By Sam Schiffer
On the heels of its announcement two months ago that there was "substantial doubt" about its ability to stay in business, the recent revelation that coworking brand WeWork would be missing $95 million in planned interest payments has not only cast the future of WeWork in doubt, but highlighted industry concerns about the challenges facing office tenants in a post-pandemic environment. More broadly, it has renewed discussion about some of the uncertainty at play in the commercial real estate market as a whole.
Commercial real estate professionals and industry analysts and observers are understandably curious about what lies ahead for not just the office sector, but for all of commercial real estate as the effect of rising interest rates, inflation, and ongoing economic uncertainty continue to leave the industry unsettled.
In that context, it's essential to understand the state of the industry today, which seems likely to influence what happens moving forward. With that in mind, here are some emerging trends and commercial real estate dynamics to monitor closely in the next 6-12 months:
A slowing pipeline
The good news about the WeWork headlines is that it appears that the company's struggles are specific to WeWork's operations and decision-making rather than a broader statement on the coworking industry in general. That said, in the last 4-6 months, we've seen a noticeable slowdown in deal flow. Commercial real estate buyers are clearly being more cautious. We are seeing many developers and investors terminating deals or putting deals on hold with plenty of "we'll revisit this after the new year" type of talk. Not all deal activity has slowed: larger, publicly traded organizations are still closing deals to meet their targets and satisfy investors. The downside? The deals are not as profitable, with valuations generally not as favorable as they were at this time last year. Certainly, no one is hitting the panic button, but the shift is palpable and seems primarily due to persistently high interest rates, access to capital, and uncertainty about where rates (and the economy) are headed next.
Minding the gap
Owners aren't defaulting on loans yet and there's still a lot of money on the sidelines. So, the slowdown doesn't seem to be the result of a big structural market change. But the uncertainty referenced above also seems to be contributing to a perception gap in asset values between buyers and sellers. Right now, the market is entering a bit of a stalemate: there just is not a lot of urgency to sell, so transactions are likely to remain slower until that perception gap narrows.
Rethinking office space
On the tenant side, the office market remains in a post-COVID period of transition.There is a large volume of space available and lots of questions about what landlords will do with that space. On the one hand, that creates lots of potentially intriguing opportunities for tenants to rethink, reposition, relocate, remodel, resize, or renegotiate more favorable terms. On the other hand, some landlords are holding out for a correction and others are looking to convert excess office into residential or other uses. Those conversions won't happen quickly, however. While we've seen some successful conversions, it's fairly variable from market to market. In some places, like New York City, office conversions have been quite successful and profitable. But converting existing office space to residential, for example, can be tricky, with lots of red tape and regulatory, logistical, layout and design hurdles that can make a conversion more complex or costly. The bottom line is that any downstream market impact on office volume won't be felt for some time.
Waiting for answers
Looking ahead to 2024, The biggest commercial real estate question marks are, well, the question marks. Industry professionals are all trying to read the tea leaves. Will we see a recession or just a slowdown? If we do experience a recessionary cycle, how severe is it likely to be? Which canary-in-the-coal-mine variables should we monitor in the meantime? The general consensus is that this isn't going to be a big slowdown or a significant recession-more of a modest and hopefully short-lived correction-but the atmosphere of uncertainty presents a continued challenge.
None of the transactional fundamentals have changed: good deals still rely on strong financial and market/demographic factors. But it's clear that the urgency of the last few years that accelerated both the volume of deal flow and the pace of individual deals has changed. Regardless of what comes next, it seems possible that this correction will prompt a more methodical approach to deal-making going forward, not just in 2024, but for a long time to come.
––––
Sam Schiffer is chair of Taft's Detroit Real Estate practice.
