RALEIGH – Fears about a crisis in commercial real estate are generating a lot of headlines around the country. What about in Raleigh and the greater Triangle? Is a downturn in leasing and construction on the horizon? Should investors, bankers and developers be worried?
“Yes,” says John Boyd, a widely recognized industrial recruiter who has been actively involved in Triangle and North Carolina deal making for years.
“They will be forced to join the club despite the Triangle’s historic strengths and the positive business climate that North Carolina offers,” he warns.
How bad is the environment?
An executive at commercial real estate firm CBRE|Raleigh warns of “tepid growth for new office development,” citing the current economic environment. The CBRE report also warns of “very real near-term headwinds” and that given tightness in the labor markets with more jobs open than available workers to fill them “some employers may be more willing to cut real estate expenses than talent.”
A flashing warning light: Vacancy rates are at 15% – a level not seen since 2009-2010 during the “Great Recession,” says commercial real estate firm JLL. Vacancies are at 1.3 million square feet – “doubling the amount gained during the brief pandemic recovery period,” its report says.
JLL study: Key data
“Flight to quality”
Some properties remain in demand, however, such as what CBRE’s Brad Corsmeier, executive vice president of the advisory & transactions services calls mixed use.
“We are seeing strength in high amenity, mixed-use projects that offer a unique, differentiating experiences rather than just simply a place to go to work,” he says.
“These flight-to-quality projects command top of market rates leading to sustained rent growth in this category. Older, suburban office buildings will continue to see decreased demand unless owners are willing to invest in their buildings to create something special to remain competitive.”
Projects in Raleigh like The Line at Smoky Hollow, Raleigh Crossing and Bloc 83 are seeing better vacancy rates.
“For me, it almost boils down to the fact that I don’t have to get in my car at all, living here,” said The Line resident Tyler Helikson. “I can live, work and play in the same building, the same neighborhood. I can walk almost anywhere to go out to eat, to go to the grocery store.”
Helikson is such a fan of downtown that he’s planning to open a Mediterranean restaurant this spring at Smoky Hollow, on North West Street.
“I think coming out of COVID people are really craving community more than ever and a building like this allows that,” Helikson said.
Yet no matter the desirability or amenities there’s the factor of costs.
Rising interest rates have hit the commercial real estate market just like they have pummeled home sales.
Jacob Sagi, a professor of finance at UNC-Chapel Hill describes the interest rate vise this way: “We’re all aware that interest rates have skyrocketed and, with that, prices of investment assets like stocks and bonds have plummeted. To understand how the same economic pressure should apply to CRE [commercial real estate] properties, consider that the typical CRE mortgage for desirable property types might have commanded an interest rate of around 3.5% in April of 2021. Fast forward two years and the rate on the same loan (with the same loan-to-value ratio) would most likely be north of 6%.
What’s up with commercial real estate? It’s a challenge, not a crisis says UNC finance professor
- RELATED COVERAGE: Redevelopment plan for South Hills Mall in Cary
The market’s outlook is hardly all gloom and doom, however. New projects continue to be announced such as plans for office towers near Shaw University and elsewhere in Downtown Raleigh. Plus there’s a redevelopment plan for South Hills Mall in Cary. Not surprisingly, most people interviewed for this story mixed positive expectations and negative concerns.
For example: Two observations made by Will Gaskins, vice president of Economic Development at the Downtown Raleigh Alliance:
- “Despite macro trends, such as increasing office availability, we continue to see positive numbers within the data in Downtown Raleigh— both Class A Office Net Absorption and Direct Office Net Absorption were positive for Q1 of 2023 (CBRE’s report). This means that high quality office space and new space that is being delivered is continuing to lease at a net positive.
- “Overall, this is a period of reflection and evaluation for commercial office space that will take time to sort out but overall office space that is near housing, ground floor amenities, and transit will be best positioned going forward. Downtown Raleigh is a great place to live, work and visit and that will continue to drive success going forward.”
CBRE graphic
The Work from Home, or hybrid work, impact; the surge in subleasing
Overshadowing the commercial market is the lingering impact of offices left largely vacant with workers banished to homes during the pandemic.
“Office demand has been impacted by hybrid work, as well as corporate cost containment and economic uncertainty,” points out L. Heath Chapman, executive vice president of CBRE Occupier Services.
To put that figure in context, The Wall Street Journal reported Monday: “The U.S. office vacancy rate reached a milestone in the first quarter when it rose to 12.9%, exceeding the peak vacancy rate during the 2008 financial crisis. Despite low unemployment, that figure marked the highest vacancy rate since data firm CoStar Group Inc. began tracking it in 2000.”
Adds CNN: “Investors and regulators, on high alert for signs of trouble in the financial system following recent bank failures, are now homing in on the downturn in the $20 trillion US commercial real estate market.”
