May 1, 2023

Dark Clouds Over Commercial Real Estate Don’t Frighten Allocators

Prices are down and dire forecasts abound, but asset owners plan to modestly boost their CRE exposure.

Reported by Larry Light

Antonio Uve

The $20 trillion U.S. commercial real estate market is limping these days, the victim of pandemic disruptions, high interest rates and recession fears. But many asset allocators, who generally have been increasing their property allocations for several years now, think the current problems will pass—and expect small gains afterward.

Commercial real estate prices dove 15% over the past 12 months, per data from real estate research firm Green Street. Some sectors, most prominently offices and retail, are candidates for long-term shrinkage. As credit conditions tighten, commercial loan issuance has plunged, and so have the tradeable pools that package them, commercial mortgage-backed securities. CMBS yields leapt to 5.1% in mid-April from 2.6% in 2019.

Despite all the bad news, many pension funds and other asset owners are raising their allocation targets for CRE, albeit modestly in view of the sector’s challenges. After reaching a 10-year high of 10.8% last year, allocators are lifting targets to 11.1% in 2023, according to a survey by Cornell University’s Baker Program in Real Estate and consulting firm Hodes Weill & Associates. After all, institutions like to say they are long-term investors and are focused on how their holdings will fare over five or 10 years, not by next Tuesday.

The Big Players

Real estate has long been a key holding for public pension funds, with a 10.7% current allocation on average. It is the fourth largest holding behind stocks (No. 1 at 42.7%), bonds (20.8%) and private equity (13.0%), according to Public Plans Data at Boston College’s Center for Retirement Research. The New York State Common Retirement Fund is typical, sporting a wide-ranging CRE portfolio. Listing real estate as its No. 4 asset class, New York Common has one-third of its property investments in industrial and one-fifth in offices, with a similar amount overseas.

While commercial real estate values have withered, the fact remains that the sector did not fall anywhere near what stocks did last year—the S&P 500 dropped 19.5%. Some portions of CRE have shown resilience, such as industrials (mainly warehouses), boosted by the pandemic-fueled home delivery trend.

In its March review of asset performance, the California Public Employees’ Retirement System acknowledged the “downward pressure on values and returns” for real estate. Nonetheless, the report pointed out that real estate, along with its cousin, infrastructure, has been a definite winner for CalPERS over time. Property has fulfilled its “role as an inflation hedge, providing income stability and some value protection,” the report said.

Real assets (which include CRE and infrastructure) make up CalPERS’ second largest allocation behind stocks. Further, the study said, real assets have a commendable track record, having delivered “strong total returns” over the past 10 years.

Certainly, the present woes in the CRE space have not spurred any land rushes into distressed buildings in the hopes of scoring great bargains amid a temporary slump. Reason: There are still concerns in some quarters about how long real estate will be hurting.

In Canada, Caisse de dépôt et placement du Québec, which has large real estate holdings, has been reducing its commitment to shopping malls, which even before the pandemic had suffered a falloff in popularity. In Virginia, the Fairfax County Police Officer’s Retirement System is not eager to expand its CRE holdings, which are about 5% of its assets. “The probability is that more pain is to come,” observes Katherine Molnar, its CIO.

Bleak Houses

CRE has a daunting list of troubles. Banks are less willing to lend. A large batch of loan maturities are coming due in the near future, and many need to be refinanced at higher rates. White-collar workers are reluctant to return to the office, and office building vacancies are rising. Consumers no longer flock to malls, many of which are filled with empty stores. Perhaps the strongest peril confronting CRE now is that the U.S. is facing a long-threatened recession.

At the moment, loan defaults are still on the low side, although an upward trend appears likely, S&P Global Market Intelligence data show. Loans more than 30 days overdue rose at year-end to 0.65% of all CRE borrowings, from 0.58% as of September 30, 2022. Still, that’s down from 1% at the end of coronavirus-shocked 2020, following a brief recession. By comparison, CRE defaults peaked at 10.9% in 2010, following the global financial crisis, Federal Reserve data indicate.

Some high-profile stress already has surfaced. Office landlord Brookfield defaulted on $161 million in debt on a dozen buildings, mainly in the Washington, D.C., area. Blackstone defaulted on a $562 million loan for offices and stores in Finland.

To be sure, especially when it concerns huge property owners such as Brookfield and Blackstone, whose corporate finances are solid, these non-payments may well be just strategic. The deadbeat act aims to bring about negotiations with lenders for better rates and other terms, says Frank Haggerty, senior portfolio manager at Duff & Phelps Investment Management. “This isn’t unusual,” he says. “It’s the start of restructuring” talks.

