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PGIM Predicts 10% Further Decline in Property Values Led By Office Challenges

Buckle up for more turbulence ahead. The latest report from PGIM Real Estate predicts an additional 10% drop in CRE values, adding to the 8% decline already witnessed in the first three-quarters of 2023.

Most concerning: The national office sector faces a particularly steep challenge, with only half of an estimated 43% decline completed, outpacing the 34% drop seen during the Global Financial Crisis. Lee Menifee of PGIM points out that this downturn, though less intense overall than the GFC, varies markedly across different sectors.

Varied impact by sector: PGIM forecasts diverse value declines across sectors in this cycle: retail might see a 13% drop, industrial 17%, and multifamily as much as 23%. Smaller sectors like senior housing and manufactured housing are also bracing for declines of 14% and 16%, respectively.

Markets on hold: An intriguing contradiction from the PGIM report is the resilience of property incomes, even as values dip in the face of rising interest rates. This creates a unique situation for investors, leading to a stalled market where sellers wait for better valuations and buyers anticipate further price reductions. "The hike in interest rates has effectively put market transactions on pause," Menifiee observes.

➥ THE TAKEAWAY

Not all bad news: Despite market challenges, PGIM projects positive revenue growth across all key commercial real estate sectors in the next four years. Lee Menifee sees potential in public real estate investment trusts (REITs), expecting increased capital investment in this area. Additionally, with a predicted decrease in lending capital in 2024, opportunities emerge for high-yield returns in the debt sector, particularly in non-core debt areas like mezzanine lending and preferred equity, where competition is lower and pricing attractive.

• Lease rework: WeWork's bankruptcy judge approved the initial request to reject 67 leases, marking an advancement in its reorganization, with a further request to terminate six additional leases.

• Ghosted: Kroger, America's largest grocery chain, has ended its partnership with Kitchen United, marking a setback for the ghost kitchen industry, which thrived on delivery-only services during the pandemic.

• Bank profit dips: U.S. bank profits fell 3.4% to $68.4 billion in the third quarter amid economic growth, impacted by inflation, rising interest rates, and real estate market uncertainties, says the FDIC.

• Apartment hunting: A Boston-area man was sentenced to 44 months in prison for apartment-related wire fraud and identity theft, and must pay $50,009 in restitution, per the U.S. Attorney's office.

• Crown Heights: Isaac Hager is re-emerging in the Brooklyn real estate scene, snagging an office condo in Crown Heights for $32.5 million, a significant markdown from the $56 million paid in 2019.

• Money in the bank: Blackstone has raised $2.6 billion for its Strategic Partners Real Estate VIII fund, surpassing its previous $1.9 billion fund from 2020 by 37%.

• Green expansion: Novva Data Centers has purchased a 7.5-acre site in South San Francisco, planning to invest over $500 million in a new, eco-friendly 28-megawatt data center, starting with a 9MW phase.

• Buckeye's boom: On Phoenix's western edge, Buckeye is rapidly growing, with its population increasing twentyfold in recent decades. Plans are underway to add over 100,000 new homes.

• Wealth transfer: According to the UBS Billionaire Ambitions Report, inheritance has recently overtaken entrepreneurship as the primary source of wealth for new billionaires, with an expected $5.2 trillion to be passed down in the next 20-30 years.

Remote Work Era Continues to Challenge D.C.'s Real Estate Market Post-Pandemic

The ongoing impact of the COVID-19 pandemic is still evident in Washington, D.C.'s commercial real estate market, especially with the rise of remote work affecting building valuations and tax revenues.

Fiscal health: The District's commercial real estate is crucial for its economy, generating over $1.1 billion in tax revenue. Valuation difficulties arise due to few sales and uncertainties in net operating income (NOI), rent growth, vacancy rates, and capitalization rates. This uncertainty poses fiscal risks for D.C., especially considering the potential for continued market decline.

Preparing for the worst: Three scenarios were modeled to understand the impact of market decline: no new leasing leading to increased vacancies, a 25 basis point rise in capitalization rates, and a combination of both. These scenarios highlight the vulnerability of the District's commercial real estate market, with possible drastic tax revenue losses.

Impact on tax revenue: D.C.'s commercial real estate, particularly in downtown areas like the East End and Central Business District, faces a high potential for increased vacancy rates. A decline in the CRE market could lead to a drastic drop in tax revenue, with a potential loss of up to $157.7 million. This is around 10% of all commercial property revenue in D.C. and represents a sizable portion of the local tax revenue, intensifying the fiscal challenge for the city.

➥ THE TAKEAWAY

Big picture: D.C.'s financial strain is compounded by the commercial real estate market's struggles. Remedies like transforming downtown into mixed-use neighborhoods require significant capital and time. The city needs to rethink its use of downtown spaces to stay economically competitive, possibly redeveloping existing commercial buildings into multifamily or non-office commercial spaces. Despite the challenges, a mixed-use approach offers a viable alternative to an outdated model that no longer serves the city's best interests.

Despite the increase in financing costs due to higher interest rates, recent MSCI data indicates growth in the real estate sector. This includes both income returns, fueled by rising rents, and capital returns, reflecting asset value growth, up to September.

While capital returns declined in other asset classes as buyers sought higher yields to offset increased funding costs, industrial assets achieved total returns of 5%, closely followed by the tourism sector at 5.3%.