More than meets the eye: Continued opportunities in commercial real estate

By Dan Brown, Jeff Huther and Sharon Whitaker
ABA Data Bank

High interest rates, weaknesses in some commercial sectors related to on-going shifts in economic activity from the pandemic and three bank failures have led to concerns that commercial real estate will undermine the health of the banking sector as a whole and smaller banks in particular. These fears have been fed by valuation price declines in some major downtown office properties as return to office rates have largely plateaued. From these collective trends, bank exposure to CRE has been cited as a potential, or perhaps even likely, source of additional bank failures.

But CRE is an incredibly diverse sector not warranting such sweeping generalizations. While downtown office buildings in large cities do indeed face severe headwinds and have gotten a great deal of media attention, downtown skyscrapers represent just a fraction of the U.S. CRE market — and many segments should prove to be much more durable. The top 25 banks hold about 65 percent of all CRE loans held by banks, but because of their size and diversity of holdings, these loans only account for 4.3 percent of their assets. Although regional banks proportionately have more assets in CRE, many regional banks have expressed confidence that their holdings are in more resilient subsectors. Regardless of any potential economic volatility that may arise in the short term, these resilient CRE subsectors will provide practical financing opportunities for banks over the medium to long term.

Components of CRE and resiliency of subsectors

The headline number cited for bank exposure to CRE is $2.8 trillion, 17 percent of all bank assets. From there, concerns arise from interest rate risk, credit risk or some combination of the two. Data on bank exposures to individual CRE borrowers is generally not available. The most detailed information for all domestic banks lists holdings of non-farm, non-residential real estate as 10 percent of their total assets ($1.7 trillion). This aggregate data, while easy to obtain (published weekly by the Federal Reserve), masks the broad diversity of CRE loans.

One of the difficulties in determining bank exposure to CRE is that loans to individual borrowers are often provided by multiple entities which have varying claims to the residual assets if the borrower does not meet its obligations. That is, even if the underlying real estate is ultimately sold for less than what a defaulting borrower owes, senior claimants (which likely include banks) will likely receive most or all of the principal they are owed.

A financing mechanism for CRE that allows for detailed analysis of the underlying collateral is the commercial mortgage-backed security market. The offering documents for these securities include information on the borrowers and business lines. As Figure 1 illustrates, the majority of CMBS is comprised of multifamily properties. Of the non-residential portion of CMBS, office makes up about 10 percent, industrial 3.9 percent, and anchored retail 5.8 percent. Therefore, broad assessments of interest rate and credit risk held by the banking sector need to be qualified by the underlying diversity of the sector.

Given concerns about regional banks, we looked at the CRE holdings of banks. While not all banks disclose detailed information in public data sets or legal filings, there are some banks that disclose sector breakdowns of CRE holdings when they report earnings. Figure 2 presents information disclosed in 2023 Q2 earnings reports and displays the distribution of CRE sector holdings. The data provide a confirmation that office exposure is a not large part of bank CRE portfolios. Similar to the CMBS breakdown, multifamily lending was larger than both office and industrial real estate lending. Among the banks reporting disaggregated exposures, multifamily lending represents around a quarter of CRE exposures. The “other” category includes a wide variety of lending such as mixed-use, hospitality, and other sectors that reflects the diversity of U.S. economic activity. Non-residential non-office (everything except for the blue and red boxes in Figure 2) is also a much larger share of the CRE space than what has been recently reported. As Figure 2 highlights, there was on average for the sample slightly more industrial loans on the balance sheets of banks (17.9 percent of CRE loans) than office loans (17 percent of CRE loans). Therefore, if office does not represent the majority of CRE lending, it is important to understand trends in these components of CRE to better assess overall performance of the asset class.

Despite diversity within the general CRE market, higher rates have negatively affected valuations for the broader market. As Figure 3 indicates, every component of CRE has experienced price declines over the last 12 months. However, these numbers show that key CRE components — such as apartments, self-storage and especially industrial properties — are up considerably over the last few years. Some of these subsectors are examined in more detail below.

Multifamily

Demand for housing remains strong across the U.S. with low inventories of houses for sale and construction tempered by high interest rates. Although rent growth has decelerated as of late, undersupply and population shifts in the United States since the pandemic still provide multifamily construction opportunities. In June 2023, rent growth nationally was unchanged, but that followed on the heels of record price increases so far this decade. Figure 4 shows rent price growth cumulatively over the last 3 years for select metro areas. Southern metropolitan areas were toward the top, with cities like Tampa and Raleigh exceeding 30 percent rent growth during the time period. Only San Francisco and Minneapolis experienced cumulative rent price declines since the start of the decade. This divergence nationally illustrates migration pattern changes within the U.S., but the existing supply of housing is clearly not sufficient to meet consumer preferences. In terms of quantifying the housing shortage, there are a range of estimates, but one of the most straightforward methods is the rental vacancy rate. Figure 5 shows that while the rental vacancy rate picked up slightly in Q1 2023, the rental vacancy rate in the U.S. is near its lowest point in about 40 years, suggesting a severe housing shortage. Coupled with migration patterns both within the United States, and even changes in preferences where people prefer to live within metropolitan areas, the risks to bank portfolios of multifamily CRE appear to be small in both the short and medium time horizons.

Construction in the multifamily space will hit records in 2023, but an oversupply of multifamily housing is unlikely. According to the National Association of Home Builders, there are currently 943,000 apartments under construction, up 24.9 percent compared to a year ago. This is the highest count of apartments under construction in 40 years. However, CBRE notes that most of these units are in areas that had the largest inflows of residents over the past few years, meaning builders are simply responding to demand. This construction surge is expected to grow the multifamily housing stock by 4.2 percent, which will help with the general housing shortage, but will not result in a significant oversupply of multifamily housing over the medium to long term.