People are still working – just not in cubicles. N.C.’s unemployment rate is only 3.5% so fewer people continue to drive to offices as companies such as Red Hat, which is laying off 800 people, and its parent IBM, which recently made layoffs as well, have work-from-home policies. So do many companies. A recent survey by the N.C. Technology Association reported that 46% of companies surveyed allowed 76-100% of employers to choose an WFH or hybrid mix option.
There are big warning lights locally which can be linked to WFH or the current economy.
“Office demand has been impacted by hybrid work, as well as corporate cost containment and economic uncertainty,” says CBRE’s Corsmeier. But CBRE’s Chapman sees more companies adjusting policies to require more seats filled at desk. “More and more companies are demanding a back to office in some form. Even at 3 days week still requires a similar footprint. And many T’s that have decided to come back to office, want new, cooler, experiential real estate so there is some demand,” he explains.
Some of those:
- Vacancy rates are up even at the top tier “Class A” space and what are labeled as “Trophy Towers.” [Barron’s defines such a building as “a landmark property that is well known by the public and highly sought by institutional investors such as pension funds and insurance companies. Generally one-of-a-kind architectural designs, with the highest quality of materials and finish, expensive trim.”]
- “Record” sublease space is available.
- Construction continues on new projects, 70% of which are not preleased.
That’s according to CBRE.
Among the spaces now being offered for sublease are what once were prime spots for biotech and tech:
- Drug giant Iqvia put 260,000 square feet at its headquarters tower on the market earlier this year
- Tech firm Citrix has put its office building (153,000 square feet) up for sublease in downtown Raleigh.
However, Gaskins from the Downtown Raleigh Alliance sees opportunity in the Citrix decision: “Sublet space like the former Citrix location are an incredible opportunity for downtown of unique, high-quality space in a great location that often is not available that presents significant economic development potential and attractiveness for a future tenant.”
Iqiva and Citrix are far from the only ones seeking to unload space. JLL says “companies continue to saturate the market with sublease space.” And JLL warns that “groundbreakings will cease until there is stability in the capital markets.”
CBRE graphic
‘Subleases will loom as a threat to future construction’
Bottom line: Subleasing is a threat to future growth, Chapman points out.
“Subleases will loom as a threat to future construction until most of it either gets absorbed on a sublease or direct basis,” he says.
In its report, CBRE cites hybrid work as the “primary cause to the rising sublease offerings.”
The JLL report also says subleasing as a potential threat to Class A office rental rates:
“The increase in sublease space on the market, along with the lower price of direct [lease] space and higher sublease rate could be creating an environment where more sublease space competes with direct. As sublease availability additions shift from suburban Class B to Class A, competition will increase between the highest-end sublet options and some direct options.”
But there have been some positive developments as noted by CBRE:
- Advance Auto Parts removed 31,338 sq. ft. from the sublease market at its namesake tower in Midtown Raleigh in anticipation of future space needs.
- BE&K Construction subleased 20,643 sq. ft. from SolarWinds at Forty 540 Building 2 in the RTP/I-40 Corridor
- ProPharma subleased 12,870 sq. ft. for its new headquarters location at 107 W. Hargett St. in Downtown Raleigh
‘Recession bell continues to ring … just got louder’ warns NC State economist in new report
A root cause for the problem: The economy
What’s gone wrong in a region where cranes rising far about the landscape have been nearly as common as kudzu since the end of the Great Recession other than COVID?
The economy.
Walden warned on Wednesday that the latest economic indicators for North Carolina are pointing at a recession. “The news is not good for the state’s leading economic index,” he declared in an email. “There appear to be three options for the near-future economy: slow growth, no growth, or negative growth. Let’s hope door #1 – slow growth – is the one that eventually opens.”
“Prospective tenants continued to experience increased uncertainty as focus shifts from workplace strategy to tumultuous macroeconomic conditions,” JLL says.
John Kane of Kane Realty recently withdrew a rezoning request for two additional towers at North Hills. but that decision was based more on a battle with the City of Raleigh and objections of local residents, according to media reports. Removing Kane for the time being from the development market isn’t expected to last long. CBRE’s Chapman says: “I believe we’ll see Kane request to rezone in several years when it’s a better time in the market cycle. Kane has a tremendous track record, and North Hills is one of the most thoughtful, well-planned developments in the country. ”
Despite problems in the market now, “The Triangle is not overdeveloped,” points out CBRE’s Brad Corsmeier, the firm’s executive vice president of Advisory & Transactions Services. “Actually good, brand new, quality Class A is really in short supply.”
What to do? JLL, a real estate firm focused on the life sciences sector, sees an opportunity in the challenges facing companies and corporate real estate needs in the Triangle.
