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Good morning. Multifamily and office real estate are wincing at sharp price declines in Q2, says CoStar. Meanwhile, U.S. bank regulators are brandishing new rules on assets and risk, leaving CRE bigwigs more than a little rattled. On a brighter note, the industrial sector is chugging along with strong 1H23 momentum, poised to steamroll through the year.

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US Real Estate Values Continue to Dip, Pressured by Declines in Apartment and Office Sectors

Nationwide, property prices are on a downward trend, with sales volumes significantly dropping in June. This fall in prices isn't just affecting large, high-profile properties, but it's also impacting smaller markets and properties.

The biggest losers: Multifamily and office sectors experienced the biggest quarterly and annual price declines among major property types in 2Q23, according to the CoStar Commercial Repeat Sale Indices. The indices reveal that all US regions reported negative YoY changes. The value-weighted sub-index for major multifamily sales fell 2.4% in 2Q23 and 14% compared to 2Q22, indicating a significant decline in apartment prices.

First time in over a decade: Data from equal-weighted indices, which reflect deals of lower-priced properties common in smaller markets, show a significant slowdown across the US. In June 2023, the equal-weighted US Composite Index fell by 1.1% year over year, marking the first annual drop since February 2012. Office prices have also taken a considerable hit, with a 7.1% drop in the 12 months ending in June.

Trickle-down problems: Overall repeat-sale transaction volume fell 48% in the 12 months ending in June, with the investment-grade segment suffering a 53% drop. The general commercial segment, representing sales in smaller markets, fell 36.5% in the same period. Chad Littell, national director of US capital markets analytics for CoStar, suggests these price declines extend to the lower end of the market as smaller private buyers shy away.

➥ THE TAKEAWAY

The ebbing tide traps all boats: The multifamily sector, in particular, experienced a dramatic swing in value from strong growth in 1Q22 to a 14% decline in 2Q23. The equal-weighted indices indicate a slowdown in lower-priced property deals across the US. And as transaction volumes fall, the recovery of property prices is expected to slow to a crawl. The West and South regions have seen double-digit declines, further highlighting the challenges faced by the national market.

Midwest: A Smart Move for Multifamily Investors

When it comes to investing in multifamily properties, the Sunbelt isn't the only option worth considering. Here are three reasons why a growing number of investors are shifting their focus to the markets in the Midwest.

Population Surge: U.S. Census data show a significant rise in people moving from major metro areas to smaller cities or non-metropolitan regions. Cities like Cleveland have seen a high influx of new residents, creating strong housing demand, particularly for multifamily dwellings.

Financially Stable Tenants: Midwest residents are often more financially literate and conservative, which means tenants, who may include professionals like teachers, nurses, or students, are more likely to make timely rent payments and renew their leases. This benefits investors in the long run.

Livability Factor: The Midwest is known for its high-quality schools, less congestion, recreational options, world-class healthcare, and diverse, affordable housing, making it an attractive place to live. As a result, once people move here, they tend to stay, contributing to long-term stable occupancy for investors.

Interested in finding out how to get started investing in the Midwest?

Disclosure: This post contains sponsored content. Past performance is not indicative of future results.

Stricter Rules May Edge Big Banks Out of CRE Lending

New rules proposed by U.S. bank regulators, requiring more assets per loan and disallowing internal risk models, have commercial real estate leaders on edge, to say the least.

Industry response: The proposed rules have been met with disapproval from industry leaders, including Mortgage Bankers Association CEO Bob Broeksmit and JPMorgan Chase CEO Jamie Dimon. The increased capital standards are expected to hinder macroeconomic growth and push lending business to nonbank lenders such as private equity-backed debt funds. Although this could increase the cost of capital, some developers believe the real estate industry will adapt and become more efficient.

Implementation timeline: The Basel III-inspired rules, aimed at banks with assets north of $100B (a club boasting 99 U.S. members), may require a 16% hike in capital reserves. With a phase-in timeline set from 2025 to 2028, and public comments accepted until November 30, the starting gun has been fired, and banking and industry groups are strapping on their running shoes.

Effects on CRE market: The proposed rules have a wider implication for the commercial real estate market. Nonbank lenders had already started flexing their muscles when previous capital requirements were set. While the intention behind the regulations is to thwart calamities like SVB's downfall, experts warn that they might spur pricier debt and a retreat from commercial real estate lending. In fact, based on regulator models, over 500 banks are already wobbling on the tightrope of CRE overexposure.

Regulatory stance: With regulators suggesting a four-year adjustment period starting in 2025, they argue that banks could comply by simply tightening their belts. Yet, the banking industry's uproar is palpable, especially against the push for standardized risk assessment calculations. The FDIC and fellow regulatory bodies maintain that standardization will enhance transparency and the evaluation of banks' capital adequacy, but many view it as a knee-jerk reaction to isolated failures.

➥ THE TAKEAWAY

Why it matters: Although the proposed rules aim to prevent situations like the downfall of Silicon Valley Bank, they are not without controversy. Critics argue that the regulatory bodies are overreacting, pointing out that a small number of bank failures does not reflect the overall stability of the banking system. There's a general consensus that these regulatory changes, while intended to ensure stability, could compound ongoing challenges like the value destruction in the office market. As banks brace for change, it's clear that adaptation and strategic adjustments will be pivotal in the industry's journey ahead.

Industrial Sector Tops the Charts with Lowest Vacancy Rates

According to a new report from Marcus & Millichap, the industrial sector is showing strong investment momentum in the first half of 2023, surpassing other CRE segments.

Impressive vacancy rate: The industrial sector's vacancy rate of 4% in March is at least 30 bps lower than every other major CRE segment. That’s definitely a great sign for industrial owners and investors and demonstrates the sector's resilience and attractiveness.

Sharp transaction velocity: Dealmaking in the industrial sector has been robust, highlighting continued investor confidence despite macroeconomic headwinds. Unlike many CRE sectors, industrial has benefited from several post-pandemic trends, including the growing popularity of door-to-door e-commerce solutions.

Untapped opportunities: Amid slower growth in 2023, CRE owners are exploring new avenues to maintain or improve their net operating income (NOI). Solar power has emerged as a promising yet untapped opportunity, offering the potential for future financial gains and sustainability. Incorporating solar can create new revenue streams while reducing reliance on traditional energy sources, benefitting both the environment and owner-operators' bottom line.

➥ THE TAKEAWAY

A solid choice: The Marcus & Millichap report highlights industrial as a cornerstone of 2023 CRE, exhibiting resilience and attracting investors due to low vacancy rates and high deal volumes. Additionally, the sector's innovative approach towards incorporating renewable energy sources like solar power adds financial and environmental value, further boosting its growth potential and attractiveness.

The Relationship Between Retail and Multifamily Real Estate Performance

This chart shows the correlation between multifamily and retail mean YTD effective revenue performance in 2023. Simply put, retail and multifamily performance is correlated right now, with a few outliers like Columbia, SC, outperforming and others, like Fairfield County, CT, underperforming.

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