Pent-up demand in the U.S. lifts commercial real estate short-term

Interview

October 25, 2021

IN BRIEF

Keep an eye on inflation, interest rates and unemployment, as they seem to be the key indicators closely linked to demand for commercial real estate transactions.
There’s been an ongoing trend away from the Mid-Atlantic and Western regions in the U.S., which was further accelerated by local restrictions and the reduced need to live where you work during the COVID pandemic.
Pent-up demand should drive the market through 2023, but don’t expect any exponential growth beyond that. Revenue will continue to increase at a very modest 1% to 2% per year.

As we begin to emerge from the pandemic, it seems that what happens in the real estate sector, specifically the commercial real estate sector, will go a long way to determining how quickly cities recover financially. The pandemic accelerated perhaps two trends in terms of commercial real estate. One, offices in cities’ business districts sat basically empty for 18 months, and a lot of those tenants are evaluating how they’ll work in the future and how office space—specifically downtown office space—will factor into that. Two, the retail sector was changing prepandemic, but the explosion in online commerce during the pandemic may have altered brick-and-mortar shopping in a significant way. Given the pandemic, it’s not surprising that the commercial real estate sector was down some 1.5% in revenue from 2015 to 2020, but the forecast gets better from there. IBISWorld, in its latest Commercial Real Estate in the U.S. report, is forecasting a relatively flat 2021 commercial real estate market at $890 billion but is predicting growth of 4.8% in 2022, 9.8% in 2023 and 4.3% in 2024. It says the market will eventually hit about $1.15 trillion in revenue by 2026, a 25% jump over the next five years. Jon Critelli, Managing Director with Protiviti and an expert on the real estate market, sat down with Joe Kornik, Editor-in-Chief of VISION by Protiviti, to discuss the U.S. commercial real estate sector and how it’ll impact the future of cities.

Kornik: Jon, thanks for joining me today. Given all that’s gone on with the sector during COVID, those numbers from the IBISWorld commercial real estate report sound pretty optimistic to me. What do you make of them?

Critelli: On the surface, these numbers seem optimistic, but the reality is mixed when you consider what makes up the commercial real estate market. While traditional, high-end office space may be in less demand, especially in densely populated urban areas, other segments such as industrial, retail and hospitality could grow. There is a generally accepted idea that brick-and-mortar retail stores will be in less demand, but recent studies are showing that consumers are trending toward multichannel shopping experiences where they move seamlessly between online and in-person shopping. Industrial segments will also likely continue to grow, based on increased demand and need for distribution and logistics hubs, along with data centers and other technology infrastructure that is supported through commercial real estate.

Kornik: That nearly 10% revenue spike in 2023 sounds exciting for the sector. Do you think that’s a matter of pent-up demand and projects that were put on hold pre-COVID returning? Or new projects and post-COVID optimism?

Critelli: I think it’s likely a combination of both but probably leaning toward the resumption of projects that were put on hold pre-COVID now coming back online or being greenlighted. New, nonresidential construction starts are actually down 5% year-to-date, so I think it’s probably a reflection of a resumption of projects that were placed on hold or were already strategically planned for. I also think revenue generated from facilities management, facilities operations and facilities optimization servicers, especially in the industrial segment, will follow the new construction through 2022, peak in 2023 and then begin to level off beyond 2023.

Kornik: What do you think will be the key factors that will contribute to a recovery? Or more simply: What needs to go right, and what could go wrong? What indicators should we focus on?

Critelli: It may seem obvious, but we have to continue to move past COVID restrictions and bring people back to gathering. We have seen that lockdowns haven’t necessarily stopped economic growth; it’s just changed some of the traditional drivers and placed more of a focus on location optimization, facilities optimization, and increased demand for industrial and high-tech tenants. In terms of indicators to watch, I’d keep an eye on inflation, interest rates and unemployment, as they seem to be the key indicators linked to demand for commercial real estate transactions.

Kornik: When you look at the segments, three-quarters of the market’s current revenue comes from office (29.4%), retail (24%), and municipal and institutional space (20.5%). Given what we know about how office and retail were impacted by the pandemic, do you envision those percentages holding as the market develops through 2026?

Critelli: Following along some of the previous themes, I think you’ll see this mix shift away from office and rebalance toward retail and municipal, as well as institutional revenue. There will be a large shift toward municipal and institutional revenue—especially related to healthcare expansion, upgrades and management. Schools will also see increased investment as children return to classrooms, and many municipalities have already raised or are in the process of raising funds for these purposes through public bonds, which will further drive revenue. I also think you’ll see a shift in revenue toward multifamily housing as investors look to develop and operate apartment buildings and complexes—especially if mortgage rates rise and residential housing inventory remains low. This will only accelerate multifamily commercial real estate activity.

Kornik: According to the report, about half the current revenue comes from construction, and about 20% comes from commercial leasing. Again, when you look forward, how do you suspect construction and commercial leasing will factor into the overall market?

Critelli: I think construction will continue to slow, especially as new, nonresidential construction starts to decline. This may be buoyed a bit by construction activity in municipal and institutional segments, but it won’t be enough to offset construction decline in other segments. Commercial leasing will likely remain steady and typically follows rental rates, which are driven by business growth and consumer spending, and both of these are showing positive signs of continued rebound and sustained improvement.

We have seen that lockdowns haven’t necessarily stopped economic growth; it’s just changed some of the traditional drivers and placed more of a focus on location optimization, facilities optimization, and increased demand for industrial and high-tech tenants.

Kornik: How about from a geographic standpoint? The IBISWorld report has the U.S. Southeast leading the way, with the West and Mid-Atlantic being close behind. As you look out, do you see anything happening from a geographic standpoint that could be significant?

Critelli: I see a potential trend related to movement away from the Mid-Atlantic and West regions in the U.S. Economic activity follows population movement, and domestic migration trends are starting to demonstrate that people are moving away from New York, Illinois, California, New Jersey and Michigan and moving to Florida, Texas, North Carolina and Arizona. This trend has been occurring since 2010 and was further accelerated by local restrictions and the reduced need to live where you work during COVID. These migration trends will likely shift revenues across the regions over the next five years until the population starts to “resettle” in the post-COVID environment.

Kornik: We’ve mainly talked about the next five years, but I’m curious to hear your thoughts about the commercial real estate sector in the U.S. longer-term—say, 2030 or even beyond. How bullish are you on the sector overall, and what could that mean for U.S. cities over the next decade?

Critelli: I think revenue will continue to increase but at a very modest or more traditional 1% to 2% per year. There will also be demand for services related to property management, property transactions, and property development or redevelopment. I think construction will slow from pre-2020 levels, but again, spending in the municipal and institutional segment—some driven by government investment—will also support this growth through 2030. I’m optimistic that the market will remain steady, but don’t expect any exponential growth beyond 2022 and 2023, and even some of those estimates put out by IBISWorld seem a bit too optimistic to me.

I’m optimistic that the market will remain steady, but don’t expect any exponential growth beyond 2022 and 2023, and even some of those estimates put out by IBISWorld seem a bit too optimistic to me.