“Now is the time for cities, developers, investors, business leaders, the real estate community and other stakeholders to come together and creatively chart the new path forward in a more holistic way,” a company spokesman says. “Challenges exist, but it is in the best interest of our communities to draw people back to our downtowns and suburbs by creating places people want to spend time, including the office.”
Inside a Triangle high-tech office. (JLL photo)
Is there enough demand?
Whether businesses can or will choose to locate in new space or expand existing leases is unknown, which is why Boyd and others are concerned.
With interest rates continuing to rise as the Federal Reserve fights inflation and the possibility of a recession grows, the economic outlook is hardly what it has been since the COVID pandemic when developers disclosed plans for 40-story office towers. Adding to worries has been recent trouble in the banking sector which led to the collapse of such institutions as First Republic, Credit Suisse and Silicon Valley Bank (now owned by Raleigh-based First Citizens Bank.)
A big challenge right now is not the “Trophy Towers” but older buildings, Chapman says.
“We are seeing strength in high amenity mixed-use projects that offer a unique, differentiating experiences rather than just simply a place to go to work. These flight-to-quality projects command top- of-market rates leading to sustained rent growth in this category,” he explains. “Older, suburban office buildings will continue to see decreased demand unless owners are willing to invest in their buildings to create something special to remain competitive.”
In its report, CBRE notes: “In a recent study of U.S. office buildings hardest hit by the pandemic and hybrid work, CBRE determined that most were constructed between 1980 and 2009 and lack access to amenities.”
At JLL, the belief is that many companies won’t require a full-time return to the office, but will embrace a hybrid model that requires a smaller footprint.
“Every company is working on finding the right balance for an organization to be successful in the long-run, and although we are three years in, this experiment is going to take more time to flush out and find the right balance,” the spokesperson says. “Hybrid is here to stay, but fully remote work is declining. There are signs of companies reversing course on fully remote strategies and recognizing having a central location where their people want to come (even if only 2-3 days a week) is better for the business and their employees.”
Pendo image of its HQ sign at new Raleigh headquarters., atop s “trophy tower”
New Trophy Towers?
Yet even building a “Trophy Tower” now with all the amenities might be out of the question now although plans have been discussed for two new ones in downtown Raleigh.
“I’m not sure how a 40-story tower gets financed in today’s environment,” Chapman says. “Banks have virtually stopped lending for new office development, and there are $1.5 trillion worth of loans coming due in the next three years. Most of these loans were made at interest rates near zero so these loans will have to be refinanced at higher rates at lower values which will create more strain on the office sector. Until these loans get worked out and office demand picks up, we will see tepid growth for new office development. ”
CBRE’s Corsmeier chimes in: “A lot of folks are getting the zoning approved so they can plan maximum density. No one likely builds 40 stories. And anything will require a major pre-lease, and as Heath says, will need debt, which is nearly impossible right now.”
Banking pressure
Bills are coming due as costs and vacancies rise. Can developers pay them?
“In my opinion the banking sector is – and should be – worried about a near-term contraction of commercial real estate,” warns N.C. State economist Dr. Michael Walden. He foresees “no widespread calamities,” at least in this state. “I think the newer growth areas – like the metros in North Carolina – will see some slowdown in commercial real estate activity, but I see no widespread calamities due to the robust economic growth that – while pulling back a little – will feel nothing like the hits to the older regions,” he explains.
Boyd says that’s a critical issue to be addressed.
“Over the next five years, more than $2.5 trillion in commercial real estate debt will mature. This is by far more than any five-year period in history,” Boyd explains. “Meanwhile, rates have more than doubled, and the commercial real estate vacancy rate is rising in the Triangle, per [commercial real estate firm] CBRE figures.”
By the ‘absorption’ numbers – from JLL
JLL chart tracks data for Raleigh space
Net space ‘absorption’ space ‘falls deeply in the red’
Slower office space demand – expressed as “net space absorption” – means more square feet are becoming available as construction continues. In the economy of supply and demand, that hurts company’s ability to raise rents.
And it’s not just new building developers who face challenges. It’s also owners of existing buildings where more space is becoming available as companies either move elsewhere or downsize. In its latest report covering the first quarter of this year CBRE cites several worries. One is that rents aren’t going up as they have been.
As new construction continues vacancy rates are climbing – a result that CBRE calls “net absorption” – and the latest data is “deeply in the red.”
Available space is 4.4 million square feet. But under construction is another 2.2 million square feet. And just 30% of that space is preleased, CBRE tells WRAL News. That includes the agreement for a new headquarters complex for Raleigh-based communications company Bandwidth.
“I don’t think anything gets built or financed with only 30% pre-leased in today’s market, so I believe there are certainly some challenges ahead for any office project currently under construction and set to deliver in the next 24 months,” says CBRE’s Chapman.
