The NAIOP CRE Sentiment Index
Release Date: Spring 2022
Download the Spring 2022 NAIOP CRE Sentiment Index Report.
The NAIOP CRE Sentiment Index for April 2022 is 53, down slightly from September 2021, and below the pre-pandemic range. However, this reading still indicates that respondents expect conditions for commercial real estate to improve slightly over the next 12 months (see Figure 1).
Respondents are concerned about the effect of rising interest rates on capital markets and real estate valuations. In contrast with September 2021, they now expect first-year capitalization rates to rise and debt to be less available. Scores for these two components of the index are the lowest recorded since the survey began in 2016 (see Figure 4).
They also expect the cost of construction labor and materials to continue to rise at a record pace. Reflecting recent inflation, respondents are more pessimistic about construction costs than in any previous survey (see Figure 3).
Increased respondent optimism about rents and employment within their own firms has kept the index in positive territory. Respondent expectations for face rents and effective rents are higher than at any point in the past two years and higher than the 2016-2019 average. Higher rents could offset the effects of inflation and rising capitalization rates. Employment expectations are higher than in 2020 or 2021, but still slightly below the pre-pandemic average.
Respondents now expect a slight deterioration in general industry conditions over the next 12 months, in contrast to their general optimism in September 2021 (see Figure 2). The score for general industry conditions (48) is calculated separately from the CRE Sentiment Index and may reflect respondent expectations for other factors that affect the commercial real estate industry, such as macroeconomic conditions.
A large majority (59.5%) of respondents expect to be most active in projects or transactions related to industrial properties over the next year. Multifamily properties attracted the next largest share of interest (26.7%), followed by office properties (8.9%). Only 4.9% of respondents indicated that they expect to be most active in retail properties.
Notable Changes from the September 2021 Survey
Figures 3 and 4 compare respondent expectations in April 2022 for the individual components that comprise the NAIOP CRE Sentiment Index to expectations in past surveys. Values above 50 represent expectations that a condition will be more favorable for development in 12 months (e.g., higher face rents, lower construction labor costs or lower cap rates). Values below 50 represent expectations that a condition will be less favorable in 12 months.
The most notable change since September 2021 is that respondents are now more concerned about the effects of inflation and how rising interest rates could affect real estate valuations and the availability of financing. These concerns reflect the continued acceleration of inflation in recent months and the expectation that the Federal Reserve will raise rates over the coming year. The yield on the 10 Year Treasury has more than doubled since last September. Respondent expectations for future first-year capitalization rates have reversed from optimism that rates would decline over the next 12 months to the current expectation that they will increase at a rate not previously recorded in the survey.
Respondents’ outlook for the availability of debt also reversed sharply from expectations that debt would become more available to current expectations for a modest contraction in lending. This is likely tied to expectations that interest rates will rise, as higher rates translate to higher debt service ratios, reducing the volume of debt that lenders are willing to issue. The outlook for equity availability is more sanguine, with respondents expecting little change over the next 12 months.
Respondents were already concerned about construction material and labor cost inflation a year ago, and their outlook for cost inflation for these inputs over the next year has worsened further.
The changes in respondent expectations for inflation, capitalization rates and financial markets are also reflected in their outlook for general industry conditions, which dipped from positive territory in September (a score of 61) to slightly negative in the current survey (48). This metric is not factored into the Sentiment Index but allows for a comparison of respondents’ overall expectations with their outlook for the fundamentals of commercial real estate development that are measured in the index. The slight difference between a positive Sentiment Index and slightly negative general industry conditions score may be due to factors not directly measured by the Index, such as respondents’ outlook for the economy or their expectations for local development approvals.
Offsetting concerns about inflation and rising rates, respondents remain optimistic that occupancy rates will continue to improve, and they also believe that face rents and effective rents will rise faster than in past surveys, as building owners pass some cost increases on to tenants. These positive sentiment trends help explain why respondents expect employment growth at their own firms to accelerate.
Levels of agreement/disagreement between respondents remain higher than levels recorded in surveys from before the pandemic. This suggests continued uncertainty about future conditions. Lower-than-usual levels of agreement between respondents may suggest that the CRE Sentiment Index for April 2022 is less predictive of future market conditions than surveys from before 2020. Lower levels of agreement among respondents may also reflect a more challenging environment for some property types and geographic markets. The open-ended comments suggest strong demand for industrial and multifamily properties and continued difficulties for office buildings (see page 3).
Expectations for Development Conditions
The sentiment survey asks developers and building owners to evaluate how important interest rates, local economic conditions, local development approvals processes, environmental regulations and other government regulations will be to their decisions to initiate or continue development projects over the next 12 months (answers to these questions are not factored into the NAIOP CRE Sentiment Index). The survey then asks developers how favorable they expect these conditions to be. The results are described in Table 1 on a 100-point scale.
Mirroring changes in expectations for capitalization rates, respondent expectations for interest rates over the next 12 months reversed from favorable conditions in the previous survey to somewhat unfavorable conditions in the current survey. Respondents remain optimistic about local economic conditions, though slightly less so than in September. They are slightly more pessimistic in their outlook for local development approvals. The survey did not record a change in the relative importance of the five factors identified in Table 1. Local economic conditions are still considered the most important factor, followed by development approvals and interest rates.
Differences Between Developers and Non-Developers
Respondents were asked to identify their primary profession. When comparing the responses of developers and building owners to non-developers, two statistically significant differences related to the conditions that comprise the Sentiment Index emerged (see Table 2). While both groups have a positive outlook on face rents and effective rents, developers and owners are slightly more optimistic about rents than other respondents. Differing expectations about future rents may lead non-developers to value commercial properties and new development more conservatively than developers.
Direct From Survey Participants
“Construction costs are getting so out of control that developers are close to walking on a lot of projects.”
“Timelines for construction are the biggest problem that we are currently facing.”
“Higher rents and compressed cap rates have been able to keep up with the huge increases in construction costs, but as interest rates and cap rates rise, I expect there to be a slowdown from the current pace.”
“Despite high inflation rates, COVID-19 and the war in Ukraine, the U.S. economy will be better than most economists are predicting, and [conditions for] commercial real estate, including office buildings, will improve significantly over the next three years. Industrial will continue to improve along with multifamily residential.”
“The office sector will likely go through a two- to three-year transition period as employers consider work-from-home options, new office layouts, amenities and other flexible work options, before settling on a strategy and policy that works for their organization. This will create some uncertainty for investors.”
“The continued shift from brick-and-mortar retail to e-commerce, onshoring as a result of decreasing globalization, and inventory builds due to supply chain issues will all continue to drive industrial demand and occupancy. This will be partially offset by decreased demand from Amazon.”
“Debt costs have risen dramatically since the invasion of Ukraine. Higher oil prices are signaling a recession in the near term. It seems virtually impossible for the Fed to slow down growth and inflation without causing a short recession.”
“Borrowing rates will trend upward, putting pressure on asset valuations.”
“There is significant capital that needs to be placed, and real estate is a great hedge against expected inflation. I strongly believe we will continue to see a strong market with quality, well-located offerings outperforming B/C product.”
“Many municipalities have not replaced employees that were let go during COVID. This has caused approval processes and other development processes to move much more slowly. We have not observed these municipalities staffing up and are concerned that the next 12 months will be characterized by even slower approval processes.”