Granite Peak sees opportunities in 2023 following market disruptions caused by higher interest rates in 2022.
As we navigate through uncertain and quickly changing market conditions, we at Granite Peak wanted to share our thoughts on some of the risks we are monitoring as well as opportunities we see in this challenging environment. The real estate market is currently in a price-discovery phase, with a wide gap between buyer and seller value expectations. During a market downturn, this price-discovery process typically lasts 6-8 months, with this current phase starting in October 2022. With inflation still elevated and interest rates continuing to rise in 2023, a moderate recession for real estate is expected to be upon us. We expect this slowdown to be relatively shallow and short due to the large amount of liquidity in the market, the moderate amount of leverage on real estate, and the relative strength of corporate balance sheets. Because of these relatively healthy metrics, we expect to see little distressed commercial real estate, with few fire sales or foreclosures.
Developers needing to pay off short-term construction loans and owners with adjustable-rate mortgages who must refinance in 2023 at double the underwritten debt service could be forced to sell or recapitalize. We believe that lenders will learn from the past and be willing to work with borrowers to extend loan maturities. This new level of lender cooperation was initiated during the COVID shutdowns as lenders and landlords worked together using payment forbearance and maturity extensions to navigate through periods of lost revenue. Positive leverage is still available for retail and non-CBD office assets, while neutral to negative leverage is the current reality for apartment and industrial properties.
Pricing for core assets will soften more and over a longer period compared to assets already trading at higher yields. We expect continued outperformance of certain asset types with opportunities for repricing on quality properties beginning in the first quarter 2023. A slowdown in construction and development is expected, which will contribute to potential decreases in the cost of land, construction labor, and materials by late 2023, making development more attractive in 2024.
Granite Peak sees varying opportunities in the different property sectors as follows:
- Industrial – Demand will continue to be strong, although at a slower pace than in the last two years, with an emphasis on shorter lease terms and away from long-term leases with minimal rent escalations. Yields will remain low for modern distribution assets.
- Office – The impact of hybrid work is causing less demand for office space, especially in downtown CBD towers and back-office cube farm users. The flight to quality will remain strong with companies seeking newer, modern, higher quality space at cheaper rents. Suburban office demand is shifting away from multi-story buildings with elevators and parking structures in favor of single-story flex buildings with creative layouts and surface parking.
- Retail – Grocery-anchored centers remain the darling of the retail sector with the lowest vacancy rate in decades due to the vacant boxes being absorbed over time and little new development. Yields are attractive and fundamentals are expected to remain stable.
- Apartments – Affordability has become a problem with the rapid rent increases in the past two years with oversupply in some markets due to excess construction catering to high priced technology markets. Rent decreases are in effect in these markets, while secondary and tertiary markets will see downward pressure on vacancies and upward pressure on rents due to migration trends away from urban areas toward more open space and larger units in areas that experienced less development.
On a regional basis Granite Peak sees opportunities in markets experiencing an influx of businesses and residents fleeing high-tax, high-regulation states to lower cost states like Arizona, Colorado, Nevada, Texas, Florida, and the Mid-West. These markets are also benefiting from the onshoring and nearshoring of manufacturing, creating growth engines led by government support and massive subsidies for factories producing essential economic components deemed national security priorities.
The repositioning of investment portfolios will continue in 2023 and Granite Peak sees attractive investment opportunities in the following areas:
- Infill submarkets with high barriers to entry where the underlying land values continue increasing due to demand above scarce supply, generating potential for redevelopment.
- Markets with highly skilled labor forces near universities that are attractive to employers.
- Multi-building assets with the ability to partition into single tenant sales that would be attractive to a larger pool of institutional buyers, driving lower cap rates and higher values.
- Properties with attractive Day-1 cash yields with downside/recession protection provided by credit tenants on triple net leases.
- Inflation protection through below replacement cost entry point and below market rents that provide greater opportunity for future rent and value growth.
- Upside potential through value-add repositioning to provide market rent adjustments and/or additional development potential.
- Grocery-anchored retail centers with the dominant anchor tenant generating outsized store sales in supply constrained and underserved trade areas.
- Flexible industrial assets with the ability to be converted to warehouse, manufacturing, R&D lab, and/or creative office uses.