Puerto Rico’s commercial real estate hangs on after triple-whammy
The market faced a challenging year in 2023, experts say.
The commercial real estate (CRE) market faced a challenging 2023, still reeling from the residual effects of the COVID-19 pandemic, record-high inflation and multiple interest rate hikes.
Higher borrowing costs and a shift to remote work have sapped demand for offices and other commercial property, driving down asset values. A lack of available credit and increased pricing have limited deal flow.
In Puerto Rico, the performance of the CRE market has been mixed, yet according to experts interviewed by News is my Business, it is better than on the mainland U.S.
Inflation is still a problem
The Consumer Price Index rose 0.4% in March, lifted by surging gas, shelter, auto insurance and medical care costs, according to CPI data released April 10 by the Bureau of Labor Statistics. Over the last 12 months, the all-items index increased 3.5% before seasonal adjustment.
The increase could stop the Federal Reserve from reducing interest rates or force it to push rates higher this year. While the Fed doesn’t directly set mortgage rates, its decisions influence them.
Inflation has driven mortgage rates to nearly 7%. The 30-year fixed-rate mortgage averaged 6.88% in the week ending April 11, up from 6.82% the previous week and 6.27% a year earlier, according to Freddie Mac data. The 15-year fixed-rate mortgage averaged 6.16%, rising from 6.06% the previous week and up from 5.54% a year ago.
Mortgage rates track the benchmark yield on the 10-year U.S. Treasury note, which moves in anticipation of the Fed’s actions. Last week, the yield topped 4.5%, the highest level since November, after the CPI report was released.
“If one were to shake a Magic 8 Ball, the answer to the question of ‘where are mortgage interest rates going to be in the next month?’ would now read ‘outlook not so good’,” said Jessica Lautz, deputy chief economist at the National Association of Realtors (NAR), as reported by Realtor Magazine on Friday. “In the coming weeks, mortgage interest rates are likely to increase, which is disappointing news for spring homebuyers.”
Persistent inflation, high interest rates and potential losses in the CRE market were among the top concerns of respondents to the Financial Stability Report released by the Fed in October. Three-quarters of survey respondents cited those issues as prominent near-term risks.
Impact of inflation on CRE
CRE is a tangible asset that usually increases in value commensurate with inflation. Owners can adjust lease terms to accommodate a fluctuating CPI, providing a steady cash flow.
Inflation affects CRE in several ways. It increases construction and operational costs, as well as the cost of borrowing. It affects cash flow, supply and demand.
CRE tends to be a good hedge against inflation, but resilience varies by asset class. Typically, the shorter the lease term, the quicker owners can adjust rents to keep pace with rising inflation. Hospitality, multifamily and self-storage usually have the shortest relative lease terms.
Puerto Rico’s CRE market
The pandemic brought uncertainty, but the Puerto Rico market has rebounded, benefiting some sectors, Ryan Christiansen, president of San Juan-based Christiansen Commercial Real Estate, told News is my Business.
“Puerto Rico is at a really opportune moment in time. We came out of 15 years of recession, and we finally have access to the capital markets, so there’s a lot of pent-up demand. Many local companies and market participants are re-engaging in the real estate market,” he said.
Christiansen said that what’s driving the local market and differentiating it from the stateside market is an influx of $68 million in federal disaster relief funds being injected into the local economy.
“Seven years after Hurricanes Maria and Irma, we’re seeing the impact of that money,” he said. “We’re seeing construction cranes and infrastructure projects. Unemployment is at an all-time low. We’ll have eight to 10 years of substantial direct and indirect economic benefit from the recovery funds.”
These conditions are “extremely positive not only for local investors and market participants, but also for stateside investors. It helps mitigate the risk associated with Puerto Rico due to unfamiliarity or being separated as an island from the States,” Christiansen said.
“It’s like we’re in a bubble,” he added. “It took years, but it’s happening.”
However, not everyone is as optimistic about the local CRE market.
“The commercial real estate market in Puerto Rico is doing OK, but I don’t see signals of a robust market,” José J. Villamil, founder of the local research and economic consulting firm Estudios Técnicos, told News is my Business.
“The office market is really struggling, and in terms of retail, you see renovations, but you don’t see construction of new shopping centers or strong activity. Go to Plaza Las Américas or any mall, and you’ll see the reality. There’s plenty of vacant commercial space,” he added.
Rising interest rates can have a negative impact on activity and pricing in any market, but the pandemic has had a mixed effect on different sectors, particularly office, retail and warehousing.
