The commercial real estate industry just signaled it may be transitioning into the next phase of processing higher borrowing costs.
One of the Federal Reserve’s intended effects of higher interest rates is to slow the pace of economic growth and inflation. In real estate, this growth is referred to as demand and can be measured in square feet of net absorption, or the net change in the amount of space occupied.
Interest rates not only increase the borrowing costs for today’s buyers but also limit the expansion capabilities of existing tenants as their cost of funds also rises. Therefore, the next phase of the market’s reaction to the higher interest rates will likely be considering the implications of underwriting higher vacancies, longer lease-up times and muted rent growth compared to the double-digit gains we saw just 18 months ago.
CoStar’s monthly repeat-sale indices noted the combined amount of added new space across the office, industrial and retail sectors is projected to reach 814 million square feet through the 12 months ended in September 2023. This is an increase of more than 9% from the same period ended in 2022. This total was front-loaded in the fourth quarter of 2022 and the first quarter of 2023 as the pace of deliveries slowed 35% to 151 million in the third quarter. For context, the quarterly average of additional new supply during the five years ended in 2019 was about 150 million square feet.
While supply levels remain elevated, the net absorption trend turned negative in the third quarter. Despite a projected 12-month demand estimate of 38 million square feet through September, the market gave back 26 million square feet of space during the past three months, which marked the weakest quarterly total for absorption outside the COVID-era since the third quarter of 2009. Demand was also front-loaded in the fourth quarter of 2022, with 58 million square feet of net absorption, whereas the following three quarters netted a negative 20 million square feet.
Considering that net absorption averaged just under 100 million square feet per quarter during the five years ended in 2019, the recent performance suggests that strong tectonic shifts are disrupting tenants’ growth plans and reducing demand for commercial space. It may be evidence that the ripple effect of higher interest rates has found its way into property markets and that it’s now a zero-sum game in securing new tenants.