Executive Summary

The economy has remained resilient and US consumers are confident, a sentiment that is underpinned by strong employment trends and some residual Pandemic savings. Wage gains, over 4% y-o-y in the latest data, are further supporting consumer confidence. A widely anticipated recession has yet to materialize. Spending on services such as travel, entertainment, education, and wellness is outstripping available supply, and service providers maintain pricing power. These dynamics are fueling stubborn inflation. Price changes have moderated but not buckled and the Federal Reserve (Fed) is sharply focused on wage and service industries inflation as they ponder next policy steps. For now, the Fed is on track to maintain, and possibly increase interest rates in July, even as rates are already more than 5% above the lows of the Pandemic period.

The Fed’s resolve to contain inflation and return to the 2% target continues to inflict pain on Commercial Real Estate markets across the country. Trepp, a well-known data provider reporting on commercial mortgage trends, indicates that real estate debt delinquency ratios are on the rise driven by Lodging and Office property defaults. Investors lack confidence in real estate valuations and many fear a wave of defaults as low-cost financing comes due and must be replaced at today’s higher rates. Even in this environment, Westchester’s fundamentals have remained markedly better than in other markets.

Labor shortages that ensued during the Pandemic have shifted the balance of power in employment arrangements, and this shift is at the root of the work from home protocols that have become so entrenched in our society. Working from home, and robust household formation trends have re-defined the housing markets for many areas of the country. Westchester has benefited from these structural and cyclical changes. A lasting influx of young households in their peak consumption years has re-energized residential housing markets and commercial real estate is increasingly enjoying a spillover effect as merchants and service businesses follow these demographic trends. Despite some pockets of weakness, commercial real estate space demand in Westchester has been resilient.

The greatest immediate risk to commercial real estate is the lack of available financing liquidity to investors. Recent bank failures have placed a spotlight on regional lenders and regulators will be on high alert when scheduled reviews take place. The great majority of larger banks have recently passed government stress tests. However, management teams are cautious about extending additional capital to commercial real estate borrowers and are only willing to underwrite strong sponsors, resilient assets, low loan-to-values (LTV) and very healthy debt service coverage ratios (DSCR).

In summary, the service segment of the economy is currently the strongest engine of economic growth, at a local and national level. Importantly, services industries, key to Westchester County’s economic health, employment, and commercial real estate occupancy, have solid prospects, over the near and medium term, due to favorable demographics that have become stronger in the post Pandemic period.

Residential Apartments Maintain their Shine

After reaching a vacancy high of 4.6% in Q3 of 2022, brisk demand resulted in an improvement in Westchester multifamily occupancy during the subsequent quarters and now stands at 3.8%. During the quarter, 612 units, equivalent to 1% of the area inventory of apartment units, were delivered and absorbed. At the same time, concessions have declined, and effective rents have increased. The remarkable strength of the multifamily segment of the market persists.

Rebounding apartment rents in Manhattan, the appeal of strong educational and medical systems, proximity to parks and other openair recreation, in addition to attractive pricing as compared to the NY City, have continued to support demand for apartments in lower

Westchester County. In addition, difficult single-family affordability is keeping households renting for longer than expected. Several local municipalities and cities, such as New Rochelle, Yonkers, White Plains and Port Chester, have enacted zoning initiatives that encourage apartment construction in proximity to transportations hubs and the pipeline of new projects is meaningful at over 10% of existing stock.

Retail Space Demand Weakens Modestly

During the quarter, demand and pricing for retail space weakened, albeit marginally. Leasing activity declined and fewer deals were completed. There was no activity in sublet retail space and overall occupancy declined as retailers gave back space. Despite sluggish fundamentals, rents have remained relatively stable, with overall inflation helping Landlord’s pricing power. New deliveries, primarily on the ground floor in new residential projects, have had difficulty leasing in an environment where fears of an impending decline in economic activity are widespread and prospective tenants are price sensitive.

Retail shops and retailers remain under transformative pressure, in response to consumer demand and preference changes that have taken place post-Pandemic. Personal services and fast-food hospitality industries have emerged as the driving force of retail demand, especially in areas of above average disposable income, such as Southern Westchester. Several big box retailers have failed, are being acquired or are currently under stress. Examples are Bed, Bath and Beyond and the Christmas Tree Shops. Town centers have seen a resurgence of ethnic or health food franchises or chains. Medical services are migrating to select retail areas where parking is available. Physical fitness concepts are looking for well-located retail in side streets. Beauty concepts are searching for convenient and affordable retail space, willing to sacrifice visibility. These trends are gradually changing the shape of in-town retail areas as well as shopping centers across Westchester County.

Office Occupancy Weakens Further

Over the last fourth quarters Westchester Offices experienced unfavorable supply-demand dynamics. Reported vacancies are now 11.1% but availability (offered for lease but not empty) stands at over 12%. Pricing has remained resilient driven by inflation and mix, as higher end, and pricier A properties, are leading lease transactions. It is remarkable that leasing activity has rebounded, however, departures have overwhelmed new leases.

Office buildings continue to experience low occupancy and multiple departures, as the dynamics of the work-from-home protocols evolve in an environment where employees have voiced a strong preference for flexibility in their work locations. Corporations of all sizes continue to struggle to lure employees back to the office and have settled for offering varying degrees of work-from-home flexibility. Concurrently, corporations are re-examining their office needs and returning space to landlords when leases come due. This friction remains central to the office sector and will shape office fundamentals over the near term.

Industrial Assets Remains Resilient

Despite some marginal loss in occupancy, Industrial assets have fared well for an extended period of time. In the most recent quarter, supply of space exceeded demand and occupancy weakened modestly. Leasing activity was brisk, and pricing remained resilient. The fundamentals for industrial use/occupancy are intact. Demand drivers are closely tracking consumer spending trends in Westchester County and companies value resilience in supply and delivery networks located proximate to the consumer, Westchester Industrial, typically located in proximity to high consumption areas, has become even more valuable.

Investment Transactions Decline

Commercial real estate value uncertainty, tight financing markets, cautious lender underwriting and an inverted yield curve- signaling an economic slowdown- are all creating hurdles for investors. Both the number of transactions and median price per square foot declined during the quarter. Slowly, we are beginning to see new offerings for sale, now concentrated in office properties. We expect investor opportunities to emerge in earnest toward the end of 2023 or when inflation trends stabilize, and investors can more confidently assess costs of improvement and future cash flows for investment properties that become available.

Houlihan Lawrence Commercial Team

Interesting commercial real estate investment opportunities will likely become available in the near future given the number of properties that will need to be refinanced in a vastly different interest rate environment. Liquidity is restrictive and poorly capitalized owners will seek to sell. However, there are numerous market and economic risks that will add to the complexities of acquiring commercial real estate. Understanding the market forces that are shaping the fundamentals for each property requires a deep knowledge of the property, local and regional insights, and close contacts with the right financial partners. Our Team is highly skilled in all these areas. Reach out to HOULIHAN LAWRENCE COMMERCIAL for a complementary assessment of your real estate, an evaluation of a purchase target, and to receive an in-depth perspective on the dynamic Westchester commercial real estate market.