Some sectors of the commercial real estate market have been significantly affected by sharply higher interest rates.
Coming up, we dig in on commercial real estate and learn what segments of this market have been negatively affected and which segments are proving to be more resilient.
From Thrivent Asset Management, welcome to episode 52 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
Earlier this year, three banks failed: Silicon Valley Bank, First Republic Bank, and Signature Bank. While there were multiple factors that led to their demise, commercial real estate loans were at least part of the problem.
So, what exactly is going on with the commercial real estate market? To make sense of it all, we asked Steve Lowe, CFA, Chief Investment Strategist, for his thoughts and insights. Here’s what he reported…
Like the public securities markets, the private commercial real estate market has been significantly affected by sharply higher interest rates, which have not only depressed valuations, but have also greatly diminished transaction activity. This has contributed to a “frozen” environment in some challenged commercial real estate sectors; limited information on actual sales prices can diminish key information that lenders need to value properties in order to extend credit.
However, unlike the 2008 banking crisis, overall loan credit quality was not the fundamental problem. But there is now growing concern over the commercial real estate market, its impact on loans, and ultimately its potential effects on financial institutions, capital markets, and the overall economy.
Although the commercial real estate market is large, it is much smaller than the residential real estate market, and its financing sources are more diversified. The total amount of outstanding commercial real estate debt is approximately $4.5 trillion. This compares to the $12 trillion in outstanding residential mortgage debt.
Who owns outstanding commercial real estate debt? The banking industry holds about 38%, owners of mortgage-backed securities – which are packages of multiple commercial real estate mortgages – hold about 22%, and insurance companies hold about 15%. The remaining 25% of outstanding commercial real estate debt is held by real estate investment trusts (REITs for short), financial companies, pension funds, and other financial entities.
Unlike the more homogenous residential housing market, the commercial real estate market is considerably more varied with apartment, industrial, office, retail, lodging, and data center properties making up key sectors.
Of these major property types, office and retail are experiencing serious fundamental challenges, while apartment, industrial, and data center properties have remained quite stable, if not strong. The market has thus become somewhat divided with apartments and industrial sites being the darlings, while retail and office – especially class “B” office space – have become the problem children.
A growing concern is the wave of commercial real estate debt refinancing that will be required in the coming years. More than $700 billion of commercial property mortgages need to be refinanced this year, followed by more than $600 billion in 2024. Office and retail properties constitute about 30% of near-term pending refinancings. Many of these refinancings will depend on the owner’s willingness and ability to inject more equity, and the current lender’s willingness to restructure mortgage debt.
Secular changes impacting downtown office space and large retail centers are evident by increasing vacancy rates and diminished foot traffic. In just two short years – fueled in large part by the pandemic, electronic commerce, and the Amazon juggernaut – e-commerce retail sales grew about 15%, and now make up 22% of total retail sales. Needless to say, this has seriously eroded the value of certain types of retail properties.
The pandemic also catalyzed the major cultural change of working from home. This significant and ongoing shift in work has led to office vacancy rates moving from 12% nationally in 2019 to 17% today. In some major metropolitan areas, vacancy rates now top 30%.
These dramatic shifts in behavior have led to significantly reduced demand for retail and office-related real estate which, in turn, leads to reduced values for these property types. These are long-term, persistent trends that will have ramifications for property owners and their lenders. However, these negative trends will continue to be slow moving, unlike the residential real estate and mortgage crisis that had a sudden grip on the financial sector and the economy in 2008 and 2009.
We expect that banks and other financial institutions will be dealing with commercial real estate financing issues over an extended period of time. However, the ultimate workout solution for problematic loans will be aided by the amount of equity property owners contributed at the initial purchase or financing. Again, as we compare current reality the years leading up to the Great Financial Crisis, these lower initial loan-to-value ratios for commercial properties contrast with the almost non-existent equity that prevailed during the residential mortgage financing binge of the mid-2000s. Still, refinancings and debt workouts will be a long and arduous process for troubled office and retail properties.
Although the banking industry does have significant exposure to commercial real estate loans, problem areas remain mostly isolated in office and retail property types. Apartment, industrial, and other special purpose real estate loans are generally performing reasonably well. Furthermore, the banking system has significantly strengthened its capital position and improved its credit underwriting since the financial crisis.
As mentioned previously, lower loan-to-value ratios that were negotiated at the onset of many financings are expected to mitigate losses from commercial real estate-related loans. Finally, the residential real estate and mortgage market remains very healthy, with residential property markets being aided by very limited supply and strong consumer fundamentals supported by a healthy labor market. In short, the banking sector will have to deal with problem commercial real estate for some time, but fret not: it is not expected that these problems will metastasize into another existential crisis for the banking industry as a whole, or for the broader economy.
Commercial mortgages, like residential mortgages, have long been packaged into securities. These commercial mortgage-backed securities are structured with various risk tranches, with some senior tranches earning AAA credit ratings. Recently, some of these highly-rated securities, which have larger proportions of office-related mortgages in their structures, have traded at significantly higher yield levels given their elevated commercial real estate risks.
However, these high-quality senior tranches are not trading at the deeply distressed levels that would signal erosion of the credit protection offered by financial institutions. In addition, this segment of the commercial mortgage-backed securities market is quite small compared to its vastly larger residential counterpart, posing little risk to the financial system or significant individual financial institutions.
Publicly traded commercial real estate, as represented by REITs, performed very poorly in 2022, due to both the commercial real estate risk issues articulated previously, as well as surging interest rates which impacted the entire market. REITs, although still lagging the broader equity market, have been range-bound through the first four to five months of 2023.
The REIT market is quite diversified by property type. The challenging office and retail sectors of the REIT market make up less than 15% of the major REIT indexes. Other larger sectors, such as apartment, self-storage, cell towers, manufactured homes, and industrial properties have performed much better on a relative basis.
Collectively, REITs as an industry have done an admirable job of keeping debt burdens and maturity schedules manageable during the past few turbulent years. Higher interest rates and reduced credit availability will be continuing issues for the real estate industry, especially the secularly challenged areas of office and retail. However, this may also lead to longer-term diminished supply of necessary real estate, which could become a possible tailwind for specific REIT categories and companies.
So, what does all this mean and what can we conclude about the commercial real estate market?
The secular changes of working from home and electronic retailing will continue to depress valuation in segments of the real estate market, as troubled properties go through the long and protracted workout process. Although these segments will clearly hinder commercial real estate as a whole, we believe that the diversity of other strong property types, along with relatively prudent historical underwriting, and a still solid residential real estate market will likely prevent commercial real estate from becoming a contagion to the financial system or the economy as a whole.
We hope you found this special episode on commercial real estate to be informative. Thanks again to Steve Lowe for his help. And thank you for listening to Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. Email us at firstname.lastname@example.org with your feedback, questions and topic suggestions for future episodes. And as always, you can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.
All information and representations herein are as of May 26, 2023, unless otherwise noted.
Past performance is not necessarily indicative of future results.
Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.