Open a major financial publication for the past several months and I’d offer you good odds that you’ll run across a piece warning of the looming demise of commercial real estate (CRE). Commercial real estate posited as “the next shoe to drop” has been a recurring theme and every once in a while, of course, it actually is. And oh boy does the story have teeth this time as covid delivered a sizeable shock to the office space system. Work from home ramifications are continuing to present an existential threat to the need for office space leases. Just think for a moment about your circle of friends and family, how much office space sits either partially or fully unoccupied now versus pre-pandemic just within your circle? The troubles are real and painful circumstances are all but certain to continue to be the result. But they aren’t enough to prohibit real estate as an active option for your diversified portfolio….and I’ll tell you why in the following paragraphs.
The broader case for inclusion
The compelling case is most easily seen from the chart below. The asset class not only pays a steady stream of growing income but has a very consistent track record of appreciation in value as well. Over the past 25 years, only the 2 years containing the Great Financial Crisis saw price declines.
Furthermore, when income is considered for a total return, 2009 was a net positive and 2008 wasn’t all that bad, especially compared to other risk assets. But along with this seemingly ever positive rising tide come questions as for when the gravy train is set to end, or when the shoe will drop. 2023 is shaping up to be a down year in prices as there is often a lag effect for when valuation adjustments actually hit CRE prices. More on that later. In the meantime, this present softness, when combined with the downright scary possibilities for some office properties can give pause to anyone considering whether now is the right time to be in the asset class.
Unfortunately, Commercial real estate and Office Properties are often conflated. As a result, it becomes all too easy to associate the problems and nasty headlines in the office space with the broader asset class of CRE. The National Council of Real Estate Investment Fiduciaries (NCREIF) maintains what is essentially the S&P 500 index of real estate. Just like stocks inside the S&P 500 are broken down by sectors, The NCREIF index is broken down by property type. As of July 2023, just 24% of the market value of the index is office property. The other 76% contains multi-family apartments, retail and industrial (think warehouse) properties. If you were to own the NCREIF index, or a portfolio of real estate that resembles its multi-sector approach, then you are diversified and have a better chance at being insulated from the problems brewing from just one of those underlying sectors. Case in point is the work from home dynamics that have put office properties in peril, have, in a way contributed to strength in apartments as household formations have increased.
Practicalities for building portfolios
For individual investors – save from the ultra-wealthy – I realize that it isn’t practical for financial, legal, and tax reasons to accumulate a diversified portfolio of direct real estate holdings. A large number of individual investors do own some pieces of CRE. You may think of someone who owns the building that houses their small business or perhaps owns a small number of homes or apartments. But a self-sourced and financed broad, NCREIF like portfolio isn’t realistic. However, it can absolutely be done and relatively painlessly through good financial partners who invest funds on behalf of clients. I’ll stop short of giving advice on specific ways and partners to go about this (I can’t give away everything for free – so feel free to contact me to further discuss!) just know the industry is chock full of both good and bad ones. Some may point to publicly traded REITS as a way to get this diversification, but I don’t hold this view. Yes, publicly traded REITS represent sound investment options from time to time but stop short of the tax, diversification and risk mitigating benefits that can be acquired through direct CRE exposure.
To be clear, my case here is to push back against the narrative that CRE is a ticking time bomb across the board. Instead, it remains worthy of a spot in a diversified portfolio (especially where tax considerations are a priority). That isn’t saying that loading up the truck on equity pieces of direct CRE is right at this moment either. But an entry point looks bright amidst the prevailing angst. The dramatic rise in interest rates during 2022 created a generational bear market in bonds, pushed down stocks and by no means left CRE unscathed. Property valuations have been declining as incoming appraisals and/or transactions reflect the impact of higher interest rates.
This August 2023 entry point gains support by the fact that, outside of office, those valuation pullbacks are indeed nearly entirely driven by the rise in interest rates. The fundamentals are sound: vacancy rates are low and lease rates are strong (a factor thoroughly reinforced by the recent bout of inflation). These lease rates are a brewing positive for CRE owners out there who have leases coming due in the near term and should be able to obtain higher rates of income as those leases are “marked to market”.
Is the worst priced into office?
I have no doubt that there is a contrarian or two reading this and asking whether it’s time to go against the grain and just go out and buy up the beaten down office properties with seemingly poor prospects. I hear you and we are kindred in spirit. Who knows, 2023 may very well turn out to have been a moment, as is often the case, where the “blood in the streets” meant it was truly a time to buy. However, offices have the opposite problem as the rest of the CRE field with leases and rather than having the inflationary benefit of marking up, they will very likely be marked down to market as they come due. The need for less office space will keep the bargaining power firmly on the side of tenants. Furthermore, many office buildings will be defaulted on as they are unable to refinance their debt and the property is handed over to the banks.
If you are adventurous and have the skill, then have my admiration for your ambition. After all, Voya recently shared that 90% of office vacancies around the country are within 30% of the properties! But my opinion is there isn’t a need to rush, and many innings of this office property cycle need to play out. Various regions and assets vary, but I believe COVID simply expedited an inevitable trend. Instead of the work from home trend that was modestly under way and set to play out over a decade or so, it was dropped on our doorstep in an instant. WFH won’t be ubiquitous but is here to stay in a major way and we’ll need time to grow into office space. Instead of jumping in, one strategy might be to figure out how to line yourself up to participate in financing the handoff as buildings get handed over to banks.
Conclusion
To wrap up, if you haven’t already, you are quite likely to encounter incoming headlines about problems in the commercial real estate market. Many of these articles will have truth to them and many properties will indeed blow up. Is it the next shoe to drop? I’m more of the mindset that if the shoe fits, then wear it. I can’t emphasize this part enough, CRE is not like the S&P 500 where you can drop your money into an index and get exposure to the asset class. Real work must be done (by you or through trusted financial partners) because bad projects go to 0. But the juice is worth the squeeze as they say given the tax advantages and return enhancing/risk reducing features virtually demand CRE remains in the conversation of well-built portfolios. And again, I’ll reiterate that if you don’t know where to start to reach out. I could talk about the subject for days and would be happy to take the call.