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How Are Rising Interest Rates and Inflation Taking Their Toll on the Real Estate Market?

Whether you’re talking about residential or commercial, rising interest rates and inflation are taking its toll on the real estate market.

In commercial real estate, demand has shifted to properties that are well-suited for e-commerce and logistics as online shopping continues to gain in popularity. The national vacancy rate in February stood at 3.9%, down 10 basis points month over month, according to a CommercialEdge report. That pushed rents up 6.9% to an average of $7.12 per square foot.

So far this year, developers have delivered 73.4 million square feet of industrial space across the country and 667.5 million square feet is under construction. The CommercialEdge industrial property outlook forecasts the U.S. industrial footprint could increase by about 8.9% over the next five years.

“Even with the historic number of deliveries we have seen in the past two-plus years, the continued appetite for space has industrial in a much better place than other commercial real estate sectors,” said Peter Kolaczynsky, senior manager of CommercialEdge.

Office properties, on the other hand, haven’t fared nearly as well as industrial. Since the onset of the pandemic, many people have shifted from working in an office to working remotely, which is impacting vacancy rates and, as a result, lease rates, new construction and investment in the subsector.

While office lease rates increased 1.5% to $38.22 per square foot in March, vacancy rates was up 80 basis points over the previous year to 16.7%, according to another CommercialEdge report.

The office sector’s lackluster performance also is impacting sales, which totaled just $6.5 billion in the first quarter — a 66% decline from $18.9 billion in the first quarter last year.

So far this year, Boston is leading in sales of office properties at $680 million, followed by Miami at $435 million, Houston at $431 million and Manhattan at $417 million.

The biggest reason Boston has maintained an active office market is the strength of its life sciences industry, which is bolstering the region’s construction pipeline. Boston had the most office space under construction in March at 13.1 million square feet, followed by Manhattan at 9.27 million square feet; San Francisco at 7.84 million square feet; and Seattle at 6.41 million square feet.

The office construction pipeline has decreased over the past few years, with developers starting construction on just 6.1 million square feet of office space so far this year. That’s less than half of the 14 million square feet started during the first quarter of 2022.

Construction starts for office buildings are expected to remain stagnant for the foreseeable future except for in the life sciences arena.

As more workers continue to work remotely as a result of the COVID pandemic, many cities are looking at converting office space to residences.

Government incentives in some markets are enabling office-to-residential conversions, but not all vacant offices will be suitable for it either because of their location or the building’s configuration.

The building’s floor plates also can be too large, ceilings too high and HVAC systems not suitable for residential. While some developers have looked at adding amenities like storage units or gyms in the center of the buildings, it reduces the amount of rentable space available.

But if developers can solve the challenges of configuration and location, converting office space to residential could be a viable option.

“As a larger portion of the existing office space becomes functionally obsolete, the idea of converting these spaces into residential is going to be more prevalent as conversions look to be a more viable option than initially thought,” Kolaczynski said.

Residential sales slipping

Sales and pricing of residential real estate are down nationally, with consumers who have low interest rates on the properties they’re in staying put to avoid the high cost of borrowing money.

Month-over-month sales of existing home dropped 2.4% in March — a 22% decline from a year ago, according to the National Association of Realtors (NAR).

“Home sales are trying to recover and are highly sensitive to changes in mortgage rates,” NAR Chief Economist Lawrence Yun said. “Yet, at the same time, multiple offers on starter homes are quite common, implying more supply is needed to fully satisfy demand. It’s a unique housing market.”

The median home price in March was $375,000, a decline of 0.9% from March 2022 when it was $379,300. Prices rose slightly in three regions but dropped in the West.

“Home prices continue to rise in regions where jobs are being added and housing is relatively affordable,” Yun said. “However, the more expensive areas of the country are adjusting to lower prices.”

First-time buyers accounted for 28% of sales in March, up from 27% in February but down from 30% in March 2022.

All-cash sales represented 27% of all transactions in March, down from 28% in February and a year ago. Individual investors or second-home buyers, who make up many cash sales, both 17% of homes in March, down from 18% in February and the previous year.

The 30-year fixed-rate mortgage averaged 6.27% as of April 13, according to Freddie Mac. That’s down 6.8% from the previous week but up from 5% a year ago.

“With overall consumer price inflation calming and rents expected to decelerate from robust apartment construction, the Federal Reserve’s monetary policy will surely shift from tightening to neutral to possibly loosening over the next 12 months,” Yun said. “Therefore, home sales will steadily rebound despite several months of fluctuation.”