of the future will be those in mixed-use areas that much more closely resemble “24-hour neighborhoods” rather than the “9-to-5 neighborhoods” of the 1980s. Distinct zones of office activity are quickly dying and are being replaced by areas where office, retail, residential and public spaces can mingle and thrive together. Employees will come back to the office, but it will take both a high-quality building and a high-quality location to do that. ●

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Furthermore, net absorption for both property subtypes has plummeted since mid-2022. The question now being asked is, where do we go from here? Mortgage lenders and borrowers are looking to determine whether the sector is simply regressing toward a new equilibrium after a positive demand shock, or if there is significant stress forthcoming for this highly favored asset class.

Before we dig into the Moody’s Analytics outlook for the sector as a whole, one interesting development of note is the divergent net-absorption paths within the industrial subtypes. As mentioned, declining lease activity has been observed for both warehouse and flex spaces in recent quarters, but the latter category is facing a much stiffer test of its resilience in today’s market.

Since mid-2022, the level of occupied square footage for flex and R&D spaces has actually declined for the nation as a whole. As the chart on this page shows, it’s true that occupied stock is still above the level recorded at the start of 2022, but a period of nearly a year without any net expansion of space usage is worrisome. As for warehouse and distribution space, it is clearer that there is a moderation in the pace of growth, rather than the growth hitting a wall.

The rationale for the divergence in fortunes stems from the nuances within the subtype uses and their relationships with the national and global economies. Flex and R&D space often has elements of the office sector (and even light manufacturing). With changes to the workplace related to hybrid and remote policies, owners of flex spaces are — and likely will continue — feeling at least some of the pain of their more specifically tailored office-space counterparts.

On the manufacturing front, the past year has been a tough one for this economic sector as a whole.  Various measurements of manufacturing activity and sentiment have been pointing toward a less-than-favorable environment. After a period of rapid growth in 2021 and early 2022, a combination of headwinds has brought current and future space needs into question for flex and R&D spaces.

In contrast, the tailwinds for the warehouse and distribution sector are considerably stronger and much less uncertain than those of the flex segment. E-commerce continues to grow. Meanwhile, accelerated migratory patterns, as well as fixes to the logistics network weaknesses that were exposed early in the COVID-19 pandemic, promote greater confidence in this subsector for lenders, developers and investors.

As for a more specific outlook for the industrial sector, Moody’s maintains a positive view for this property type. Warehouse and distribution spaces should continue their upward trajectory, while the flex/R&D segment is expected to regain its footing. A new and higher growth path has been established as companies reshore or nearshore their manufacturing activities, which will lessen supply chain pressures over the long term and allow the growth of e-commerce to endure.

Lofty construction expenses for manufacturing facilities are serving as a leading indicator of this path. Additionally, innovative shipping methods and the push to ship many goods in less time requires a larger and more spread-out footprint of warehouse and distribution facilities. The construction pipeline indicates that many of the projects started during the height of growth in this sector will come online in 2023, meaning that new supply will likely exceed net absorption for the first time in several years.

Nonetheless, relatively constant vacancy rates in the 4% to 5% range are poised to keep effective rent growth rates in the region of 6% per year. This is still well above the historic yearly averages prior to 2020. ●

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Hotel occupancy rates rebounded and average daily room rates soared as households looked to spread their wings and spend their excess savings. But as we know too well, nothing lasts forever. Stimulus funds have dried up, home price appreciation is stagnant or declining, and equities are currently on their own bumpy ride. And while a national recession is far from guaranteed at this point, an economic softening is upon us.

The overall labor market will remain relatively tight over the next couple of years, given an imbalance in skill and a general shortage of workers, but companies have already been conducting layoffs, particularly in middle-management positions. Elevated uncertainty for these middle-class workers will surely dampen their plans for lavish travel this summer.

This is not to say that the bottom is about to fall out for the hospitality sector, but the reaction of hotel performance metrics to lower leisure demand will be an intriguing summer story. To gauge the impact of economic changes upon the hotel industry, let’s sift through some of the most relevant demand drivers.

Positives: Excess savings is declining but still in the black. As of February 2023, excess savings (or the extra money consumers saved beyond the level they would have without the pandemic) was approximately $1.5 trillion. This is well below the September 2021 peak of $2.5 trillion but is nothing to scoff at. Some cushion remains for those who have lost jobs, or fear a job loss, but these funds will most likely be saved or used for necessities.