Office space: US
The U.S. national office vacancy rate rose to a record-breaking 19.6% in the fourth quarter of 2023, according to Moody’s Analytics. That’s the largest quarterly increase since the first quarter of 2021, surpassing the 19.3% level reached twice in 40 years. The average pre-pandemic office vacancy rate was about 16.8%.
U.S. office demand dropped again in the first quarter (Q1) of 2024, pushing the vacancy rate to 20.2% and “exceeding the 20% threshold for the first time on record,” reported Global CRE firm Cushman & Wakefield, citing slow growth in office-using employment and a sluggish construction pipeline that has shrunk 63% since 2020, the lowest since early 2013.
Historically low office occupancy can be mostly attributed to remote work, according to Realtors Property Resource (RPR) in its 2024 Commercial Real Estate Forecast. Even hybrid schedules aren’t enough to justify massive office buildings, and owners and investors are trying to figure out what to do with all the empty space, RPR reported.
“The troubles continue in the office sector,” echoed the National Association of Realtors (NAR) in March. “Leasing activity has dropped, office availability and delinquencies have increased, but construction remains nearly at the same levels,” the NAR said, adding that there are more than twice as many more unoccupied office square feet than occupied compared with a year ago and predicting further increase in availability.
In its 2024 Commercial Real Estate Outlook report, J.P.Morgan concluded: “Despite these headwinds for office, it’s important to remember that while there is and will continue to be obsolete office, the office is not obsolete … there could be opportunities to convert central business districts’ office space into apartments or data centers.”
Office space: Puerto Rico
According to Cushman & Wakefield’s latest Marketbeat report for San Juan, overall office vacancy at the end Q1 2024 stood at 12.2%, showing a small deterioration from 11.9% in Q4 2023.
Last year, the office market vacancy rate reached 29% partly due to a post-pandemic drop in transactional volume driven by downsizing and reductions, hybrid work and demand for coworking spaces, according to JLL’s Puerto Rico Office Market Report H1 2023.
The San Juan market is still adjusting to the hybrid work scheme, JLL reported, “thus multinational companies are taking advantage of the tenant-favorable conditions that allow them to reduce space or relocate to smaller spaces with ease.”
JLL expects the vacancy rate to increase “until the market adjusts completely, and space reductions and reinstatements cease to drive demand. Increases in vacancy have created downward pressures in market rents, thus, rents have started to decrease marginally.”
Office is the most problematic CRE area post-pandemic and in general, Christiansen said, citing downsizing and space reduction trends, high construction costs, a shift in the layout and programming of office space, and a current preference for community-driven office spaces versus large business centers.
“We’re not seeing absorption — new companies coming into the market to absorb space,” he said. “Before our first government shutdown in 2006, we were seeing 250,000 to 300,000 square feet of absorption a year. Now, that absorption is significantly less. It may even be flat.”
Large offices are no longer desirable, Christiansen noted, explaining that more employers and employees now prefer open spaces, shared spaces, and collaborative spaces — community-driven office spaces that offer a better quality of life.
“These areas are very desirable. It’s where people want to be,” he said. “They don’t want to have to dress up to go work in a central business district like Hato Rey. They rather work in smaller buildings in Santurce or Miramar, where they can walk downstairs and have bars, restaurants, supermarkets, a post office, etc., meet their friends and be more social.”
Remote work has not been as big a problem in Puerto Rico as on the U.S. mainland because of a weak infrastructure and local cultural values, Christiansen said.
“You need to be constantly connected to the internet, have online meetings, but power surges and electrical outages make that more challenging,” he said.
But there’s also a cultural issue. “In the States, family members often live in other cities and states. Here, we have family members that live in the same house, on the same street, in the same neighborhood, and they can pop in and hang out anytime, making it difficult to work from home,” Christiansen said.
“So, I see more people going back to the office here than in the States,” he added.
Retail: U.S.
Demand for retail spaces in Q1 2024 continues to slow down versus a year ago, with net absorption seeing a significant reduction, falling by approximately 30 percentage points, NAR reported. Despite lower absorption rates, the limited availability of retail spaces maintains vacancy rates at about 4%, the lowest rate among any other sector in the commercial real estate market.
“With fewer new construction deliveries expected, the fundamentals of this sector will remain solid in 2024,” NAR stated.
While e-commerce continues to grow, it only makes up about 15% of all retail, so there’s plenty of room for brick-and-mortar operators, J.P.Morgan reported. “Retail will emerge as the stalwart in 2024. The asset class is expected to experience steady performance, with unchanging vacancy rates and moderately positive rent growth for neighborhood and community shopping centers.”
Even with e-commerce’s continued growth and most mega malls being half empty, there’s some hope on the horizon for neighborhood-focused retail success, RPR said in its 2024 forecast.
