Key Takeaways:

• Reduced demand for some types of commercial property coupled with high-interest rates spells bad news for property owners and lenders.

• The outlook for smaller banks has deteriorated due to uncertainty around their CRE exposures.

• Multifamily housing, industrial facilities, and warehouses offer some hope for the overall sector.

Commercial real estate (CRE) is a broad category of real estate used for business purposes such as office spaces, retail stores, warehouses, industrial facilities, and multifamily housing. The CRE market is a complex and ever-changing industry and is a large and important asset class that comprises roughly 20% of the US economy and accounts for trillions of dollars in transactions annually. In this post, we explore more in-depth the implications of the pandemic and rising interest rates for the CRE market and our assessment of the outlook for this industry.

The COVID-19 pandemic and its aftermath had a dramatic impact on the CRE market. The lockdowns accelerated structural shifts towards remote work making many of the prime office spaces less valuable as office tenants downsized or even relinquished their offices, thus leading to falling rents and increasing vacancies that have hit a record high of nearly 13%. E-commerce worsened the outlook for brick-and-mortar retail stores. Other CRE segments like warehouses and industrial facilities have fared somewhat better. Industrial space has proven the most resilient segment, benefiting from the growth of e-commerce. Multifamily housing has also remained buoyant due to strong demand, even with rapid growth in single-family housing markets. In fact, rents have increased markedly, as much as 15 percent by some measures, since the pandemic began and have contributed to the overall increase in inflation. Finally, while hotels were hit particularly hard along with the tourism industry by the travel restrictions and social distancing measures, the post-pandemic rebound has led to a partial recovery in this CRE segment. Figure 1 plots the performance of the largest office REIT (Boston Properties, Inc—BXP), the performance of the largest residential REIT (Camden Trust—CPT), and an equal-weighted ETF of real estate companies in the S&P 500 by Invesco (EWRE). While CPT and EWRE have recovered to pre-pandemic levels, BXP is down roughly 60 percent since the onset of the pandemic.

To complicate matters further, the increase in interest rates around the world has made financing CRE loans more expensive and reduced the value of future rental income from these properties.  Similarly with residential real estate (RRE), there are owner-occupied properties—where a business purchases the property for its own use—and investment properties that are purchased to generate income from rent—from other businesses—or capital appreciation. These CRE purchases are typically financed by either traditional banks or by non-bank lenders which include real estate investment trusts (REITs); private equity firms; collateralized debt obligations (CDOs); and commercial mortgage-backed securities (CMBS). Brokers act as intermediaries between buyers and sellers and also help facilitate commercial property leasing. They perform due diligence, negotiate contracts, and coordinate the closing of transactions. 

CRE market performance is driven by the tightness of the markets, the number of transactions, and the growth of rental income. In the short term, rising vacancies and decreasing rental income mean increased credit risk for all lenders. While the banking system as a whole appears well-capitalized, recent experience from the Silicon Valley Bank turmoil has reminded us that there might be hidden weaknesses in smaller banks or banks with weaker internal risk management frameworks. Indeed, some estimates suggest that smaller US banks account for more than 80% of bank CRE loans. An interesting point to note is the secular shift away from traditional bank-based lending towards non-bank lending like those mentioned above. In 2020, non-bank lenders financed approximately 20% of all CRE loans, up from just 10% in 2010, and this trend is expected to continue. These other financing channels are more ‘market-based’ which has meant that while they provide cheaper and more flexible financing options, they also are less regulated and more vulnerable to market swings. 

We believe that secular trends support the more resilient CRE segments—multifamily housing, industrial facilities, and warehouses—but we are pessimistic about the outlook for office space and retail stores. These concerns are likely priced in already into property values and the valuations of the other securities like CDOs and CMBS noted above. The problem is that it is difficult to ascertain which individual financiers are more vulnerable to adverse developments in these segments because it is impossible to know from the outside, for example, the share of a bank’s exposure to office space versus warehouses. Based on this—and other pressures not discussed here—we think it is wise to trim exposures to banks and other financial institutions.