Recession Fears Lessen But Other Worries Persist: Survey

In the six months since the last Commercial Real Estate Survey from Allen Matkins and UCLA Anderson Forecast, interest and cap rates have increased and a possible recession has become less of an immediate challenge. This Summer 2023 survey, one of two forecasts a year from these groups, reflects an overall cautious but optimistic tone regarding new home and related retail development, as well as industrial growth for California markets. If a recession occurs, it’s expected to be milder in the state than for the rest of the country. 

Yet, challenges persist and include required equity percentages and investment return hurdle rates that are likely to rise over the next three years. The three-year mark is a significant benchmark since that’s how long most new commercial projects take to be completed since they include the need for a business plan, preliminary architecture study, search for financial backing and finetuning of plans. Here’s a snapshot of how the different sectors look:

Office markets. The return-to-office sentiment began to pick up last year but then waned to the point of becoming negative in eight markets surveyed. Participants responded that they expect rental and occupancy rates to weaken in the coming year and don’t foresee a full recovery before the end of 2026. The bottom line may be less new office construction in the year ahead. Ongoing remote work has affected the state’s Central Business Districts. 

For example, in Northern California only 14% of panelists have plans to start a new office project in the next 12 months and none are going to begin more than one. In Southern California, none of the panelists reported plans for a new project in the next 12 months. The prime reason for this is that the jobs that led to an office boom before the pandemic can be done remotely. As a result, vacancy rates have gone up to 30% or more in San Francisco and downtown Los Angeles. Another reason is that financial markets are more challenging and there’s no immediate easing of lending conditions expected.

Landlords hoping to fill vacancies are wise to invest in amenities and modern features to attract businesses and workers and utilize space more, according to Matkins partner Alain R’bibo.

Retail markets. The good news is that there are positive signs for the beginning of a new cycle by 2026 as retail sales increased nationwide and California posted solid gains through the end of 2022. Three forces are helping to inspire optimism at least in Southern California and Silicon Valley retail markets, a return to the office has increased even if not back to where it was; new housing has created demand for new retail nearby, and an expectation of increased demand for reconfiguring retail establishments to open-air post-COVID-19 spaces is also luring back consumers. Yet, the percentage of panelists planning new developments over the next 12 months is lower than the percentage that began new projects previously, particularly in Northern California. 

Industrial space markets. This sector has been the equivalent of the belle of the ball with record high occupancy rates and strong lease rate growth. But it’s not all optimism as a slight cooling in current development has occurred. Yet, in Southern California, there are warehouses under construction as developers respond to low vacancy rates. As supply catches up, these vacancies may increase, which is why panelists responded that they expect 2026 not to be as profitable as this year was. But more new projects are nonetheless planned. A key drive of industrial growth and new development comes from rising demand for electric vehicles and need for infrastructure for these cars. In California, this is pervasive due to the state’s zero-emissions requirement for new vehicles sold by 2035 and tax credits provided by the Inflation Reduction Act to incentivize EV ownership. 

Multifamily housing markets. Despite softening rents, panelists remain bullish about the coming three years with vacancy rates in some at a low level and rental rates expected to increase more rapidly than inflation in the next three years. Different parts of the state reflect slight differences with more optimism amid panelists in Southern California. More than half the panelists said they will begin one or more new projects in the coming year with a slightly greater percentage in the Southern sector than up North. Two other factors are expected to help over the next three years: growth in the inland parts of the state and state laws that have made land available for multifamily structures rather than just single-family homes. There’s also hope for affordable housing, as Emily Murray, partner at Matkins, said, “A general rule of thumb, the more affordable housing you include in your multifamily project, the more benefits you may be able to avail yourself of under state and local law. It’s been interesting to see developers try and figure out how to reconcile those options.”