How much longer before we get an honest to goodness commercial real estate crash? Your guess is as good as any. Yet, we keep hearing that it can start at any time.
The problem with fear when one is investing is that it clouds one’s vision. So rather than live in fear, it’s always best to drill down through what you see before making any bets.
It’s Scary to Drive Down the Streets
It’s a sign of the times. I’m sure anyone who lives in a big city is having a similar experience. But when I drive down the North Dallas Tollway, most office buildings, both single story and multi-story are fronted by For Lease signs. And the Tollway is not the only place, as this is happening throughout the Dallas Fort Worth (DFW) metroplex.
In fact, commercial real estate is so far under water these days that it seems to have spawned a new sub sector of You Tube videos.
For investors, this ongoing distress may be reaching a major decision point. The major question to ponder is whether this is the bottom or the beginning of an acceleration phase to lower lows as the debt levels threaten to wipe out equity.
How Bad Are the Numbers?
Unless something changes, the commercial real estate market (CRE) has a potential for $38 billion dollar or more in losses when foreclosures, defaults, and other forms of distress are summarized. This according to The Real Deal.com website. Of those loans, $18 billion are due for renewal within the next twelve months. Moreover, according to ratings agencies, three quarters of those loans will be difficult to refinance.
In a report, citing the Wall Street Journal, the Real Deal wrote that only 35% of office loans converted to mortgage backed securities were paid off in 2023 compared to 90% in 2021. That means that in three years, the commercial real estate market is on fumes, as the combination of higher interest rates and remote work increase the vacancy rates for most office buildings.
According to figures cited by the Real Deal, the national office vacancy rate is 13.8%, a 4 percent increase from 21017. Other cities, including San Francisco are reporting vacancy rates as high as 36%. In Chicago, Blackstone and New York Life are bailing out of distressed buildings, more than willingly taking on big losses. Rumors are that Blackstone is asking for $66 million for a building it purchased for $123 million. The loan matured in March 2023. Apparently, the owners are not able to pay the loan while banks are resisting offers to extend and renegotiate.
Meanwhile, New York Life is asking $56 million for a building tied to a non-performing loan with a New York based real estate firm.
Office Woes are Spreading
And while the office market grabs the headlines, the up until recently buoyant warehouse and logistics market is starting to slow. Warehouse REIT Prologis (PLD) just reduced its future guidance lower after beating its most recent quarterly earnings expectations. Warehouse vacancy rates rose to 5.8% from the prior quarter’s 5.2% in Q1 2024.
The price chart tells the story of how the market is suddenly responding to the sudden decline in fortune for the warehousing sector.
Is it Time to Buy or to Look Elsewhere?
The tried and true mantra of real estate is location, location, location. And it’s no different in the present, with one exception. If you’re a real estate investment trust (REIT) investor, it’s more about niche. Here’s what I mean.
If you’re using baskets of investments such as ETF’s it makes sense to be focused as broad baskets such as the Vanguard Real Estate ETF (VNQ). Its price chart illustrates investor’s indecision about real estate. VNQ is a diversified ETF with Top 10 holdings which don’t include any housing related REITs. In fact, its largest holding is Prologis.
Note the difference in the price chart between VNQ and apartment owner REIT Avalon Bay (AVB), which has just broken out to a new high. This bullish action in AVB illustrates where investors are starting to put their money when it comes to REITs
What May Buy CRE Some Time?
It is equally possible that the pending crash in CRE we’ve been hearing about for years may not fully develop. The reason is the actions of the Federal Reserve. The recently announced slowing in bond sales by the central bank, also known as a reduction in its QT cycle has led to a decrease in the U.S. Ten Year Note yield (TNX).
This decline in bond yields has likely bought the CRE sector some time. If the Fed eventually lowers interest rates, it may offer those REITs which have survived the ongoing difficulties an opportunity to refinance debt at more favorable rates. That won’t fix their occupancy problems, but it may buy them some time.
Bottom Line
Commercial Real Estate’s future remains murky at best. There doesn’t seem to be much of a reason to invest in the low occupancy riddled sector where the combination of rising debt and worsening cash flow continues to lead to defaults and where the risk of foreclosure is rising.
The housing related REITs are certainly not without risk. But the difference in investor’s perception of its potential is clear.
While lower interest rates will help both residential and commercial REITs, if you’re going to invest in the sector, the best bets currently are in housing related entities.
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