If you, dear reader of this blog post, were enticed by the headline and jumped in expecting another listicle laying out yet another investment manager’s top markets for commercial real estate investing this year, I must confess, you are in the wrong place. What I aim to offer instead is a deeper layer of insight into how investors should approach market selection for commercial real estate investing in 2023 based on a) their own specific goals and tolerances and b) the unique risks and considerations presented by the current state of real estate investment and capital markets. This, I hope, will be much more valuable than a handful of target markets based on criteria questionably aligned with your investing strategy. That being said, a few of our fund’s target markets will be exhibited throughout this post so this content should still (somewhat) deliver on its headline.
In any investing environment, but especially in periods of economic uncertainty or shifting fundamentals, it is imperative for individual investors and fund managers alike to approach market selection with an eye toward investment objectives and goals. Factors such as hold period, risk appetite, investment strategy, desired property type, etc. can all establish markets that may be perfect for one investor profile as a poor fit for another. Furthermore, market fit in the context of investment objectives should be considered at both the individual investment and portfolio levels as diversification is one of the most effective risk mitigation tools.
For example, in Axia’s Value Development Fund we focus on ground-up development or deep value-add opportunities among recession resilient property types with a hold period of around 3-5 years. This means, for us, the best markets are those with fundamentals that reasonably support healthy capital markets activity (ability to finance), positive net absorption, demand for new or improved industrial or self-storage assets, and a political climate friendly to businesses, trade, and property owners. All these factors taken together underly our decision to develop a 230k square foot multi-tenant warehouse right here in Salt Lake County, UT, just a short drive from our Axia HQ.
Our decision to develop in proximity to our office was not arbitrary and leads to another facet of consideration when selecting target markets with investor profile in mind – feasibility. Between volatile materials prices, labor shortages, unpredictable weather or natural phenomena, and lender caution in the debt capital markets there are a variety of reasons in 2023 to consider familiar or those with ease of access. If you plan on investing in projects requiring close coordination with general contractors, property management, architects, engineers, etc. as you would on any value-add or development project, this feature can be even more important.
2023 will also require investors to navigate many factors introduced or exacerbated by immense economic uncertainty and Federal Reserve induced asset repricing. As a result of the Fed hiking interest rates at an unprecedented pace and engaging in quantitative tightening through the sale of balance sheet assets into the open market, financial conditions have become extremely tight. Many lenders, after funding a mountain of deals in the first half of 2022, have now pulled back significantly as their deposit base shrinks and deal economics worsen. Unless an investor intends to purchase a property or fund a development project entirely with cash, selecting a market based on lender relationships and the ability to obtain financing should not be overlooked.
Another unique factor to consider in targeting markets for 2023 commercial real estate investing is the glut of investment activity seen throughout 2021-2022 in the wake of the pandemic. Investor capital poured into hot markets from across the US and around the world to capture value presented by rapid demographic and demand shifts. With an eye toward 2023 we now face a landscape in which many CRE markets have either been overbought or will face significant new construction oversupply in 2023, pushing up vacancy and pushing down lease rates. Many of these markets are still desirable for many of the reasons that attracted investor capital to them in the first place, but opportunities with significant upside in these markets will require a more granular approach to evaluation focused on specific neighborhoods or submarkets.
Florida and the rest of the SunBelt are a perfect example of this dynamic. We remain bullish on many SunBelt markets for their relative affordability, attractive climate, and underexposure to the volatile tech sector. Markets such as Orlando, Nashville, and Atlanta saw intense acquisition and investment activity over the past few years and while valuations in these areas may be overstretched currently, peripheral or submarkets should still maintain attractive fundamentals.
Perhaps one of the most important considerations to keep in mind for 2023 when evaluating target commercial real estate markets is the very high probability the US and other developed economies will experience some form of recession. Given the backdrop of factors likely to contribute to a US recession (tightened financial conditions, increased unemployment, lower business investment, higher cost of capital, etc.), we do not anticipate a systemic shock to the US commercial and residential real estate industries as experienced in the Global Financial Crisis of 2008. However, a pullback in employment, business and capital investment, and a reduction in demographic mobility will nonetheless have some negative effects on many markets. Investors should consider how markets under evaluation are likely to be affected and avoid driving by looking in the rear-view mirror. Many markets that benefitted most during the brief post-pandemic economic expansion will in turn experience a more pronounced return to equilibrium during a recession, exhibiting negative rent growth, increased vacancy, and low absorption.
