CRE Hot Spot Sees Activity Begin To Fizzle As Recession Concerns Mount

An era of frenetic growth in Dallas-Fort Worth’s commercial real estate market may be coming to a close as symptoms of a looming recession begin to hamstring activity, both in the city and across a state that has long boasted of "the Texas Miracle."

For months, industry stakeholders dismissed claims that economic headwinds like rising interest rates and inflation could counteract historic momentum in the DFW market.

But things took a turn in Q3, and seemingly resilient asset classes are beginning to weaken as broader state and national indicators head downward.

DFW's office market, which made a triumphant return earlier this year after sustaining several pandemic-induced blows, recorded negative absorption of about 575K SF in the third quarter, mostly due to an abundance of sublease space put back onto the market by tenants, a report from CBRE found.

Vacancies ticked up, and asking rents dipped slightly.

As concerns mount over a potential recession, many companies are coming around on the hybrid or remote work models they pushed against in the past, said Chelby Sanders, executive vice president with CBRE’s Advisory & Transaction Services group.

Those who feel the need to tighten their belts are more keen on subletting space than resorting to layoffs, she said.

“There is a lever to pull that they did not have in the last downturn,” Sanders said. “Rather than continue to try to mandate [a return to office], they see this as an opportunity to reduce costs.”

This trend is also apparent in the amount of space tenants are asking for, Heady Investments Executive Vice President and partner Sayres Heady said. Instead of taking down 20K-50K SF, Heady said he is seeing a lot more leases in the 3K-5K SF range.

At their latest build, the 105K SF Allen Tech Hub in the Watters Creek development, the company is responding to the evolving needs of tenants by offering smaller blocks of space at a slightly discounted rate, a method Heady said has been incredibly effective.

“We’re being inundated, but we do typically see more bigger deals, and these are a mixture, but a lot of smaller deals,” he said. “More than I normally see.”

While his company has yet to let its foot off the gas, Heady said he has noticed an overall slowdown in projects. Rising interest rates have thrown off development pro formas to the point some companies are unable to secure construction loans, especially on speculative projects, he said.

“A lot of the banks simply won’t look at spec office loans right now,” Heady said. “There are still some local Texas banks that will work with you, but big groups that do commercial lending, they’re pulling back a little bit.” 

The number of new office projects under construction declined by more than 4% from Q2 to 5.7M SF in the third quarter, CBRE’s report found.

Several factors are behind the dip, including six completions that totaled almost 700K SF. 

Fewer new projects in the pipeline are to be expected after the explosive amount of new builds DFW has had underway over the past few months, CBRE field research analyst Tishay Davis said. Close to 6M SF of office space was being built in Q2, a nearly record-breaking amount for the Metroplex, she added. 

“That was the second-highest under-construction square footage we’ve ever had,” Davis said. “I definitely don’t think there is a decrease in demand, it’s just a leveling out to where it probably is supposed to be.”

The amount of new construction is vastly outweighed by the 9.7M SF of sublease space on the market. That has led some to question whether large swaths of new office space are wise investments for North Texas. 

But Heady said tenants are having no issue subletting space in areas where companies are eager to be, which is indicative of healthy demand despite an influx of availability.

“We’re seeing sublease space get absorbed fairly quickly,” he said. “In terms of Class-A office spaces in Class-A locations, absorption is going to remain strong, sublease space is going to remain strong.”

Office is not the only area of commercial real estate that is beginning to feel the effects of a possible looming recession.

The multifamily industry, widely held as the regional darling of CRE, has seen rental rate growth steadily decline since June, according to ApartmentData.com. And while still significantly above its historical average, the company predicts that annualized rent rate growth of 13.8% is expected to drop to somewhere around 8% by the end of the year.

“2023 is shaping up to be a year when flat [growth] might be considered a win,” ApartmentData.com President Bruce McClenny said in a statement. “Recall that 2021 was a year that pushed through at least three years of growth.”

A waning of demand in both the office and multifamily markets could be linked to job growth screeching to a halt this summer. After jobs increased at a torrid annual rate of 5.6% for the first seven months of 2022, state employment growth was flat in August, a recent report by the Federal Reserve Bank of Dallas found.

Senior economist and Vice President of the Dallas Fed Pia M. Orrenius said her office was stunned by the sudden reversal and is still trying to determine what exactly caused the drop.

“It was so sudden and so sharp,” she said. “There was over 7% job growth in July month-over-month, and then all of the sudden, to drop close to zero in August, that was very hard to explain.”

McClenny blames the Fed’s overzealous attempt to control inflation for the uptick in unemployment.

For the apartment industry, less job growth will likely translate to fewer people being able to afford their units, and an already-reported phenomenon of negative leverage may get worse as the prospect of raising rents on cash-strapped tenants becomes less tenable.

“We are on a collision course with poor economic times,” McClenny said in a previous Bisnow interview. “The Fed is just absolutely hellbent to drive us into that. It’s a shame — just how they messed up going up, they’re going to mess up coming down.”

The rising cost of capital means time is of the essence when closing on a new apartment deal, said Kip Sowden, CEO of RREAF Holdings, a Dallas-based company that specializes in all facets of the multifamily space.

A portfolio RREAF closed on in late September had a fixed interest rate of 4.37% — five days later, that same rate would have increased to well north of 5%, he said.

“Spreads are widening, underwriting is getting much, much tougher,” he said at a Sept. 27 Bisnow event. “With cap rates not trending up as quickly as interest rates, you’re getting into negative leverage territory or, at best, neutral. As a result of that, the cost of transacting today is extremely difficult.”

The rising cost of capital is going to be more damaging for some industries than others, Orrenius said. Highly leveraged sectors like commercial real estate are bound to be impacted.

But fortunately for DFW, record-shattering levels of activity over the past few years means there is a lot of legroom before market activity dips below its historical average.

“We are not forecasting a recession for Texas, but we are definitely going to see certain interest-rate-sensitive industries in decline,” she said. “There will be a lot less momentum in the regional economy, but hopefully we will avoid an outright downturn.”