However, CBRE’S Corsmeier says “2 [million square feet] across the Triangle is not a scary-big number under development.”
That’s the equivalent of several 20-story towers, given that each is built to different designs for a variety of purposes from office towers to residential to a mix of retail, business and condominiums or apartments. Raleigh Crossing at 301 Hillsborough Street in Raleigh, for example, stands 20 stories and is topped by the headquarters of software startup Pendo. The building has 280,000 square feet of space.
Some key points from CBRE’s report:
- “In light of scarce leasing activity and intense competition from sublease space, landlords are becoming more aggressive with broker incentives and concessions, and rent growth is
beginning to slow. - “The average Class A asking rate rose just 0.8% year-over-year in Q1 2023 compared to increases of 5.4%, 4.6% and 6.3% in the first quarters of the previous three years.
- “Trophy buildings [such as so-called Class A space available at the newer towers that have sprouted over the last decade] remain the exception, with owners continuing to push rates higher in these properties.”
CBRE data also says new office construction is outpacing demand even as some projects – such as the most recent concept for expansion at North Hills led by Kane Realty – are put on hold.
- Vacancy rates – low in the past, contributing to higher rents – surged to 13.4%, up 50 basis points
- Class A direct vacancy climbed to 14.4%, an increase of 60 basis points
- Sublease space is at a record high 4.4 million square feet – an increase to 8.3% of Triangle office space inventory
- Also, existing tower space continues to come on the market such as drug giant Iqvia’s tower along the I-40 corridor in Research Triangle Park.
- “Negative absorption” of space available was 212,217 square feet in the quarter, CBRE says.
- Meanwhile, sublease space surged a “negative absorption” 566,000 square feet.
As noted earlier, JLL reports a 15% vacancy rate.
Concrete floor inside factory or warehouse building with empty space for industry background. Overhead crane or bridge crane include hoist lifting for transportation, manufacturing, and production.
Domino effect on banks?
If developers can’t pay then the banks financing projects are in trouble, Boyd warns.
“Refinancing commercial real estate loans is going to be incredibly expensive and likely lead to some kind of crisis, especially within the regional banking community where some 70 percent of commercial real estate loans are owned,” Boyd says.
“Fast rising interest rates are teaching investors and developers a valuable lesson. There’s no such thing as free money.”
Walden concurs.
“Commercial real estate is always vulnerable to recessions, or even to fears of recession,” he says. “Like real estate broadly, investors in commercial real estate took advantage of the historically low interest rates – complements of the Federal Reserve – during the pandemic and immediately afterward. Now, with interest rates rising and a recession very possible, the commercial real estate sector is challenged.”
UNC Professor Sagi says there will be pain, but a crisis?
“That CRE, and the office sector in particular, is unlikely to cause a national financial crisis should not be taken as trivializing the pain or impact of the stress within that asset category. According to the FDIC’s Community Banking Research Program for the end of 2022, roughly 27% of small/community banks (typically with loan balance sheets of $2 billion or less) are “CRE specialists” with CRE loans comprising 30% or more of their balance sheets,” he wrote. “Some of these institutions could fail or may have to curtail their overall lending, and this could hurt some communities – especially those that are underserved by larger banking institutions. In addition, stressed properties with growing vacancies will likely mean a declining haul in property tax (and, therefore, local services) and the risk of growing urban “deserts.” There will be pain, but it is likely to be felt locally, with some communities suffering more than others. If anything, instead of CRE causing a crisis and taking us into a recession, it may be that a recession, instigated primarily by other influences, will further exacerbate troubles in the office sector, amplifying the pain in some communities.”
Downtown Durham
The future?
Short term pain …
JLL sees short-term challenges continuing: “High-quality assets are significantly outperforming the rest of the office market. Office demand is expected to remain subdued through the first half of the year leading to a gradual recovery.”
Long term gain …
Boyd, the site recruiter, believes that “North Carolina will weather this storm better then many other states because of its critical mass of colleges and universities and high quality workforce, continued in-migration from high tax states, its diverse industry sectors, and its overall positive business climate.”
Gaskins, the Downtown Raleigh exec, remains very upbeat.
“Downtown Raleigh is a desirable market that will continue to attract companies like the recent ProPharma headquarters announcement, which announced plans of adding approximately 75-100 new jobs and leased Class A space in the core of Downtown Raleigh,” he says.
“The Downtown Raleigh office market is also well positioned now and for the future. There is an incredible talent pool of people living in Downtown Raleigh that companies are attracted to and downtown has highly desirable urban amenities—like density, restaurants, storefronts and transit—that are unique in the Triangle market. The quality of the office space in downtown is also attractive as companies evaluate their footprints and move towards higher quality space in new leases.”