Negatives: Retail sales growth has weakened over the past year. March 2023 spending levels were roughly level with their October 2022 reading. Service-sector performance is still outpacing that of goods, but consumers have been tightening their purse strings across the board. In fact, with annualized inflation still running well above normal, spending levels declined throughout much of the winter and spring. It’s likely that this will turn around a bit as lagging tax returns make it into consumers’ hands, but as previously mentioned, fear and uncertainty tend to lead to more conservative spending habits.

Neutrals: The labor market is softening — and will soften further — but it won’t fall off a cliff. This is not the same situation as the Great Recession and its 10% unemployment rates, but rates of 5% to 6% by this time next year are not out of the question. What is a wild card here (and what may keep unemployment down and wage growth positive) is a high ratio of job openings to unemployed persons. Entering the two other recessionary periods of this millennium, this ratio was considerably below 1.0. As of this past February, the ratio was falling but still above 1.5.

Neutral but leaning positive: Corporate and event travel is not part of the “revenge” definition, but it is still quite important to the health of hotels. Placer Labs recently utilized cell phone data to track visits and usage for a variety of locations and transit types. Using measurements such as the timing and frequency of air travel, as well as visits to convention centers, they concluded that business travel is seeing a resurgence but has yet to return to pre-pandemic levels. Will this type of travel fully return? It may not happen in the exact same fashion, but a full recovery is possible in the next few years with a realization that education, networking and sales are more effective in person.

As the chart on this page illustrates, the hotel-sector roller coaster is forecast to come to an end, with occupancy and room rates above pre-pandemic levels. A continued resurgence of business and event travel, along with a resilient labor market, will outweigh a pullback in revenge travel. ●

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Even before the calendar flipped to 2023, office performance metrics had deteriorated. The national vacancy rate increased by 60 basis points during the course of 2022 and the year-end rate of 18.7% was a pandemic-era high. Furthermore, the record-high vacancy rate of 19.3% (last observed in 1991 in the wake of the savings and loan crisis) is now within striking distance.

Layoffs across office-using companies continue to be a concern. Downsizing by Salesforce, Twitter and Amazon, among many others, have populated headlines for months. Interestingly, however, these headline-inducing layoffs may be misleading in terms of office real estate. Current labor market dynamics may actually make CEOs reluctant to significantly reduce their workforce as a way to manage profit margins in this softening economy. Instead, reducing the amount of office space may be more palatable.

While real estate tends to be a small share of the corporate cost structure, the potential to use hybrid and remote work (even temporarily) makes some office space expendable. For business executives who were already unsure of their long-term office-space needs, any leases expiring in the near future are prime candidates for nonrenewal or significant renegotiation.

The coming troubles in the office sector will be particularly apparent for Class B/C properties in urban areas. As leases expire and tenants opt for space reductions, it is likely that the number of vacancies across existing properties, along with any new inventory, will prompt decisionmakers to consider higher-quality and better-located spaces. Savings from reduced space, combined with likely concessions from property owners, may make this an ideal time for an upgrade. This situation in no way makes urban Class A offices immune to trouble. The recent news of difficulty for two prominent properties in downtown Los Angeles, along with continued woes in Midtown Manhattan, shows the breadth of the struggles within the sector.

This year will be particularly telling in terms of the longer-term sentiment for office investors. Following the Great Recession, 2013 was a rebound year for capital-markets activity. An upcoming “wall of maturities” that includes many relatively low-debt-yield loans will make refinancing difficult in today’s interest rate environment. A good deal of additional equity will need to be offered by market participants to make any refinance or purchase transaction push through. There is plenty of dry powder ready to deploy into commercial real estate, but it remains to be seen whether the office sector will be a main recipient.

No matter the angle taken, it is clear that the office sector is going to be tested in the next couple of years. Reaching a new equilibrium will likely require some rightsizing of the market. This will necessitate the repurposing of certain properties, and it is likely that some traditional office clusters in certain metro areas will be forced to rezone toward mixed use. But this is not necessarily a negative for the long-term future of these neighborhoods.

Finally, the next few years are unlikely to result in an apocalyptic situation for the sector. Yes, there are many challenges, but there are also opportunities to revamp the office stock while creating better, healthier spaces for workers and urban residents alike. Physical occupancy may never return to its pre-pandemic levels, but as office spaces and locations improve, positive sentiment regarding the usefulness of in-person interaction will return.

The combination of a more flexible workplace and better work environments may usher in a new era of productivity, which would ultimately be a boon for office-space needs. In fact, Moody’s Analytics models show that occupancy rates will improve starting in 2024. Without sounding overly optimistic, offices will remain an integral part of society and a new equilibrium will emerge, but some dark skies and choppy waters must be traversed to get there. ●

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