Risks and opportunities in commercial real estate.
Empty buildings overgrown with weeds. Zombies walking halls. The media has recently evoked this imagery when discussing commercial real estate (CRE). There are clear risks within CRE, but painting with a broad brush can obscure opportunities to create value in portfolios.
CRE, to put it mildly, is large. The FTSE EPRA NAREIT Global Index had a net market cap of $1.6 trillion at the end of May, with U.S. property owners comprising almost $1 trillion. Within CRE, there is a wide range of property types, from apartments and data centers to towers and warehouses. Each has its own unique supply-demand dynamics.
When inflection points in supply-demand are identified, a key question is whether it is cyclical or structural. Cyclical inflections are temporary and shorter term, while structural are often permanent and longer term. As the market is seeing with CRE today, answering correctly matters when trying to create value.
Structural Demand Changes…
Pre-pandemic, e-commerce increasingly disrupted retail properties. If one thought e-commerce was not a serious structural threat to brick-and-mortar retailer earnings, then inexpensive valuations may have led some to buy retail real estate. After all, as the following table shows, retail had outpaced the FTSE EPRA NAREIT Global Index from 2005 – 2013 as e-commerce emerged. Yet e-commerce inflecting from 2013 – 2019, more than doubling its share of retail sales from 6% to 14%, led to higher vacancies, weaker rental pricing, and higher capital intensity as properties attempted to reposition for a new era. Retail defaults and property closures increased. Post-pandemic, the structural shift to e-commerce accelerated, exacerbating pre-pandemic pressures.
Notably, the pressure on one CRE property type, retail, created opportunity for another CRE property type, industrial. Extrapolating historic returns from 2005 – 2013, when industrial soundly lagged retail, falling -3% vs retail’s rising +4% per year, would have meant missing an important inflection. The structural demand improvement for industrial from e-commerce (via warehouses, distribution centers) combined with favorable starting valuations enabled it to reverse its fortunes vs retail from 2013 through June 30, 2023.
Today’s CRE fears often revolve around another property type that faces a structural demand shift: office. And there are plenty of stats to feed the media’s zombie narrative. Kastle Systems, an office security company, tracks office usage by employees in the ten largest U.S. metros. As of June 26, the number of employees that came into offices was 50% of March 4, 2020, levels, reflecting a structural change in demand driven by work from home. Offices are increasingly not just used less but not at all. The national office vacancy rate was 18% in 1Q23 vs around 11% at the end of 2019 per CBRE.
This pre-pandemic vs post-pandemic structural shift is reflected in returns. From 2005 – 2019, the S&P Global REIT Office Index returned almost +7% per year; since then, it has declined almost -13% per year.
…Meet Liquidity Concerns
This structural demand pressure is happening in an environment with tighter financial conditions and significant loan maturities. Almost one-third of the $4.5 trillion outstanding CRE loans will mature by the end of 2025, according to Morgan Stanley. CommercialEdge, a CRE data provider, estimates around 16% of total office outstanding loans will mature by 2025. Meanwhile the net percentage of banks tightening CRE loan standards is close to historic highs.
Funding gaps can emerge as banks tighten since banks comprise approximately 60% of office and 65% of retail CRE loans, per RCA, a CRE data provider. Defaults result. Especially for older, poorly located buildings without amenities where repositioning the property is uneconomical, floating rate debt was used, the loan-to-value was above 65-70% (many analysts estimate private market values for office properties could decline over 30%, making high loan-to-value loans difficult to refinance), and structural demand is pressured.
Naturally, structural demand pressure and tougher liquidity conditions have cut public market valuations for public market office and retail REITs by over 40%. Retail REITs have gone from trading at 21x funds from operations (REIT earnings) in 2015, when e-commerce was 7% of U.S. retail sales, to 12x today, with e-commerce’s share of U.S. retail sales at over 15%. Office REITs have gone from trading at 20x pre-pandemic in January 2020 to around 10x.
A cheap valuation compared to history is a sign to buy, right? Not so fast.
A change in valuation is just one of three key components of total return. Osborne Partners normally invests with a multi-year horizon. And over that period, profit growth and dividends are usually larger components of total return. A healthy supply-demand dynamic is critical for both. Without it, cheap assets can get even cheaper.
So where can opportunities emerge?
Fears around CRE as a general category can mean indiscriminate negativity. Select property owners with favorable supply-demand dynamics can trade to levels where all three key components – 1) cheap valuation with catalysts to drive multiple expansion; 2) solid earnings growth; and 3) sustainable dividend income – combine to create an attractive upside vs downside. CRE, after all, is a diverse asset class, where pureplay office and retail assets are only 20% of the FTSE EPRA NAREIT Global Index. There is a wide range of fundamental environments across the remaining property types. Stress in one property type can create opportunity in another, like retail and industrial in the past. Generalized anxiety can create ripe investment targets in areas where there is restrained supply plus cyclical and structural demand tailwinds like outpatient healthcare and manufactured housing parks.
Beyond property owners, service businesses and asset managers can benefit from CRE fears. Service companies, for example, can help property owners reduce costs via outsourcing and execute projects to repurpose properties to better use, improving long-term economics for occupiers. Asset managers, within the real estate and alternative investment asset classes, can selectively fill the funding gap created by banks tightening lending by providing liquidity, plus invest opportunistically in attractive assets at discounted prices.
So, while there are clear risks to key parts of the CRE market, namely retail and office, opportunities will continue to emerge. The Osborne Partners Investment Team will strive to execute its disciplined approach to capitalize on these opportunities to create value over the long-term.