The commercial real estate (CRE) market is in a reset. Deal activity is down, and property prices are declining. We recently examined what clues history can provide about the potential length and depth of CRE price declines. Today, let’s examine what current CRE fundamentals can tell us about where we are in the process of resetting.

"However, even pre-pandemic benchmarks aren’t perfect, as the pandemic fundamentally changed the way we used space. When CRE prices and volumes adjust to the new normal, it may look different than what was considered normal before 2020.”

Deal or No Deal?

CRE transaction volumes, which surged to record heights during the pandemic, have fallen dramatically. In May, deal activity fell by 71 percent compared with the prior year. However, some perspective is helpful, as deal volume in May 2022 reached $74 billion, a record amount for the month of May. Still, transaction volume in May 2023 was 55 percent below the cumulative average monthly transaction volume for the five years preceding the pandemic. Either way you look at it, the market is slow right now.

Multifamily Vacancy Rates Move Up

While tight credit conditions partly explain the muted deal volume, other fundamentals are also softening. Office vacancy rates have risen and, given the uncertainty surrounding return to work, they are expected to increase further. Multifamily vacancy rates have also increased from the troughs observed in 2021, returning to levels in line with pre-pandemic rates. Industrial leasing activity is slowing, but generally demand for industrial space remains high. The retail property market is benefitting from limited new supply, which has kept retail vacancy rates low.

Rent Growth Slowing

As vacancy rates have inched up, or in the case of office, climbed up, rent growth has moderated across all asset classes. While slowing, rents for industrial properties still grew at a double-digit pace in the first quarter of 2023, 10.6 percent, compared with the first quarter in 2022. Multifamily rent growth has decelerated significantly, slowing from a peak of nearly 11 percent annually to just below 3 percent in the first quarter this year. Office rent growth, which is butting up against the headwind of remote work, has stagnated and remains near zero. As office leases expire, landlords will likely need to lower prices to compete for the reduced market demand, which should put considerable downward pressure on office rental prices. Retail rent growth, which was just below four percent in May, will depend to a degree on the strength, or lack thereof, of consumer spending.

A Small Price to Pay

What’s the consequence of muted transaction volume, rising vacancy and decelerating rent growth? CRE prices are falling, and in some cases steeply. As of May, prices for all asset classes are falling (industrial had been the last holdout until April), with multifamily prices declining the most at 12.5 percent annually.

Suburban office prices declined at the second fastest pace, 8.1 percent, but suburban office price growth outpaced Central Business District price growth during the pandemic, so the price declines are falling from higher peaks. Additionally, these office price figures are likely understating the true impact to office valuations, since only office buildings that have been sold are included in these prices. Many office buildings have not traded because owners know if they sold now, they’d take a loss. For owners that might be forced into selling offices in the near future, recent comparable transactions have shown that office price declines can be extremely steep.

So, What’s the X-Factor?

The proof is in the price. CRE property prices skyrocketed for most asset classes during the pandemic, and we’re currently undergoing an adjustment from that record-breaking growth. Therefore, any year-over-year comparison made right now needs to be taken with a grain of salt, an awareness of recency bias, and an eye towards what trends looked like before the pandemic exogenously shocked us all.

However, even pre-pandemic benchmarks aren’t perfect, as the pandemic fundamentally changed the way we used space. When CRE prices and volumes adjust to the new normal, it may look different than what was considered normal before 2020.