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To the casual observer or spouse wandering by my home office, it may look like I am not doing much for much of the day. I am in my incredibly comfortable office chair, often with my feet on the desk, coffee cup close at hand, and reading.

So far this morning, I have read the Wall Street Journal, skimmed the online New York Times, read the new issue of the Oil and Gas Journal (key takeaway - the outlook for US natural gas producers is very bright. You have to have patience and discipline, but much money will be made over the next decade. That is a topic for another day)…

As well as the newest release from the U.S. Bureau of Economic Analysis, a handful of Fed regional surveys, and a daily real estate update.

That is all after I skimmed through the morning infusion of Wall Street reports and the emoting Forbes and Bloomberg updates.

The essential stuff, like the overnight baseball news, I reviewed over breakfast.

This is not to brag (Okay, maybe a little). As Charlie Munger once observed, I do not know any intelligent or successful people who do not read a lot. His partner, Warren Buffett, also reads an extraordinary amount every day and is said to spend well over half his day just reading news and reports.

Whatever level of success I have achieved in life, I attribute it to my love of reading. It's not just a hobby, it's a key to unlocking new opportunities and gaining a competitive edge. The more you read, the more you learn, and the more you can achieve.

My reading for this week has included many real estate-related reports. I have found that the best research comes from people with skin in the game. I want to read what folks need to be right way more than they are wrong.

Commercial real estate brokers, services companies, and investors need to get it right, or they lose clients.

For that reason, I make it a point to read the new information published by firms like Colliers International (CIGI), CBRE (CBRE), Newmark (MNMRK), Jones Lang Lasalle (JLL), Costar Group (CSGP), and others.

This week, I take a deep dive into two segments of the market that have been out of favor and could see huge returns as the markets for these sectors normalize and improve over the next couple of years…

Go over what’s Hot🔥 and Cold🧊 right now…

And end with a real estate Stock of the Week, for Premium subscribers only.

Let’s get to it!

Where We Are Today

The office real estate sector is experiencing a significant divide between prime and non-prime properties. According to CBRE's analysis, prime office buildings outperform their non-prime counterparts, representing only 8% of total U.S. office space by square footage and 2% by building count. As of Q1 2024, the prime office vacancy rate stood at 14.8%, 4.5 percentage points lower than the non-prime vacancy rate. This performance gap has widened since the COVID-19 pandemic, reflecting a noticeable shift towards quality among office tenants, which is significantly impacting the market.

Absorption trends further evidence the preference for prime office space. From Q1 2020 to Q1 2024, prime buildings recorded positive net absorption of 49 million square feet, while non-prime buildings experienced negative net absorption of 170 million square feet. This stark contrast underscores the growing importance of building quality and amenities in the current office market landscape, necessitating a shift in strategy for all stakeholders.

Rental rates also reflect this divergence, with prime office space commanding a significant premium. As of Q1 2024, the average prime office asking rent was 84% above the average non-prime rent, an increase from the 60% premium observed in Q2 2018. This widening gap highlights the increasing value tenants place on high-quality office environments, particularly in the context of hybrid work models and the need to attract employees back to the office.

Where We're Heading Next

Looking ahead, the supply of prime office space is expected to tighten. Only 22 million square feet of prime office space was under construction in Q1 2024, with completion dates extending through 2027. This represents a sharp decline from previous years, with deliveries expected to slow to just 4 million square feet in 2025. Based on current absorption trends, CBRE forecasts that the prime vacancy rate could return to its pre-pandemic average of 8.2% by 2027, potentially earlier in some markets.

However, the overall office market still faces challenges. CBRE predicts that office vacancies will peak at nearly 20% in 2025, coinciding with a peak in office cap rates. The market must absorb 33.5 million square feet of new inventory expected to be completed over the next two years, a period when office-using job growth is anticipated to slow. This oversupply situation is particularly acute for older, less desirable buildings, which are struggling with high vacancy rates and potential obsolescence.

The disparity between prime and non-prime office space is not uniform across all markets. In some cities, the contrast is particularly stark. For instance, in downtown San Francisco, Washington, D.C., and Denver, there is more than a 10-percentage-point gap between prime office vacancy rates and overall downtown rates. Similar trends are observed in suburban markets, with suburban Philadelphia, Kansas City, and Denver showing significant outperformance of prime office space.

While facing its own set of challenges, the hotel sector appears to be on a path to recovery. According to CBRE's U.S. Hotel Investor Intentions Survey for 2024, investor sentiment in the hotel market is generally optimistic. Half of the surveyed investors plan to increase their hotel investments in 2024, driven by expectations of higher total returns and lower prices. Only 16% of respondents anticipate a decrease in their acquisition activity.

Investors clearly prefer value-added and opportunistic investments, with over 70% targeting these types of assets. This strategy indicates a willingness to take on properties requiring repositioning or improvements to increase their long-term value. In terms of location preferences, resorts, and central business districts (CBDs) have emerged as the most attractive options for investors.

What You Can Do About It

The survey also reveals a strong preference among investors for upper-upscale and upscale/upper-midscale chain scales. Luxury assets are viewed favorably, while midscale/economy properties are less sought after. This preference may be influenced by recent RevPAR (Revenue Per Available Room) declines in the midscale/economy segment.

Despite the overall positive outlook, the hotel sector faces several challenges. Increased borrowing costs and rising labor expenses are the most significant concerns, followed by higher insurance costs. These factors are expected to put pressure on profit margins. Interestingly, competition from alternative lodging options such as short-term rentals and cruise lines is not perceived as a significant threat by most investors.

Performance metrics for the hotel sector in the start of 2024 show mixed results. According to the Colliers U.S. Hospitality Brand Performance Comparison Report, the overall U.S. hospitality market experienced minimal growth in the first quarter of 2024. Average Daily Rate (ADR) increased by 2.6%, and RevPAR grew by 1.5% compared to the same period in the previous year. However, occupancy rates declined by 1.1%, suggesting a softening in the market's operating fundamentals.

The report attributes this slowdown to several factors, including decreased hotel room demand over the past four quarters. The timing of Easter and Passover in 2024 had a particularly significant impact on first quarter performance. While high-end leisure travel has remained resilient, and there are signs of a potential return in corporate transient travel, persistent inflation and increased living costs have negatively impacted hotel room demand from lower-income households.

Stabilizing demand measures will be a key focus for the remainder of 2024, especially during the summer months. Despite economic uncertainties, the continued and newly implemented regulations on short-term rentals are expected to drive summer leisure travel demand toward traditional hotels. ADR is predicted to continue growing as long as inflation remains above the Federal Reserve's target level of 2%.

The office and hotel real estate sectors are navigating through a period of transition and recovery. The office market is experiencing a significant bifurcation between prime and non-prime properties, with high-quality assets outperforming and likely to see tightening supply in the coming years. While facing some headwinds, the hotel sector is showing signs of recovery and attracting investor interest, particularly in the upper segments of the market. Both sectors must continue adapting to changing market conditions, economic pressures, and evolving consumer preferences in the post-pandemic landscape.

The Big Five REITs will expose you to the most important national trends and Boston Properties (BXP) will be a major beneficiary of the office markets. You will own significant office, retail, and apartment properties along with warehouses, industrial parks, and data centers

Stock of the Week

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