“Densely populated urban and suburban areas strip malls are propping up the retail sector with growth and positive numbers,” PRP reported, predicting that with less new construction and less competition, neighborhood and community shopping centers will show strong vacancy rates and positive rent growth for the foreseeable future.
Retail: Puerto Rico
Retail in Puerto Rico is stronger than ever, Christiansen said, attributing its strength to the disaster recovery funds now circulating in the local economy.
“Tenants are expanding, opening much larger stores, occupying more space,” he said. “They’re filling the gap caused by the big players that left, such as Kmart and JCPenney.”
Supply and demand continue to be very tight in the local retail real estate market, Carlos Izquierdo-Fortuño, senior analyst for lease administration and leasing at Kimco Realty, told News is my Business.
“Nationally, out of every two stores that open, one closes, so there’s an imbalance in supply and demand,” he said. “We have lines of people wanting to be in our shopping centers, businesses wanting to move to more convenient spaces that are better integrated with consumers’ lifestyles,” Izquierdo-Fortuño said, adding that Kimko’s occupancy rate in Puerto Rico is 96.5%, higher than in the past 10 years.
New York-based Kimko is a publicly traded owner and operator of open-air, grocery-anchored shopping centers. It owns interests in more than 579 shopping centers and mixed-used assets comprising 103.3 million square feet of gross leasable space. The company manages 2.1 million square feet of retail space in Puerto Rico, including Plaza Centro in Caguas, Trujillo Alto Plaza, and Rexville Town Center in Bayamón.
Because of lower overhead costs, strategic locations and consumer spending trends, open-air, grocery-anchored shopping centers are in a better position than enclosed malls, Izquierdo-Fortuño said.
“The traditional enclosed mall is more expensive to maintain. The cost of air conditioning alone is extremely high. Open-air, grocery-anchored shopping centers have lower overhead costs, convenient locations near residential areas, and grocery stores that attract consumers regardless of the current economic situation,” he explained.
These shopping centers also work well for e-commerce because of the ease of setting up curbside pickup systems, which have exploded in popularity since the pandemic, he said.
Another trend gaining ground since the pandemic is small businesses that specialize in both retail and services setting up shop at strip malls.
“For example, we used to find solar panels in wholesale establishments or warehouses. Now they’re entering shopping centers because it’s no longer just about selling the product, but also about having a space for the customers to get service,” he said.
Meanwhile, the restaurant segment is stronger than ever in Puerto Rico, especially properties with drive-through facilities, according to Izquierdo-Fortuño.
“We’re seeing a lot of desire to open restaurants, like never before,” he said. “The main attraction is the free-standing properties with a drive-through. Those are super competitive, and leases renew at any price.”
But the most important thing happening in the Puerto Rico CRE market has to do with the attitudes of the retailers themselves.
“Retailers are being more meticulous, seeking competitive locations, strategic points,” he said. “They’re thinking about online shopping and pickups, which means the stores also serve as distribution points, so they’re looking to do business 24/7. They also have educated themselves about leasing; they dare to negotiate more than before.”
Realtor Jorge Rodríguez-Suárez, founder of JRS Real Estate, points to retail’s increased focus on entertainment for its resilience.
“A mall that only has stores can’t survive anymore,” Rodríguez-Suárez told News is my Business, citing the T-Mobile District next to the Puerto Rico Convention Center and Liberty Square at San Patricio Plaza.
Another trend growing in popularity is the food truck park, he said.
“Because construction prices are so high, landowners are leasing spaces to food truck operators. They add electricity, water, some parking, and they don’t have to build anything,” he said.
Food truck parks represent a viable alternative for investors with land they can’t afford to develop because of the rising costs of construction, he added.
Industrial and warehousing
Industrial continues to perform well, especially cold-storage properties, according to the J.P.Morgan report.
“Re-shoring and nearshoring efforts in manufacturing may provide a further boost for the sector, but the asset class may be moderating as the post-pandemic demand for more inventory decreases and renters hold off on expansion,” J.P.Morgan reported.
Moody’s Analytics forecasts that annual rent growth for warehouse and distribution properties will consistently track at approximately 5% to 6% per year over the next 10 years.
Warehousing had a huge boost because of the pandemic, Christiansen said.
“After the hurricanes in 2017, a substantial chunk of the inventory was wiped out, and a lot of the owners simply didn’t rebuild, so tenants became very aware and focused on avoiding business interruption and relocating their operations to disaster-resilient warehouses,” he said.
The pandemic also fueled the e-commerce industry, further lifting the warehousing market.
“There’s a tremendous growth of e-commerce in Puerto Rico. So, warehousing and logistics have been the clear winners, by a mile,” Christiansen added.
