Rental Rates in 2023: Can We Bank on Normalization?
Mike Maroon, SIOR, doesn’t like generalities, certainly when it comes to rental rates. “Depending on who’s doing the reporting, you’ll read that rates have grown as high as 11% since January,” says the managing partner of the Acclaim Group in Cranford, N.J. But those numbers are always skewed by two factors: locational activity and the presence of new construction.
National numbers, he says, take into account New York and Los Angeles data—with their greater square footage and populations—”more so than, let’s say, Dallas or Raleigh, thereby skewing national averages on rental rates.” Ditto new construction, which “is obviously priced at the very top of the market.” Overall, he says, national numbers “aren’t real,” and he adds that 5% to 7% rental rate increases are closer to market realities. And this is why, “I’m not a believer in giving blanket numbers,” he concludes.
That said, those national numbers do provide a guide on direction. Relying on national statistics as a measure of trends, Colliers reports that in Q3 of last year, rents in the top 25 markets were up 15.2% year over year, and they increased 4.1% in Q2.
Yet despite a surge of new construction, market demand remains strong. The firm reports that none of the top 25 markets posted vacancies over 7%. “Year-to-date new supply in the U.S. totaled 331.7 million square feet,” says Colliers. At the end of Q3, there was a reported 657 million square feet of product under construction.
DRIVING FORCES
With the turn of the calendar, of course, we face a new set of what-ifs that could impact the direction of rental rates. These include how climbing construction costs, largely the result of ongoing supply chain delays, as well as the still looming recessionary threat, will all play out at the negotiation table.
Simply put, “All of these issues have continued to push prices higher,” says Boston-based Arlon Brown, SIOR, Parsons Commercial Group’s senior advisor. He relates that he’s working on an industrial transaction with rents hovering around $17 a square foot triple net. (According to Lee & Associates, that’s a jump of nearly $5 a foot from the second quarter of 2021.)
Maroon sees a recession “slowing business growth and the voracious appetite” that have marked industrial leasing volume to date.
And that’s exactly what’s happened in the U.K., as Carter Jonas partner Andrew Smith, SIOR, explains. He sees it as a game in two halves.
“In the first half of the year, rental rates were still climbing,” he says, by as much as 9%. But in the second half of the year, despite a market he sees as robust, “we really had little growth from a rental point of view against inflation.”
That flattening of rents can be attributed in part to the economy. “Yes, we’re technically in a recession now,” he says, “and fear always plays into decision-making.”
“Getting those deals done amid shifting post-COVID market dynamics is, of course, where SIOR members shine.”
But U.K. market dynamics come with a major asterisk that sets them apart from U.S. conditions. For one, they felt the pinch of the Ukraine war earlier and harder. And then comes internal politics and what The Associated Press dubs former Prime Minister Liz Truss’ “ill-conceived economic stimulus plan.”
“The market reacted dramatically and adversely to the budget statement,” says Smith. “It spooked the capital markets.” (And it ended Truss’ stay as prime minister—after 45 days in office.) Fold in double-digit inflation and the rising cost of materials, and there’s been an “immediate effect on the occupier market. Had things remained equal, and we didn’t have those shocks, we would have seen another 9% growth.”
BAD NEWS/GOOD NEWS
While the “R” word might send shivers through the market, a further slip into recessionary territory could have some positive effects, such as “slowing the rate increases,” according to Maroon. We got a taste of that when Amazon famously gave back so much space earlier this year. “Not everyone needs a big, new 36-foot clear, super-teched-up building.”
“Belt tightening will have some impact,” says Smith. “What we don’t know is how dramatic that’ll be. In past recessions, you get second-hand stock to sublease, and there’s a possibility of some of that happening now.”
Plus, as supply chain restrictions ease, we’re starting to see some—if not complete—normalization of construction pricing.
After 2022’s record cost increases, CBRE for one, is predicting a gradual return to normal, with “cost increases declining back to their historical range at 4.3% [this year] and 2.9% in 2024, as supply chain issues abate, inflation eases, and production of materials hampered by the pandemic gets back to full speed.”
In the meantime, deals have to get done. “For the present time,” says Brown, “people continue to do deals in our market.”
HELPING CLIENTS OVER THE FINISH LINE
Getting those deals done amid shifting post-COVID-19 market dynamics is, of course, where SIOR members shine. But, as stated above, that begins with the understanding that local conditions often belie market reports, and “there’s always the anomaly market that’s going crazy,” says Maroon. “You can’t build much in New Jersey because there’s just no land. But in Houston or Dallas, if you don’t like the price of that guy’s building you can just go down the street.”
“We have to explain to our clients where we think the market is going,” says Smith. But the guidance they provide in terms of pulling the trigger on this or that project must be tackled case-by-case. “The advice we give depends on the project, obviously. About six months ago, we felt the market was too hot and rents were spiraling. Seeing this, some of our clients hit pause on their plans.”
Maroon agrees, noting that rental guidance has to be custom-tailored “because everyone’s circumstances are different.” If there is a rule of thumb, “I advise my clients that rent growth will be pretty close to flat in the U.S. in the next year or two. And if it doesn’t remain flat, it might rise by 2% or 3%.
“Also, consider the comparative cost of a relocation,” he continues. A relatively low-tech warehouse is largely a matter of moving racks. “A month of free rent might offset some of that. Always look at the metrics and do some analytics. See if you can map out where the lower rents and taxes are.”
Brown agrees. “Tenants have to be able to absorb the cost or move further out,” he says.
Drayage costs, for one, might increase the farther out you go, but still, adds Maroon, “you’ll probably be better off than paying the rents of upscale markets.”
There are options as well even if the ultimate choice is to stay put. “If you absolutely have to stay where you are, I’d try to do a two- or three-year term as opposed to a five- or 10-year term,” he says, even though landlords will always push for longer stretches. “You might pay a premium for that, but then, you might not.”
And therein lies the power of a market-savvy broker.
CONTRIBUTING MEMBERS
Arlon Brown, SIOR
Mike Maroon, SIOR
Andrew Smith, SIOR