But what if things get worse? These days, dire predictions are in the wind. Lisa Shalett, CIO for wealth management at Morgan Stanley, recently forecast “a peak-to-trough CRE price decline of as much as 40%, worse than in the Great Financial Crisis.” That would be quite a slide. Indeed, from the end of 2007 to 2009’s third period, the span of the Great Recession, CRE prices plummeted by about one-third, St. Louis Federal Reserve numbers show.

Other prognostications are not as dark. Property broker Cushman & Wakefield just projected a 16% worst-case price dip from now until the end of 2026. If the nation has a mild recession, which many expect, then prices will not suffer any more than they have, the firm contended; all the declines would be in the past. Cohen & Steers, the real assets-oriented investment company, puts the figure at 20% to 25% from today to its worst.

With $2.9 trillion in floating-rate commercial mortgages sure to reset over the coming 24 months, Morgan Stanley’s Shalett warned, many landlords face rate hikes ranging from 3.5 to 4.5 percentage points on their loans, up from low single digits they paid initially.

Banks, especially the smaller ones, are pulling back on commercial property lending. The failures of Silicon Valley Bank and Signature Bank, while not related to real estate, have added to the unease within the regional lender realm.

This can be seen in the dramatic tumble of commercial mortgage-backed securities, which package the loans for sale to investors. The downside for banks is that they now have a harder time offloading their mortgages to Wall Street, further hobbling their ability to lend in the future.

CMBS issuance has contracted mightily of late, beginning in 2022’s second half. Issuance fell by about one-third in 2022 from the year before, according to the Mortgage Bankers Association. In 2023’s first quarter, the volume plummeted to slightly less than $6 billion, from $29 billion in the comparable year-before period. The CRE mortgage market is roughly $4.5 trillion.

Commercial Mortgage-Backed Securities Issuance Falls as Yields Rise

$125b

5.4%

5.1%

$110b

$100b

$97b

$75b

$70b

$50b

2.6%

$56b

$25b

$29b

1.4%

2.0%

$4b

$10b

$0b

2019

2020

2021

2022

2023

Full Year Issuance

Year Through Mid-February

CMBS Average Yields

$125b

5.4%

5.1%

$110b

$100b

$97b

$75b

$70b

$50b

2.6%

$56b

$25b

$29b

1.4%

2.0%

$4b

$10b

$0b

2019

2020

2021

2022

2023

Full Year Issuance

Year Through Mid-February

CMBS Average Yields

$125b

5.4%

5.1%

$110b

$100b

$97b

$75b

$70b

$50b

$56b

2.6%

$25b

$29b

1.4%

2.0%

$4b

$10b

$0b

2019

2020

2021

2022

2023

Full Year Issuance

Year Through Mid-February

CMBS Average Yields

$125b

5.4%

5.1%

$110b

$100b

$97b

$75b

$70b

$50b

$56b

2.6%

$25b

$29b

2.0%

$4b

$10b

1.4%

$0b

2019

2020

2021

2022

2023

Full Year Issuance

Year Through Mid-February

CMBS Average Yields

Source: Mortgage Bankers Association, Bloomberg

Building the Future

Some real estate sectors stand to do better than others during a downturn and in the recovery. In the grand scheme of things, investors can take heart that CRE values, while down lately, still are ahead of where they have been. By Cohen & Steers’ measure, CRE value is up since 2012, even after the recent fall.

Meantime, investors with a taste for CRE can find some solace with real estate investment trusts, argues Dave Harden, of Summit Global Investments, which manages money for institutions. These vehicles have the advantage of being liquid, unlike other types of real estate investing. “And diversification is easy,” notes Harden, as REITs are traded on the stock market.

One heartening note: In the first quarter of 2023, the REIT index has nudged up almost 2% amid a broader stock market increase. If nothing else, this demonstrates the equity market’s expectations for the future are moderately positive. While all REIT categories were negative in 2022, this year they are almost all in the black—with the exception of retail (off 1.5%) and woebegone offices, down 16%.

The best hope is that interest rates will, at some point, ease. Then CRE can pick itself up and do what it likes to do best, grow. That, of course requires inflation to abate and the Federal Reserve to then relax its tightening campaign.

To Martha Peyton, global head of real assets research at Aegon Asset Management, a rate reduction in 2024 seems possible. “Then investors will be more settled,” she says. “And the worst will be over.”