Industrial

Macro trends such as onshoring, e-commerce and aging industrial properties should provide significant long-term demand for industrial real estate. Figure 6 shows industrial absorption from 2006 to Q1 2023, and leasing activity since the beginning of 2021 has clearly outpaced pre-pandemic trends. As of April of 2023, industrial rents were up 17.2 percent year over year, and the current vacancy rate of 4.7 percent is still well below the historical vacancy rate of 5.3 percent as well as pre-pandemic rates, which is further pushing up rents in industrial properties. In terms of regional strength, transit intensive areas seemed to have the most amount of leasing activity with the Dallas/Fort Worth market having the highest leasing activity in Q1 2023 (14,369,727 square feet) followed by California’s Inland Empire (7,515,794 square feet), and Chicago (7,386,787 square feet). In terms of the size of industrial deals, JLL notes that liquidity has been deepest for transactions below $50 million, and that higher rates are starting to impact larger transactions.

However, there is substantial evidence that there is a significant shortage of class A industrial real estate. According to a JLL research piece on industrial property age, the average industrial property is 42 years old. Within the industrial space, modern warehouses are typically smaller and more spread out geographically to meet quick delivery timelines, have higher ceilings to more efficiently store goods and are typically much more energy-efficient. Therefore, while higher interest rates may stall some deals in the short term, there are long term tailwinds in the industrial sector that will provide financing opportunities for lenders and suggest low risks for lenders of outstanding loans.

Storage space

Another unexpected winner of the pandemic was storage businesses. CoStar estimated the combined valuation of self-storage properties to be around $400 billion in Q1 2021. While declining home sales because of higher rates have coincided with normalized demand for self-storage spaces in 2023, data from Cushman and Wakefield shows that price valuations for self-storage spaces appreciated nearly 23 percent in 2022. Sales volume also increased 180 percent between 2021 and 2022, reaching $23.6 billion. This unprecedented demand propped up class B and class C storage facility properties that may not have been as desirable otherwise. Asking rents for storage properties have slightly declined since the peak in the summer of 2022. However, this follows a 30 percent cumulative increase in self-storage rents from 2020-2022 which is considerably above the long-term rate of increase.

Although the Call Report does not have information on CRE subsectors, banks’ preference to guarantee self-storage small business loans through SBA lending programs gives us a window into trends for self-storage projects. In 2021, the 7(a) program guaranteed a record 364 loans worth $484 million to small businesses in the self-storage industry. These loans were used to construct, refinance, or buy existing self-storage facilities. As Figure 7 shows, these projects were disproportionately in areas with migration inflows over the past few years. Texas had the most activity, with 15 percent of all self-storage 7(a) loans going to projects in the state, but other states with outsized self-storage lending activity include North Carolina, South Carolina, Idaho, and Arizona—all of which have seen sizable migration inflows. Therefore, if the housing market is bottoming out and more Americans become willing to relocate, self-storage can expect to continue to grow.

Data centers

Data centers are an emerging subsector within CRE that is also critically underbuilt and is growing rapidly. Data from CoStar estimated the combined valuation of data center properties was around $200 billion in Q1 2021. The North American primary market vacancy rates for data centers is 3.2 percent, the lowest reading ever. Figure 8 illustrates the market share of major data center corridors in 2022, with over 50 percent of activity occurring in Northern Virginia. Vacancy rates are critically low in Northern Virginia at only 1 percent. That submarket’s demand may not be fully met in the medium term, not because of financing issues, but rather a lack of available land and overloaded power transmission lines. Power transmission supply concerns will persist for the time being and estimated to continue until at least 2026. These constraints are expected to keep rents elevated in the key Northern Virginia market and should increase demand for additional properties in other markets as the subsector continues its rapid growth rate. CBRE presents Omaha and Salt Lake City as examples of localities with friendly tax environments that could see increased data center activity to offset constraints in other markets.

New trends will further drive demand for new or revamped data center properties. First, remote and hybrid work required many companies to turn to cloud service providers to ensure connectiveness of operations. Cloud services typically require hyperscale data centers (data centers with at least 5,000 servers and 10,000 square feet), which grew in number from 259 in 2015 to 700 in 2021. Looking forward, the emergence of more sophisticated artificial intelligence (AI) will require both new and reimagined data centers to process AI applications.

According to a CBRE report on AI’s data center needs, AI requires higher-performance processors which need more power and more cooling than a traditional data center. This may reduce demand for AI data centers in warmer areas with less water as well as areas of the country with power supply bottlenecks. On the plus side, while the data centers of today typically require proximity to top-of-the-line fiber optic infrastructure, AI data centers will not have to be as close to the end user or other data center facilities. This could ease pressure to build near current data center hubs and incentivize future data center construction in areas with adequate power and cheaper land.

Conclusion

While concerns have been raised about small bank exposure to commercial real estate, the data suggest that small bank exposures are likely to be concentrated in subsectors that have generally not been adversely affected by the work-from-home phenomenon. Intuitively, it is likely that the exposures that are most concerning — large office buildings in large cities — are the ones that are supported by large banks that have layers of protection (that is, banks that have taken on low-risk portions of loans that involve multiple lenders and were underwritten with relatively high levels of capital from borrowers). Given the diversity of the CRE sector, banks should not be painted with the broad brush of urban office space exposures.

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