So how do investors put the above considerations into practice? At Axia Partners we navigate the noise by focusing on several quantitative market metrics coupled with a handful of qualitative aspects to determine which markets fit our investing thesis and strategy most appropriately.
Previously we viewed “net in-migration” as an important indicator of current and future market potential. As the name implies, net in-migration refers to the net population growth or loss of a market over a specific period. We now prefer to use “net household formation” which accounts for the change in household units regardless of population change thus capturing the economic and affordability effects of a market on renter demand. For example, if a market experiences zero net population change, but is affordable and economically supportive enough to enable residents to move out of their parents’ homes or to move out of a shared living environment, this market will exhibit a net increase in the number of household units to be served by that market’s rental and housing supply.
Net household formation can be coupled with numbers on current and future rental or housing supply to examine the ratio of households to housing supply. This ratio can give great insight into the ability for a market to meet or exceed its demand for housing. If a market’s ratio of household formation to housing supply is strong this can be a good indication that rent growth and continued development will be supported. If weak, for example due to an increased cost of living and robust supply pipeline, this can indicate the potential for short to medium term negative rent growth and price weakness.
As mentioned previously, qualitative measures should also supplement any quantitative approach during commercial real estate investing. For example, is a market that seems to have attracted many remote workers due to its affordability and quality of life features likely to attract and retain new residents if the tech industry experiences large layoffs or rolls back its remote/hybrid policies? Or is a market with a robust pipeline of industrial development, but that is primarily positioned to accommodate international trade likely to be affected by a global economic slowdown? These features should be evaluated in tandem with some of the more quantitative metrics to form a more complete picture as to the investment potential of a specific target market.
To wrap it all up, identifying and selecting target markets for commercial real estate investing in or developing commercial real estate should reflect the objectives and parameters specific to the individual, fund, or portfolio for which the markets are being considered. The potential for further uncertainty, volatility, and economic recession in 2023 introduces additional considerations to selecting target markets, but also opens the door for opportunities to capture value. While 2023 will no doubt present unique challenges to investors, we at Axia Partners feel the best time to take action is often when others bury their heads in the sand.
This year, a few of our top commercial real estate investing markets to watch include:
Idaho Falls, ID – Multi-Family Target Market
Idaho Falls makes it into our target market list for its above average household formation rate and 5-yr growth. This market also has a below average inventory to households ratio among our list of market candidates. Idaho Falls has maintained a relatively tight apartment market while exhibiting a healthy average of 6.5% rent growth over the past 3 years.
Logan, UT – Multi-Family Target Market
Logan also exhibits above average household formation rate and 5-yr growth, and has a below average inventory to households ratio among our list of market candidates. Logan’s multi-family vacancy rate has remained exceptionally low at 2.6% and absorption remains strong. Rent growth is expected to continue at a moderate pace as the supply pipeline is not expected to drastically impact stabilized vacancy in the market.
Fort Wayne, IN – Self-Storage Target Market
While Fort Wayne is slightly below market average for it’s 5-yr net household formation growth, it still exhibits positive household formation and more importantly has 7.57 net square feet of storage space available per capita, below the benchmark national average of 8.33 square feet. A stable and growing number of households, low per capita supply, and reasonable 8.3% annual rent growth in storage street rates all point to this market being well positioned for self-storage investment and development.
Portfolio Manager - Director of Investment
Before joining Axia, David developed real estate experience at Everbank/ TIAA CREF in the distressed MBS trading unit and on one of Colliers market-leading investment brokerage teams. David brings a decade of financial services experience, working at Credit Suisse and Goldman Sachs within their Wealth Management and Hedge Fund Strategies groups, and an MBA from Vanderbilt.