The Fate of Commercial Real Estate

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

Commercial real estate has been getting a lot of attention lately as an area of the economy that has struggled to adjust to post-pandemic norms. One of those headwinds has been the costs of borrowing. The combination of higher rates and the tightening of bank lending standards has raised the cost of capital. At the same time, there have been vacancy issues in commercial properties. Those issues do not appear to be broad-based though, as offices seem to be the area that has struggled the most.

Many of the business models in the commercial real estate space are based on leverage, so some of the concern centers around the impact this can have on the debt markets. Now offices are not necessarily a dominant share of real estate debt, accounting for less than 20% of commercial mortgage debt outstanding. However, a quarter of those office loans are set to come due this year. That means those loans will either need to be paid off or rolled over into new loans. That could prove challenging given that banks have already been tightening the belt on the credit they’re willing to extend to these properties.

The question then becomes: who owns these loans? In general, banks are the largest holders of commercial mortgages in the U.S. with a little under $1.8 trillion on the books, which covers all commercial mortgages, not just offices. A lot of that exposure appears concentrated in smaller regional banks when measured as a share of total bank assets. The larger institutions with more than $250 billion asset bases have only 6% of their assets in commercial mortgages, compared to more than 40% for banks in the $1 to $10 billion asset base range.

The fact that some of the largest, systemically-important financial institutions in the U.S. have relatively contained exposures to this reduces the odds of a contagion event if the trouble in offices becomes a bigger issue. With that said, that does not mean investors should be complacent about the risks. One of the things we’re watching is corporate bonds spreads in the banking sector. After spiking higher around the collapse of Silicon Valley Bank last March, spreads have started to come back in much closer to normal, suggesting that markets are not as concerned with their health. Additionally, the spreads on commercial mortgage-backed securities, which are essentially packaged pools of commercial mortgage debt, have drifted a bit higher. But that’s mostly been on the lower credit quality rungs like BBBs. The higher quality tranches like AAA have remained relatively contained and are a far cry from some of the spreads seen during the last systemic financial event around the Great Financial Crisis in 2008.

So what does this mean for investors? Well for one, investors should be careful to avoid the knee-jerk reaction to sell their real estate investments based solely on the prospects of one sub sector, especially since offices now represent a much smaller slice of the real estate universe pie than they have in the past. Offices are not reflective of the broader opportunity set, which these days includes alternative property types such as data centers, cell towers, warehouses and other sectors not facing the same headwinds. If anything, this may highlight the value of active management in this space, to focus on investments that have a more attractive fundamental backdrop.

So in summary, commercial real estate is facing dual challenges from higher rates and tighter lending stands, alongside vacancy issues in offices. While offices aren’t a huge part of the outstanding commercial mortgages, a quarter of their loans mature this year, which will require them to either pay off or refinance. The exposure to those loans appears largest in smaller regional banks at this time. The risk of a commercial real estate-triggered contagion events appears low for now, but ongoing vigilance is necessary. In this environment, investors should avoid hastily divesting from real estate, as offices are only a sliver of the broader opportunity set. Beyond the trouble in offices, there may be more promising investment opportunities than commonly perceived.

Thanks for listening! And please don’t hesitate to reach out with any questions.