Top 10 CRE Predictions for 2022

Title:?????????????Top 10 CRE Predictions for 2022

Author: ???????Joseph Ori, Executive Managing Director of Paramount Capital Corporation, a Commercial Real Estate Advisory Firm

It is hard to believe that 2022 is almost here and below are my top ten predictions for the CRE market in 2022. ?

1. The hot industrial market will begin to slow

The super-hot industrial market that has seen the national average rent increase 3.8% to $7.07 and a vacancy of 5.9%, will begin to slow down due to extreme overvaluation and more than 500 million square feet of new space coming to market in 2022. Net lease rents per square foot have almost doubled in many markets from ten years ago like Orange County at $13.03, Los Angeles at $11.90, the Bay Area at $11.60 and New Jersey at $10.20. There has also been extreme cap rate compression that will also cause a slowdown in the sector. Industrial cap rates on Class A properties are currently at 3.50% and down from a more normal 6.0%, only a few years ago.?

2. Interest rates will continue to rise

With inflation rising at a 40-year high, interest rates will follow. I predict the 10-Year Treasury Note that is currently 1.43% will increase to over 2.25% in 2022. Fixed-income investors will cause the long-term end of the yield curve to rise and not the Federal Reserve as discussed in my number three below.

3. The Federal Reserve will not increase interest rates

The consensus opinion among economists and Wall Street players is that the Federal Reserve will taper its $125 billion per month in purchases of Treasury bills and mortgage-backed securities for six months and then begin to raise the Federal Funds rate from zero percent to at least 1.0%. I do not believe that the Federal Reserve is serious about tapering and raising interest rates. They like to talk about these negative measures, but other than maybe cutting back their monthly purchases by a few billion dollars, they are not serious about raising interest rates. This will be especially true in an election year. The U.S. national debt is now at $30 trillion which has tripled since Obama became President in 2009. If the Fed does raise rates, the stock market and economy will crash, and the country will enter into a nasty recession.??

4. Brick and mortar retail real estate will make a big comeback

The retail industry, which has been left for dead many times during the last several years, will make a big comeback with higher occupancies and rents. Many of the weaker retailers have gone bankrupt or closed their stores like JC Penney, Sears, Gymboree, Forever 21, Lane Bryant, Brooks Brothers, Barneys and Chuck E. Cheese. Malls will see increased traffic over the holidays and demand for retail space will increase. As I have discussed previously, in the next five years, approximately 30% of mall leases will move to percentage rent only with no base rent per square foot. The leases will still be triple net, but annual rent will only be paid as a percentage of the retailer’s sales. Although this will shift the rent risk and volatility to the landlord, it will keep tenants in malls and occupancies high. This will be a significant benefit to the tenants as their rent will correlate 100% with sales and result in higher operating income and lower financial risk.

5. The majority of employees will finally return to the office

As the covid pandemic has become a political tool and not a worldwide virus anymore, the dozen or so states that have been in a lockdown with mask and vaccine mandates, will finally open up their economies. These states include California, Maryland, New York, Illinois, Oregon, and New Mexico in which only about 25% of employees are back in the office. Although some companies have moved to a hybrid work environment, 95% of office employees and their employers want to be back in an office setting. More employees back in the office will be good for the office market and local retailers and small businesses that have been annihilated by the lockdowns.

6. Consolidation in the software and data analytics sectors will continue

One of the bright spots in the service sector of the CRE business is the high growth and high valuation of the software and data analytics firms. The companies in these two sectors are continuing to consolidate as seen by the following recent deals, Thoma Bravo’s taking private of one of the leading software and data firms, RealPage for $9.6 billion, RealPage’s acquisition of the software firm Buildium for $580 million, CoStar’s acquisition of Ten-X, the auction firm for $190 million, MSCI’s acquisition of data analytics firm Real Capital Analytics for $950 million and Altus’s acquisition of data firm Reonomy for $200 million. There are dozens of smaller software and data analytics firms that will be gobbled up by the larger firms or investors in the next few years.

7. Net asset value REITs will see their share prices decline

As interest rates rise, cap rates will follow and many of the large net asset value REITs will see their share prices begin to decline. These REITs sell shares of stock to the public at $10 per share and they value their portfolios on a monthly basis using cap rates and discount rates. Since they entered the market several years ago, they have been able to use lower cap and discount rates even though interest rates have risen during this period to increase the value of the portfolios. The share prices per their calculations have increased every month with one major REIT’s stock price at almost $14 per share from its $10/share IPO price. With rates increasing, they will now have to increase their cap rate and discount rates, which results in lower asset values and net asset value per share.

8. The net lease market will see values decline

With rising interest rates and much higher inflation, investors that hold portfolios of long-term net lease assets will see the value of their portfolios decline. Many of these net lease portfolios have average lease duration periods of 10 to 15 years with rent increases only every five years based on the CPI or at fixed increments. These investments are in substance a bond spread game wherein the investor buys the net lease at a 6.0% or 7.0% cap rate, finances it at 4.5% or 5.0% and earns the spread. As inflation and rates rise the value of these bond-like assets will tumble.

9. Hotels will be big winners in 2022

The hotel market which has struggled tremendously during the covid scare is beginning to make a comeback with higher occupancies, cash flow, RevPAR, and valuation. Per Smith Travel Research, a hotel consulting firm, the hotel market as of December 2021 in the U.S. had an average occupancy of 58%, an average daily rate of $127 and a RevPAR of $70. These amounts are down from November 2019 which saw occupancy at 69%, an average daily rate of $132 and a RevPAR of $91. Returns for lodging and resort REIT stocks were down -23.6% in 2020, but up 14.72% through September of this year. With higher inflation and economic growth, more employees returning to the office, increased conference and meeting schedules, and more business and leisure travel, hotels investments will be one the biggest winners in 2022. They are also the most correlated CRE real estate asset to inflation with one-night leases.

10. CRE in high growth low tax states will outperform high tax, high crime states

There has never before been a time when location and market are vital when investing in CRE. Today, the high growth, low tax states are experiencing tremendous influxes of new residents and their economies are booming. The high tax, high crime states are experiencing just the opposite, large outmigration’s, poor economies, and very slow growth. A diversified portfolio of CRE assets in high growth, low tax states, will outperform a similar portfolio in high tax, high crime states.

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