June 19, 2023
Slowing economic growth, a challenging interest rate environment and turmoil in the banking industry are prompting warnings from the Federal Reserve of a potential crisis in the U.S.’s commercial real estate (CRE) market.
Approximately half the size of the U.S. stock market, the CRE sector is valued at $23.8 trillion.1 It encompasses all nonfarm nonresidential property in the U.S., a broad-based category that includes office buildings, retail stores, hotels and warehouses.
Here are three themes for investors to keep in mind as they evaluate the future of the CRE:
CRE debt holders face refinancing risks amid weak office fundamentals and higher interest rates
In the Federal Reserve’s May 2023 Financial Stability Report,2 52% of respondents surveyed cited commercial and residential real estate as a potential risk to the U.S. financial system, up from 12% in November 2022. The Fed noted that valuations for CRE remain near historic highs, even though widespread price declines occurred. The combination of elevated valuations, higher interest rates and particularly weak fundamentals in the office market spurred the Fed to warn of increasing refinancing risk and potential losses for CRE debt holders. Notably, these dynamics could pose a risk to banks, which held just over 60% of CRE debt at the end of 2022.
Source: May 2023 Financial Stability Report from the Board of Governors of the Federal Reserve
Remote work trends continue to loom over office properties
Since the pandemic-fueled shift to remote work, office buildings, especially those in central business districts (CBDs), have struggled with low occupancy levels and declining rents. Data from Kastle Systems, which tracks daily security swipes into buildings in 10 major U.S. cities, indicates that weekly average office occupancy in Q2 2023 continues to hover near 50%.3 Hybrid work environments and increasing layoffs reduce tenants’ square footage needs, resulting in higher vacancy rates and lower property valuations. A recent report from Bloomberg Intelligence4 noted Moody’s Analytics REIS forecasts the national office vacancy rate to end 2023 at 19.2%, up nearly 40 basis points from 2022 and over 200 basis points above pre-pandemic levels.
The outlook for office properties is concerning. However, we believe the markets may have already priced in these office woes. In 2022, the 19 office properties in the FTSE Nareit All Equity REIT Index fell nearly 38%, trailing the broader Index’s 25% decline, ranking as the worst-performing industry group. Year-to-date, through May 29, 2023, office REITs continue to lag the industry. Over the last decade, on a compound annual basis, office properties have generated negative returns on a 1-year, 3-year, 5-year and 10-year basis.5
A silver lining: The market’s major real estate index has limited exposure to office woes
Office’s impact on the S&P 500 Real Estate sector is somewhat immaterial, in our view. The S&P 500 Real Estate Index is comprised of 30 companies, including shares of 29 real estate investment trust (REITs). There are only two office REITs in the S&P 500 Real Estate Index, and one focuses on the life sciences industry. Combined, they represent just a 3% weighting in the Real Estate Index based on FactSet data.
The highest-weighted names in the S&P 500 Real Estate Index are leveraged to growth-oriented themes such as mobility (cell towers), cloud computing (data centers) and e-commerce (industrial). Per FactSet, these segments account for ~46% of the S&P 500 Real Estate Index, while the Index’s top ten constituents represent 63%.
The chart below, sourced from FactSet, highlights the industry diversification of the S&P 500 Real Estate sector.
Source: FactSet and American Enterprise Investment Services, Inc.
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