Commercial Real Estate: Going Granular

Transcript

The fastest rate hike campaign since the 1980s is causing financial cracks seen in bank turmoil. That has raised concerns over U.S. commercial real estate due to the sector’s reliance on bank loans.

The asset class is not a monolith. There has been increasing differentiation between real estate sectors post-Covid. We get granular as part of our new investment playbook.

1) Being strategic in real estate

We’re underweight real estate on a horizon of five years and beyond.

This view is based on the fundamentals of real estate investments made by private open-ended funds. We think valuations need to fall further due to the economic backdrop.

2) Differentiation in real estate

The differentiation in real estate is also evident in ways to invest in the sector. We believe private assets have the potential to diversify returns but are not suitable for all investors.

3) Pandemic hit real estate differently

The shift in work has cut into demand for U.S. offices as seen by higher vacancy rates.

Bank real estate lending concerns have added to market jitters. That has raised fears over the ability of these properties to refinance maturing debt.

We favor other property types like industrial real estate.

We see structural trends, like the expansion of e-commerce and geopolitical fragmentation, feeding long-term demand for industrial assets.

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The fastest rate hiking cycle since the 1980s is causing financial cracks. This has caused bank turmoil and raised concerns over U.S. commercial real estate due to its high vacancy rates and reliance on bank loans. Yet, we see varied risks across sectors, regions and investment choice. So we use our new playbook and get granular. We favor selected sectors such as industrial real estate as we see long-term forces like e-commerce and geopolitical fragmentation fueling demand.

Not a monolith

Notes: The chart shows the nominal capitalization rates for industrial, office and retail properties as implied by transaction values per quarter. Nominal cap rates are used to gauge the yield of property transactions.

We went underweight private growth assets from a view of five years and over in 2023’s first quarter. That includes broad commercial real estate – a sector we’ve projected negative returns for since June 2022. Yet, we know commercial real estate is not a monolith. Case in point: Capitalization rates – a yield metric that rises when valuations fall – have diverged. We expect retail cap rates to keep rising (green line in chart) due to pressure from e-commerce growth. Office cap rates (yellow line) are likely to rise too as they have since 2022. Investors are requiring higher cap rates for offices given rising interest rates and higher vacancy rates due to remote work. We expect industrial cap rates (dark orange line) to stay low relative to peers as we see higher earnings growth for the sector. Private assets can play a sizeable role in long-term portfolios, with potential to diversify returns, in our view. Private markets overall are complex, with high risk and volatility, and aren’t suitable for all investors.

Varied impact

The impact of the pandemic and bank turmoil on commercial real estate sectors has varied, too. Shifting work habits have cut demand for U.S. offices, based on a high vacancy rate of about 13% in March, National Council of Real Estate Investment Fiduciaries (NCREIF) data show. Banks’ exposure to real estate added to market jitters. Banks held 40% of outstanding real estate debt as of 2022’s third quarter, the Mortgage Bankers Association found. That has raised fears high-vacancy or highly levered U.S. properties will struggle to refinance debt, causing some to hit the market at cheaper valuations or default. That dynamic may create a funding gap but also chances to scoop up discounted assets – with risks. We see the gap as a bigger concern for U.S. assets: Private European valuations are cheaper than U.S. peers, MSCI and NCREIF indexes show.

We’re cautious on private commercial real estate valuations: We think they need to fall more as rate hikes raise financing costs and cool inflation. That combo will likely bite into commercial real estate income growth. Exchange-listed real estate valuations are largely lower across the U.S., UK and Europe as real estate investment trusts (REITs) sold off with stocks in 2022, indexes show. Public REIT values tend to lead private markets by a few quarters. Yet, REITs’ near-term correlation with stocks means they diversify portfolios less and may see more volatility when stocks fully price in economic damage.

Getting granular

Industrial assets – referring to warehouses used for distribution, manufacturing and research & development – have fared better than office. Industrial assets have a vacancy rate around 2% as of March, and their share of the commercial real estate market has doubled since 2016 to take up roughly a third of the market now, according to NCREIF data. This differentiation is why we get granular. We like industrial assets that could see structural trends feeding demand in the long term, like distribution and last-mile logistics centers. The expansion of e-commerce looks set to keep on driving demand as it has for decades, in our view. We also think geopolitical fragmentation will likely shift supply chains and prompt companies to re-shore operations – bringing manufacturing closer to home. Companies have already been storing more goods locally to prevent renewed supply chain snarls, U.S. Census Bureau data show. Some may aim to widen their web of warehouses to cut transportation costs and to support new manufacturing plants. Construction spending on the latter rose to about $147 billion annualized this March vs. $90 billion in March 2022, U.S. Census data show.

Bottom line

Financial cracks have fed concerns over commercial real estate’s outlook. We’re cautious on the sector. Yet, we go granular in our portfolio views. We see better value in real estate sectors that may see long-term demand, like industrial.

Market backdrop

The Fed signaled a pause may follow last week’s rate hike. The U.S. two-year Treasury yield sank 0.5% percentage points near 2023 lows, before reversing about half the fall by Friday when April U.S. payrolls beat market expectations. The data also confirmed a tight labor market and wage pressure keeping inflation sticky. That makes rate cuts unlikely this year, in our view. We think that’s true for the European Central Bank, too: it pointed to more hikes after raising rates again last week.

All eyes are on U.S. inflation data this week. We expect services to keep inflation sticky even as interest rates stay higher. We’re also watching survey data to see how the consumer is holding up. We expect pandemic savings to dwindle and further crimp spending. We see the Bank of England hiking again this week as inflation remains stubbornly high.

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